Alfred Marshall, the 19th century British economist who analyzed the laws of supply and demand, knew that prices rise when the supply of a product decreases and demand increases. But Marshall was never in the coffee business.
To the casual observer, the current state of supply, demand and pricing in the coffee industry flouts logic. Coffee-bean supplies are approaching their lowest levels in 11 years — with the high-grade arabica beans coveted by companies such as Starbucks (NASDAQ:SBUX), Green Mountain Coffee Roasters (NASDAQ:GMCR) and Peet’s Coffee & Tea (NASDAQ:PEET) particularly hard hit.
At the same time, demand for the beverage is soaring, driven by an improving economy and increased coffee consumption among young adults. Against that backdrop of dwindling supply and rising demand…coffee futures fell to $1.74 last Thursday — their lowest price in 17 months.
What’s going on here? And what does it mean for shares of companies with a big position in coffee?
At this time last year, coffee prices were heading toward the stratosphere. By May, coffee had reached nearly $3.09 a pound — the highest level since 1977. But since then prices have fallen by nearly 35%.
Chalk up the volatility to two big factors: bad weather and commodity speculators. Coffee prices rose in part because Colombia, a major producer of high-end arabica beans, has had four years’ worth of meager harvests due to unusually heavy rains.
Prices fell dramatically on expectations that Brazil, the world’s largest coffee producer, would experience an unusually strong harvest. That’s exactly what happened back in 1977.
But while Brazil will have a good harvest this year, it’s now apparent that the crop won’t be as robust as initially expected. To make matters worse, Brazil’s production could fall by as much as 7% next year, likely triggering a coffee-supply deficit in 2013-2014, according to Brazil-based Archer Consulting .
Still, a potential global shortfall of arabica beans doesn’t concern coffee-company executives as much as wild commodity-price swings. Last year, Starbucks CEO Howard Schultz railed against hedge funds and others whose “financial speculation” had driven a spike in commodities prices “not based on supply and demand.”
“This has resulted in every coffee company having to pay extraordinarily high prices for coffee,” he said.
Whenever the price of a commodity spikes, it pressures the margins of companies that rely on those commodities. That’s true whether they’re buying steel and aluminum to manufacture cars or beans for coffee.
Companies obviously will try to pass those costs along to consumers, but “commodity-fueled inflation” still weighs on earnings. Cases in point include ConAgra (NYSE:CAG), Kraft (NYSE:KFT) and General Mills (NYSE:GIS), all of which are bracing for a possible impact on earnings later this year.
The bottom line: Whether the blame for coffee’s price volatility lies with speculators or Mother Nature is beside the point. It’s only a matter of time before Marshall’s laws of supply and demand kick in and coffee prices start rising again.
Not only will a rise in coffee prices impact retailers such as SBUX, GMCR and PEET, but it will also extend to Kraft and J.M Smucker (NYSE:SJM), which produce the Maxwell House and Folgers brands, respectively. It also will impact food chains such as McDonald’s (NYSE:MCD) and Dunkin’ Donuts (NASDAQ:DNKN), for whom premium coffee offerings are becoming an increasingly important niche.
Consider, too, that valuations on many of these stocks are really high: SBUX trades at 25 times earnings and PEET at 37 times earnings. Before its plunge earlier this month, GMCR was trading at 23 times earnings.
Now is probably a good time for a coffee break.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned stocks.