Position Management for Roasters

Position Management forCoffee Roasters

David JoelsonNCA ConventionMarch, 2014

Position Management – Who Cares?

1. The market is on a ferocious bull run

“I sure hope we bought lots of coffee when prices were lower…what’s this going to do to my P&L this year?”

2. The market is dying, looks like it could go to zero

“I hope we don’t get stuck with too much high priced coffee….will we be competitive? Will our customers who locked in prices be competitive?”

3. The plant just shut down.

“WHERE ARE THOSE GUATS?”

Position Management

1. Risk Management -- Managing Exposure to Market Prices

“I don’t want to bet the company’s fortunes on our ability to call the market correctly every year.”

2. Inventory Management

“Prudent inventory management should not cause extreme price exposure”

Manage risk and inventory separately. They do not overlap

OK Slight Overlap

Differential Mgt.

4 Myths What Matters Having a strategy Measurement/Data “Hidden” risks derived from market price moves Having a futures account

I. Managing Exposure to Market Prices

Myth 1: “We only buy specialty coffee so we have no exposure to market prices”

Source: J Ganes Consulting, LLC

Guatemala SHB FOB Price vs C Market2004 -- 2008

60

80

100

120

140

160

180

Cen

ts p

er L

b

C Mkt

Guat SHB

Myth 2: “You’re a roaster therefore you are always short”

What is your true position before any hocus pocus?Short: profit from a down market

Long: profit from an up market

Neutral: Market has little impact on results

True position can differ by business segment

Hedge: Used to offset true position

Myth 3: “I got a ton of inventory on hand so I can turn off the screen for at least a week”

Combines independent items: inventory levels and market exposure.

Use of physical coffee to manage market risk is expensive and inflexible

Myth 4: “The most important thing is how much priced coverage we have”

If you maintain constant priced coverage…Must buy replacement every day

So how does it matter how long you are*?

*OK it matters a little:Length of coverage will determine WHEN today’s purchases will hit your P&L

Impact of Market structure…in a normal market will pay extra for distant coverage approx. 1 cent/Lb per month (Arabica)

So What Matters

When do you add coverage

When do you draw down coverage

A disciplined approach, informed by your market view but not wholly dependent on it

Priced Coverage MatrixNew York Coffee Futures Example

(coverage in weeks) Market View

Market Price Bearish Neutral Bullish

< 72 13 – 15 16 – 18 19 – 21

72 – 106 11 – 13 14 – 16 17 – 19

106 – 121 9 – 11 12 – 14 15 – 17

121 – 154 7 – 9 10 – 12 13 – 15

> 154 5 – 7 8 – 10 11 – 13

Assumes reversion to the mean

Within a price range, target longer when bullish, shorter when bearish

For a given view, extend at low prices, draw down at high prices

Estimated Colombian Diffs:Volatile but Within a Tighter Range

Source: ICO Indicators and 2nd position NY Futures used to estimate differentials. YMMV.

Monthly average futures has a range of 240 cents, estimated Colombian diffs 80 cents.

Differential Coverage MatrixColombian Example

(coverage in weeks) Market View

Market Price Bearish Neutral Bullish

< 5 15 – 22 22 – 28 26 – 40

5 – 8 13 – 18 16 – 21 17 – 30

8 – 14 10 – 15 12 – 14 15 – 28

14 – 23 9 – 12 10 – 12 13 – 20

> 23 8 – 10 9 – 11 11 – 13

Source: ICO Indicators and NY Futures used to estimate differentials. Monthly Averages used. YMMV.

Policy matrix on differential coverage is normally limited on the short end due to length of physical pipeline

How to Calculate Coverage

What is included in price coverage?Priced purchases

Green Inventory (if priced) and Work in Process (green basis)*

Finished Goods (green basis)*

Futures and delta-equivalent options

Differential Coverage – Inventory* plus open purchases

Recommendation: convert Tonnage to Weeks using annual average consumption

*If LIFO accounting, anticipated year-end inventory is not included in coverage

Priced Coverage

Hidden Risks Associated with Markets

Risk Market Condition Mitigate Risk

Supplier defaults causing replacement at much higher price

Rising Market • Defer pricing until shipment (hold futures)

• Track M2M by supplier

Supplier ships late/not at all disrupting operations

Rising Market (usually)

• Alternative blends• Awareness of spots• Early warning signals

(e.g. no pre-ship sample)

Lack of spot coffees to handle unanticipated needs

Inverted market( = scarcity & rising prices)

• Alternative blends• Sales lead times• More inventory

Customer orders exhibit “adverse selection” depending on the market

Moving Markets • Track customer sales & enforce contracts

Quality Risk Extreme markets • Pre-shipment samples

Operational Risk: A Yacht called “The Unable”

Moving Markets • Get educated• Segregate duties• Spot checks

Futures Account: Should you have one? Advantages

Concentrated orders

Reduce counterparty risk – hold your own futures

Improve control

More techniques available – options, swaps, switches

Protected by SEC/Exchange rules Role of clearinghouse – Mark to Market fully funded

DisadvantagesInitial & variation margin – risk of cash outflow. However:

Variation margin (for a long position) is required in falling markets …when less cash is required to finance inventory

In rising markets, variation margin will generate positive cash

Increasingly complex accounting

Cost of broker commission (small)

Tips ToolsTerms

Vendor Managed Inventory (VMI)?

II. Managing Inventory

Inventory Management

Conflicting objectivesEnsure supply

Keep inventory low (cash/quality/leanness)

ChallengesUncertain demand

Forecasts become less accurate at the lowest levels

Long/variable supply line

Tip: Classify Green Types for Inventory ManagementGreen Type General Characteristics Strategy

Unique

Limited supplies Seasonal Few or one supplier No substitutes Expensive Unique: cup or story Strong strategic reason for being

Hi inventory target when its available Monitor quality Monitor sales closely Seek substitutes or complementary products

Common

Plentiful supplies Multiple suppliers Substitutes Available all year Used in many products

Tighter inv. target Leave 15-20% room in position Watch the spots

Tip: Weekly supply chain or “S&OP” meetings

Focus on Data Identify & Understand Variances

SalesProductionGreen usage

Especially Watch Unique Items

Example: Explore why we used so much more Colombian Coffee than planned last week. Is this a real change in requirements or just a shift between weeks?

Purchasing Terms: What is optimal for you?

Terms Coffee Price Cash Required

Admin Effort

FOB Origin Lower Higher Higher

C&F/CIF

Ex-Dock

Ex-Whse./Del’d

Vendor Managed Inventory (VMI)

Higher Lower Lower

Within these choices, still need to clarify other terms such as:•Quality rejection terms•Payment terms•Buyer influence on sourcing: Relationship coffees? Preferred shippers?•Rules/costs around taking coffee late

R E S P O N S I B L E F O R I M P O R T I N G

Benefits & Costs of VMI

Benefits to BuyerOne time cash (reduced inventory)

Less admin effort

Suppliers have increased flexibility

CostsSupplier charge for holding coffee

Premium for delivery timing uncertainty

Reduced competitive bidding