Why cheap beans don't make cheap coffee

World coffee prices are at their lowest level for 30 years, having fallen by 50% in three years. And yet, coffee prices remain high in shops and cafes. BBC News Online explains why.

Why are world coffee prices low?

World coffee prices are low because there is an oversupply of coffee, the world's second most valuable commodity after oil.

Many coffee growers across the developing world have produced too much coffee which they have simultaneously released into the world market.

The global supply is estimated to be about 8% above demand, according to Oxfam.

This has depressed world prices.

Why have the coffee exporters flooded the market?

Coffee producing countries used to control the supply and the price of coffee, in accordance with the International Coffee Agreement.

But in 1989, coffee exporting states failed to agree on quotas.

This happened partly because countries that never used to produce coffee begun to grow the crop, thus adding to an already mature market.

Subsequently, many countries flooded the market with reserve coffee that had previously been held back to keep world prices high.

At the same time, consumers' demand for coffee fell in many parts of the world, in part due to competition from other drinks.

So world coffee prices halved and have remained volatile ever since.

Was this break-up of the coffee-makers' cartel good news for coffee drinkers?

Not immediately: It took four years for the supermarkets to slash the price of coffee, and then only by 20%.

And when prices bounced back in 1994, up 50%, the retail price rose immediately and stayed high despite another fall in world prices in 1995.

Are the supermarkets ripping off consumers?

If only it was that simple.

From bush to supermarket, some coffee beans can change hands as many as 150 times.

Most coffee farmers sell their coffee beans to local coffee dealers who will transport and store the coffee beans until they sell it on, sometimes to other dealers.

The processing and handling of green, or raw, coffee adds 50% to its price, according to estimates by the Fairtrade Foundation which works for a better deal for coffee producers.

Much of this goes towards paying for transport, storage and handling costs.

Then, as part of the exporting process, freight and insurance will add about 10% before an importer takes over.

So what happens after the coffee arrives in the UK?

The importer, which is usually a major trading company, will then incur port and customs charges before the coffee moves to a large coffee roasting company.

In the UK, where many people prefer instant coffee, the coffee beans go through a costly spray-drying or freeze-drying process.

Alternatively, the coffee is roasted and ground to make filter coffee.

Only then will the coffee tins and jars be filled, labelled and transported to the supermarket shelves or to the coffee shops.

Along this long chain, everybody will take a cut of the profit.

But why are coffee prices in the supermarkets and cafes stable while world coffee prices fluctuate?

Many of the expenses incurred - for example taxes, customs charges and wage costs to coffee roasters - are fixed.

The fixed costs account for a large proportion of the price paid by consumers in the UK, while the fluctuating world price for coffee is but a small part of the total.

In addition, the big coffee processors, like for example Kraft, Sara Lee, Procter & Gamble and Nestle, will hedge their risks using financial futures contracts, and this will stabilise the prices they pay for green coffee.

So what are the reasons for the fluctuation in world coffee prices?

When the supply of coffee is great, the world price of coffee falls, sometimes to levels below the actual cost of growing coffee.

Many farmers then go out of business, or they stop growing coffee to grow something else instead.

Consequently, the world supply of coffee falls, and prices rise again.

Once again, this makes it worthwhile for farmers to produce coffee instead of other crops.

As they do so, the supply rises and prices fall again.

In other words, coffee is a cyclical crop.

Are there other factors that influence the level of world coffee production?

Sometimes storms, a late frost, crop disease, war, exchange rate fluctuations or other unpredictable events can force coffee farmers out of business.

While at other times, centralised political decisions to produce more or less will affect output levels.

Small farmers are often encouraged to grow more coffee by governments eager to boost their exports earnings.

These governments are sometimes encouraged by the International Monetary Fund and the World Bank to produce more.

Is this bad advice?

Seen in isolation, it is probably good advice.

But if many countries and many farmers are advised to produce more when coffee prices are high, the end result is invariably a slump in world coffee prices caused by a dramatic oversupply of coffee on the world market.

Coffee traders in the financial markets are also often blamed for causing the world coffee price to fluctuate by placing speculative and sometimes market-moving bets on tomorrow's prices in the financial futures market.

What are the consequences for coffee producers?

Many countries rely heavily on their coffee exports as a source of foreign currency.

Coffee can make up about three-quarters of some countries' exports earnings.

Between seven and ten million farmers make a living from growing coffee.

Many of them are working on small farms which are unable to cope with downturns and too weak to take advantage of the good times.

The Economist explains

Why are coffee-growers unhappy?

COFFEE has many devoted drinkers. Its appealling aroma and caffeinated kick mean that 83% of all American adults drink it, 63% of them on a daily basis, according to a survey from the National Coffee Association. Yet despite the strong demand for coffee, some suppliers are unhappy. In Brazil, which produces a third of the world's coffee beans, farmers are striking over falling prices and burning sacks of coffee in protest. Why are coffee-growers feeling the strain?

There are two main varieties of coffee bean: arabica and robusta. The former, which accounts for around 60% of the world's crop, is considered superior and fetches higher prices; the latter is a hardier crop, resistant to leaf rust, but has a more bitter taste. Most of the beans produced in Brazil are of the arabica variety. But these beans now fetch around $106 a 60kg bag, less than half of what farmers could get for them a couple of years ago. Farmers in Colombia and Ethiopia, who also produce arabica beans, are suffering too. The reason is that production of coffee, and of cheaper robusta beans in particular, is booming. Vietnam has gone from growing almost nothing a decade ago to producing 25m bags of robusta beans a year today. The result is an oversupply of coffee.

This hurts producers of arabica in particular, for several reasons. First, consumption in the developed world—American, European and Japanese drinkers consume more than half the world's coffee—is flat, and the recession has squeezed the profits of big food companies such as Nestlé and Kraft. They have taken to blending cheaper robusta beans into their products to maintain their margins, causing the price of robusta to fall more slowly than that of arabica. In the developing countries such as China, Indonesia and Brazil, meanwhile, where the emerging middle classes are discovering the joys of coffee and the market is growing by around 5% a year, robusta is the bean of choice. To make matters worse for arabica growers, falling prices have been accompanied by rising costs: coffee is still largely picked by hand, and wages are rising fast in Brazil and Colombia. Many Brazilian and Colombian farmers invested to boost production of arabica in response to the high prices of 2011, which has added to the oversupply and further depressed prices. And good weather in Brazil means that this year's crop has turned out to be unexpectedly large. That is why Brazil's farmers are striking, and are demanding more protection, in the form of fatter subsidies, from the state.

Farmers who grow arabica beans tend to be specialists, and do not plant other sorts of crops (which is the usual way for farmers to insulate themselves from volatile prices for a particular crop). Prices for sugar cane, a potential alternative, are also low. Aficionados' demand for the fanciest coffees, which fetch higher prices, is healthy, but for farmers to move upmarket takes time and expertise. Indeed, discerning coffee drinkers are also feeling the pinch, because the Central American countries where the finest coffee is grown, including Guatemala, Nicaragua and El Salvador, have been hit by leaf rust, which could wipe out 30% of this year's crop. So even while arabica beans fetch low prices on commodity markets, the price of the fanciest beans is going up. A storm in a teacup it ain't.

Coffee prices

Brewed awakening

Plenty of coffee, too few drinkers

Mug’s game

NOT everyone appreciates the pungent smell of roasting coffee. Just ask the authorities in Brazil, who have been faced with farmers burning bags of beans and chanting slogans borrowed from recent nationwide protests to demand fatter state subsidies. The farmers are upset by falling prices: their beans now fetch around $106 a 60kg bag, a four-year low and less than half what they could get a couple of years ago. A reversal looks unlikely soon.

A third of the world’s coffee is grown in Brazil. Along with other countries that mainly cultivate the tastier and pricier arabica-bean variety, it faces two problems. First, the traditional markets for their wares are saturated. Growth in Europe, America and Japan, which between them glug over half the world’s coffee, is flat. Second, in places like China, Indonesia and Brazil itself, where coffee is an affordable luxury for the middle class, the market is growing by around 5% a year. But these drinkers are filling their pots with cheaper robusta beans—what Kona Haque of Macquarie dubs the “emerging-market coffee”.

Strong demand for entry-level coffee—40% of the world’s coffee crop is now robusta beans—has enabled Vietnam to go from almost nothing a decade ago to producing 25m bags today (see chart). Worse still for arabica producers, the recession in Europe has hit demand and squeezed profits for roasters. These processors, including big food firms such as Nestlé and Kraft, have responded by blending cheaper robusta with arabica. As a result robusta prices have not fallen as fast as arabica. Even so, the narrowing gap between them has not yet prompted beancounters to reintroduce the costlier variety.

Nor is the supply of arabica beans likely to fall. In response to the high prices of 2011 Brazilian farmers invested heavily in new acreage and improved yields with better husbandry and more fertiliser. High prices also convinced Colombian farmers to replant many coffee plantations with more productive bushes. What’s more, the bumper harvest of 2012, an “on” year for Brazilian coffee bushes, should be followed by an “off” year as the bushes’ yields naturally fall after their exertions. Yet good weather means that even this year’s “off” crop is a bumper one, with the prospect of another “on” year to come.

Low arabica prices are accompanied by rising costs. Coffee is a labour-intensive crop; picking is still largely done by hand. Wages in Brazil and Colombia are rising fast and production costs are above prices. Planting other sorts of crops, the usual response to agricultural boom and bust, is not an option. Prices for sugar cane, a potential alternative, are low. Coffee is mainly grown on small plots by farmers who have known nothing else.

Consumers ought to benefit from low prices, but discerning drinkers will still be disappointed. Demand for the fanciest arabica beans is healthy, as the global proliferation of coffee chains shows. Much of the finest coffee is grown in Central America in places such as Guatemala, Nicaragua and El Salvador. That region has been hit by leaf rust, a fungal disease, which could destroy 30% of the crop this year. Cutting back plants to deal with it is set to hit production next year, too. For the tastiest coffee, there is no chance of a cheap shot.

From the print edition: Finance and economics