25 November 2024
Weather anomalies and coffee production vulnerability
Agriculture crops have been always exposed to weather anomalies. This variable is one of the main reasons why commodity output and prices have long been extremely volatile, as showed by the comparison of commodity derivatives prices to equities and currencies.
Coffee is certainly an agriculture crop vulnerable to weather shocks, considering its phenology and geographical origin. Over the past three years, in particular, the coffee industry has collectively witnessed the consequences of these weather anomalies firsthand.
Coffee growing is extremely sensitive to climatic variations. The Arabica plant (60-70% of global coffee is Arabica type) can resist temperatures outside its range for short periods of time. It might only take a couple of hours for the tree to die if the air temperature drops lower than -4°C, causing the water in the plant cells to freeze. Moreover, the coffee plant relies on a specific pattern of rainfall for its growth cycle. Adequate rainfall is crucial to initiate flowering, followed by a dry period that facilitates fruit development. Subsequently, another round of rainfall is needed to prevent flower abortion.
Over the last three years weather patterns have been often erratic in key coffee origins. For instance, a brief frost event in 2021, following a severe drought, caused a reduction of 12- 14% of the Brazilian Arabica crop. In 2022, rainfall above historical norms, and excessive cloud cover from the La Niña weather phenomena, lowered Colombian coffee yields by 10%. 2023 was the hottest in Brazil's historical records and the heat continued into 2024. Until early October, Brazil has been experiencing an unprecedented drought, the most severe in 70 years, resulting in strong a delay of Arabica trees’ flowering (5% against the historical average of 20% at the end of Q3). These weather anomalies have caused significant variability in coffee output and substantial fluctuations in coffee prices.
Anticipating these weather anomalies, which are projected to become more frequent and intense according to the IPCC studies, is of utmost importance. For coffee industry players, manufacturers, traders, and farmers, it is crucial to comprehend the potential impact on the quantity and quality of coffee available, to assess the viability of their business both in the short and in the long run.
Challenging in forecasting
The assessment of climate change's potential impact on coffee, particularly in relation to weather shocks, has been extensively studied in the literature*. However, these models have certain limitations, especially when it comes to evaluating the frequency of weather events.
One of the primary limitations of "frequency models" is the availability of data**. Most studies rely on monthly weather or climate datasets, while weather extremes - as described above - often occur at sub-monthly temporal scales. The absence of disaggregated coffee data is another constraint. Many countries only report annual exports, or country average data on farmers’ practices (irrigation, use of fertilizers, etc.), but climate anomalies rarely occur uniformly across time and space. This lack of detailed information makes it difficult to capture the localised impacts of weather shocks on coffee production. Furthermore, there is a scarcity of high-resolution climate data, especially in tropical mountainous regions – where most of the Arabica coffee originates.
The difficulty in anticipating weather anomalies and in turn their impact on coffee output exposes coffee manufacturers to supply uncertainty and price volatility. A sudden and significant decline of coffee availability from a crucial origin may challenge the sourcing supply chain, leading to stock depletion, production delays, or interruptions. For those coffee producers known for their specific origin or flavour profile, a sudden decline in availability and origin substitution may not align with consumer preferences. Failing to anticipate a sudden price increase can erode profit margins, while a lack of expectation for a price decline can lead to missed opportunities in terms of more effective budget allocation.
Considering the challenges associated with predicting the timing and impact of weather anomalies, it is crucial to explore effective strategies for coffee producers and buyers to manage these uncertainties.
Mitigations for price volatility
Alongside the ongoing research efforts to enhance forecasting models, coffee buyers and sellers can at least protect - in the short term - their business from price volatility leveraging a tool which is about 150 years old, financial derivatives of agriculture commodities.
These are financial instruments that allow farmers, traders or manufacturers to manage their exposure to price fluctuation in agriculture commodities. The most common instruments are futures and options.
In the example of the 2021 arabica rally, triggered by the frost event in Brazil, a coffee producer could have bought the December 2021 delivery futures contract in May 2021 at 145 Usc/lb, ahead of the Brazil frost period (June-July) and the flowering period (Sept-Oct), as a prudent approach to secure a fixed price. Alternatively, purchasing a call option in May 2021 with a strike price of 170 Usc/lb would mean paying an insurance premium that gives the right to buy at 170, should the market trade above this level. Just like coffee buyers, growers and sellers can leverage futures contracts and options to manage their exposure to price fluctuations in the agriculture commodities market.
While these strategies have been utilized for centuries, there has been a notable increase in their use, particularly for options, in recent years. Options serve as a valuable insurance tool, requiring a premium to be paid for protection against unexpected events. According to data from the CME (Chicago Mercantile Exchange), the use of options as price insurance in agriculture markets has been steadily rising, in line with the growing evidence of agricultural supply shocks. This trend reflects the recognition of options as a valuable risk management tool in the face of increasing uncertainties in the agriculture sector.
However, it is important to note that the use of financial derivatives is complex and requires specific expertise, knowledge, and infrastructure to implement effectively. It is essential to have a thorough understanding of these instruments and their associated risks before engaging in derivative trading.
Finally, it is evident that while financial derivatives can offer price certainty for a limited time horizon (maximum two or three years), they do not guarantee physical availability. In the event of a crop disaster or supply shortage, no financial instrument can fully offset the impact of limited physical availability. It is therefore imperative to find solutions for mitigating the impact of physical risks.
Mitigations for physical risk
To ensure physical availability, manufacturing companies can employ various mitigation strategies based on their specific business models. These strategies include diversifying sourcing origins geographically, adopting flexible recipes, increasing physical stocks, and maintaining high inventory levels. Additionally, collaborating with suppliers and farmers to improve farm care, soil management, and providing better financing for increased fertilizer and water irrigation systems can enhance production resilience. Utilizing more weather-resistant plants is another effective approach.
Collaboration among different stakeholders in the supply chain is crucial for developing effective mitigation plans. For instance, coffee manufacturing companies have been supporting farmers in implementing regenerative agriculture practices, providing training and technical assistance in order to increase yields and make production more resilient. Examples of regenerative practices include the use of organic fertilizer to improve soil conditions, encourage agroforestry to support biodiversity, better water management, encourage replanting, renovation and pruning to increase yields of the coffee plot.
Furthermore, collaboration between food manufacturing company research centers and universities has yielded significant achievements. One accomplishment is the joint effort that successfully led to the breeding of improved arabica coffee varieties, more resistant to disease and drought.
Each of these measures, however, presents some challenges such as economic constraints, limited knowledge and awareness, lack of technical expertise, inadequate infrastructure, policy and governance issues, which require an extensive and joint effort from the coffee industry.
Conclusion
In conclusion, it is crucial that the work to improve forecasting models and implement effective mitigation strategies continues. The challenges posed by climate change and weather shocks in the coffee industry necessitate ongoing research and efforts to enhance our understanding and ability to manage these risks.
*For a comprehensive summary of the latest findings: Projected shifts in coffee production and sustainability due to climate changes. Rahn, E.; Bunn, C.; Craparo, A. (2024)
** Christian Bunn, Scientist at the Alliance of Biodiversity International and CIAT, and one of the authors of the study summarized these challenges in a recent communication.
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Please note that this article is intended to be descriptive of historical events and the content should not be interpreted as projections of future outcomes. All opinions expressed are solely my own and do not reflect the views of my employer.
Corinna Olearo
Visiting Fellow, Centre for Business, Climate Change and Sustainability