Supply glut heats up Vietnam coffee derivatives market

Overproduction and resulting lower prices could spur development of nascent sector

Pile of coffee beans

Vietnam's coffee producers and exporters are staring at the wrong side of a price spike and with oversupply set to continue, it should pave the way for deepening coffee derivatives use, despite obstacles that may remain in the market.

Since banks in Vietnam first started offering hedging products for the coffee market in 2006, there has been solid growth in activity, with commodity derivative pioneer BIDV reporting average year-on-year volume gains since then of 10% annually. Players have reported that volumes of NYSE Liffe Robusta coffee futures traded by Vietnamese players reached 300,000 lots last year.

But at the same time, no one has quite managed to crack the market opportunities onshore. A partnership between BIDV, Techcombank, SME Securities and CWT Commodities launched the Vietnamese Commodity Exchange in Ho Chi Minh City in 2011 with contracts in coffee, steel and rubber, but volumes were reported to be negligible and the exchange has had operational difficulties. In May this year, the Ministry of Industry and Trade granted a licence to Ocean Group to establish the INFO Commodities Exchange, which will also offer coffee, steel and rubber contracts, but no launch date or location has been set.

The current failure by onshore commodity exchanges to pick up any sort of momentum is in part due to the shackles on both the demand and supply sides of the hedging market. On the supply side, the State Bank of Vietnam keeps a tight grip on the commodity derivatives markets and to date only a handful of banks, including Techcombank, BIDV and Standard Chartered, have licences to offer commodity derivative products onshore. And even though the banks have been growing their businesses, actual market penetration remains consigned mostly to large players and non-state owned enterprises.

On the demand side, the key remains educating market players about the ways that hedging can protect them from market risks. It's not just the local banks that have sought to do this; in 2011 the World Bank delivered a training course in Vietnam on price risk management. However, in 2011 prices were booming and for such a fresh market, locking in prices when there remained potentially more upside was possibly not an attractive option.

Now, however, the situation is reversed. Coffee prices fell to seven-year lows in November and many producers and exporters have found themselves exposed to serious losses. Such volatile conditions typically result in derivative volume growth and Vo Dieu Thuy, head of the derivatives and commodities division at BIDV, is hopeful the same will result here.

"Volatility is likely to encourage a growth in hedging. Actually, volatility is probably a crucial issue that Vietnamese enterprises have to tackle when making deep integration into the international market. The deeper integration, the higher volatility and finally the higher necessity of hedging," she says.

There are two main coffee beans used in consumer production: the higher quality arabica and the lower quality robusta, which is used in instant coffee. Brazil is the world's largest coffee producer and exporter and the crop there is predominantly arabica. Vietnam is the world's second largest producer and exporter and its chief crop is the robusta bean, of which it is the largest exporter, selling 1.7 million tonnes abroad last year. The main global derivative contract for arabica is the Ice futures contract, while the NYSE Liffe Exchange (recently bought by Ice) holds the primary robusta futures contract.

In February 2011, the robusta Liffe contract price hit $2,316/tonne, at the time a two and a half year peak and during the first quarter this year was still trading above $2,000/tonne. But record crops across the world and especially in Vietnam sucked the price down close to $1,400/tonne during November.

A combination of heavy rains and producers choosing to store their beans has led to a recovery in prices and at the time of writing, the price had swung back up above $1,600/tonne. Such volatility should encourage more hedging anyway, but more worrying for Vietnam's producers and exporters is the long-term bearish attitude from analysts such as Vanessa Tan, Singapore-based investment analyst with Phillip Futures.

"Ultimately, even despite the current support for prices, I'm still bearish on robusta," she says. "Definitely the low price will affect the South-east Asian producers. They planted a lot in the hope of getting higher prices but these low prices are a disincentive to plant so much in the future."

Barnabas Gan, Singapore-based commodity economist at OCBC, says the roots of the current oversupply go back to the success seen in 2011 which led to suppliers increasing their planting. With the resulting bumper crops, oversupply could continue for several more years.

"The coffee plant requires an amount of time to grow and harvest and right now, we're in the middle of this [2011 plant] harvest time and the high production is inevitable given the high planting habits that coffee producers around the world had two years ago," he says.

"It could well be another one or two years down the road for the situation to balance. The supply surplus for coffee is likely to extend to 2014 or even 2015. Although the demand prospect for coffee is pretty healthy because of the pick-up in emerging market growth, and global growth in general, it is not likely to match increasing supply in the next two years," he adds.

Although it's too late for Vietnam's producers to lock in the higher prices from earlier in the year, ruling out increasing use of commodity swap contracts, coffee options offer a way to establish a price floor and limit losses should prices fall below cost of production.

Charlie Brown, Sydney-based commodity risk management consultant at FCStone Australia, says that physical market players not used to financial products often view options with suspicion, but he points out the benefits they bring in a downward price cycle.

"Typically people who have never been exposed to options think they are a risky business. There are two things they say: 'they are risky and they're expensive'," he says.

"But if someone knows it costs them $2,100/tonne to produce something, they go out and buy a $2,300/tonne put for $100 and that means in the worst case they get $2,200/tonne, so they've locked in $100 profit on the cost of production. On the flip side, if the market finds a base and rallies to $2,500/tonne at expiry of the option, they only lose the cost of the option, so they're selling at $2,400/tonne."

FCStone's Brown points out the importance of understanding such products and while he says that current market conditions could promote greater use of coffee options among Asian players, the chances are that volumes won't immediately rocket.

"The reason the bigger companies will perform better than the smaller companies during volatile times [in the coffee market] is because they know how to deal with situations like this. They have much stronger and more versatile risk management procedures and products they hedge with, so they can participate in these scenarios," he says.

"There's potential for these events to spur options use, but it's worth bearing in mind education of hedging using options can be a long process. First you need to educate a grower on the potential benefits of selling the crop forward rather than relying on simply selling their crop once it's harvested, then on hedging using futures and then to using options. For instance, options have been around for 30 years in the grain markets but producers have only really been actively hedging with them for the past 10," he says.

Many in the Vietnamese market still view swaps and options as exotic and risky. Although there are no official statistics available, BIDV's Vo says that among the players involved in coffee derivatives, Liffe futures outweigh deals in over-the-counter swaps and options.

For Le Duc Huy, deputy general director at major coffee trader Simexco Daklak, based in Buon Ma Thuot, using options would involve taking a position in the market, which is something the firm tries to avoid doing.

"We have quite simple strategies. We just do the physical. We know about options and swaps but never trade them. We do physical and futures trades back to back. We don't use options because we don't take a position. We try to synergise our trading book so it makes more sense for us to make daily decisions. It would be a rare occasion to take extra protection and have a position," he says.

Huy adds that while options are suitable for producers, he is not comfortable with the exposure the firm faces if they choose to store their coffee in expectation of rising prices.

"Producers should use options to fix their maximum production costs but we don't have production costs and we don't look to take either long or short positions. We buy and sell immediately but with options you have to wait and then it's easy to be overexposed. We're not particularly comfortable with the instruments and that's why we don't currently use them. To manage a position with options is difficult, particularly with the price being very volatile," he says.

FCStone's Brown says he has seen more interest in coffee options but that when producers are facing a difficult pricing environment, there is a disincentive to spend more money.

"It's definitely a time when you see a lot of interest in options and all forms of risk management but the question is whether you see people actually pull the trigger and do something. It's rare for people to do something for the first time in these circumstances," says Brown. "The problem at times like this is you've got a producer making less and less money and what we're saying to them is to spend money to protect themselves and it's obviously the worst possible time to think about that."

Aside from options, the immediate outlook for deeper market penetration in coffee swaps use appears to remain limited to the biggest players, and for Standard Chartered, the majority of the deals are done with exporters.

Pham Nhu Anh, head of client coverage for Standard Chartered Bank Vietnam, says that volume size dictates whether or not a firm will choose to hedge its exposure.

"We focus on the group of clients with large sales revenues and a good position in the market and most of the time these are the market leaders. We can offer to the manufacturers as well if they approach us to use the facility," she says. "But we tend to work mainly with the players with very large volume because the client normally looks for hedges when they have large volumes. For those with smaller volumes, they can manage the risks themselves."

Nonetheless, the banks in Vietnam remain highly optimistic about the prospects for coffee derivative volume growth. BIDV's Vo believes that state-owned enterprises will have to enter the markets sooner rather than later, while the bank is also continuing its work educating smaller players.

"Hedging has mainly been conducted by the private sector in Vietnam. Many big state-owned enterprises exposed to lots of price risk have not been active in this market due to lack of knowledge of the power of derivatives and fear of personal responsibility, among other factors. Nevertheless, things need to change with the growth of the Vietnamese economy and financial markets. Thus, the corporations that play a key role in the local economy are likely to be the new market participants," she says.

"Smaller producers and traders need to have more training on derivatives and hedging strategies and this is what we are also doing with our clients: educating them to get better hedging results and for a more professional derivative market in Vietnam."

Vo expects the government to release a regulatory framework for commodity derivatives in Vietnam. This would follow on from moves made by the Bank of Indonesia in its own derivatives market in the aftermath of the extreme foreign exchange volatility that slashed the value of the rupiah this year.

"For better market operation, the Vietnamese government should soon build up a full legal framework on commodity derivatives in Vietnam, including things such as product definition, market guidelines, accounting policy, tax policy and transparent information disclosure requirements," Vo says.

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