Contracts are essential for building long-term sustainable relationships in the coffee industry. By using them, those who both buy and sell coffee can achieve stability and transparency by recording the terms of their transactions.
However, in recent months, contract defaults in the coffee sector have been increasing. Defaulting is where one party (in this case, the farmer) fails to deliver on their commitments as outlined in the contract.
As early as May 2021, Reuters reported that farmers in Brazil were renegotiating coffee contracts to receive higher prices in line with market movements. Since then, reports of farmers defaulting and traders and exporters suing farmers have steadily increased.
But why are farmers being sued over these defaults? And what are the implications for the supply chain? I spoke to the Senior Vice President of Trading at StoneX Group Inc. Albert Scalla to find out more.
You may also like our article on why it is getting more expensive to ship coffee.
What are contract defaults?
Buying and selling coffee is a complex process. It is logistically burdensome and costly. As such, contracts are often used to increase security and stability, while also theoretically streamlining the process.
“Producers can sign a contract with a buyer on long-term contracts – usually six to 18 months,” Albert tells me. “Sometimes contracts last for two or three years to deliver coffee at a specified time and a specified place.”
However, sometimes the parties don’t fulfil their contractual obligations. This is known as defaulting.
“Strategic” defaulting is when a change in market conditions – such as the price of coffee – makes it more advantageous to abandon one contract in favour of another sale.
There are two types of contracts used to manage the sale price of coffee in the industry: fixed and differential price contracts.
Differential price contracts change the sale price for producers as the market price fluctuates, whereas fixed contracts do not. The vast majority of contracts where we’ve seen farmers default in recent years are fixed contracts.
In early December 2021, it was reported that coffee prices had reached a more than 10-year high. This increase in prices was exacerbated by shipping container shortages and extreme weather in Brazil – a highly influential origin as far as global supply and demand are concerned.
“Brazil and Colombia are the two main coffee-producing countries for defaults,” Albert says. “In Brazil, farmers have been defaulting more than in Colombia, simply because of the sheer size of the Brazilian coffee sector.”
He adds that in general, any time markets experience considerable price spikes, defaults will occur across the board, irrespective of the country.
“Farmers started defaulting on contracts in Colombia less than two years ago, as internal market prices have almost doubled in the past 12 to 14 months.”
He explains that there are two primary reasons why producer defaults can occur: either a fall in expected production figures (often climate-driven) or a sharp rise in prices for previously-contracted coffee.
In November 2021, an article from Reuters stated that Brazil, Colombia, and Ethiopia – the three largest producers of arabica coffee in the world – were all seeing an increase in contract defaults from farmers.
“Now that harvests are coming in, a small number of producers are choosing to deliver coffee at the stipulated prices back in January,” Albert explains. “But others want to sell those previously contracted coffees at today’s market price, which is higher than it was around a year ago.”
The implications of contract defaults
“Producers default to take advantage of the higher prices, so it’s beneficial for them,” Albert says. “It’s one of the reasons why they’re doing it.”
However, while farmers might receive higher prices when they default and sell elsewhere, doing so can have negative consequences.
“If they default, a producer could have problems selling through their previously established channels,” Albert says. “They might end up being blacklisted by traders, exporters, or roasters.
“Maybe they won’t be able to supply coffee to buyers that they worked with in the past. However, a 100% increase on their initial contracted price might be too tempting an offer to pass up.
“Essentially, they’re exchanging short-term gain for long-term losses because they may not be able to sell the coffee through the typical routes in the future.”
As the largest coffee producer in the world, Brazil is reporting the highest number of contract defaults seen in decades. Reports state the defaults even amount up to 4,500 bags in some cases – often over US $1 million in value.
This has serious consequences further down the supply chain for traders and exporters who receive less coffee than was contractually agreed upon.
“Any time you default on a contract, it’s not good, because each of the supply chain actors makes commitments based on the commitments of the other parties,” Albert explains.
Why are farmers being sued?
In late 2021, Euronews reported that up to 1 million bags of coffee had failed to be delivered in Colombia alone because of contract defaults.
As Colombia is the second-largest arabica producer in the world, defaults of this scale naturally have an impact on global coffee prices.
“Farmers are being sued over contract defaults because somebody in the supply chain is taking a large financial loss, and they want to make up for that by enforcing the previously agreed contracts,” Albert explains.
“When the producer defaults, the suppliers, co-ops, and exporters aren’t able to deliver the coffee at the previously contracted price. So, the co-op or the exporter then has two choices: go on to default themselves, or buy the coffee at today’s price from another supplier and take the loss.”
Some reports indicate that these losses are amounting to up to US $10 million for individual large-scale traders, which is ultimately leading supply chain actors to take legal action against producers.
According to Reuters, several high-profile coffee traders (including Louis Dreyfus Company and Volcafé) are currently suing hundreds of Brazilian coffee farmers for failing to supply coffee as contracted.
“When the market price goes up from US $1 to US $2.50, we’re talking about huge losses,” Albert explains. “And when you start accounting for all the co-ops or exporters, the losses accumulate.”
What could the impact on the entire supply chain be?
Albert explains that the early impact of contract defaults is generally felt mostly within coffee-producing countries.
“The default often stays within the producing country. Either the co-operative or the exporter will have to take the losses on their books,” he says. “This is because they now have to buy the coffee at today’s price and deliver it at last year’s price.”
He adds that traders are usually the ones who take the biggest loss, as they often end up absorbing the cost when receiving less coffee than contractually agreed upon.
“In Brazil and in Colombia, some traders now have to buy coffee at US $2.50/lb in order to sell it at US $1.20/lb.”
However, despite prolonging and complicating the already-difficult process of exporting coffee, contract defaults don’t necessarily diminish global coffee stocks. For this reason, Albert explains that roasters and consumers don’t experience the immediate repercussions of farmers defaulting on contracts.
“Roasters aren’t being affected because the coffee is still there and ready to be exported,” he says. “The default happens internally, and instinctively between the producer, the co-operative, and the exporter.”
Producers receiving a stable and reliable living income is necessary to create a truly sustainable industry, but increasing income by defaulting on an existing contract is not a healthy option.
Ultimately, while the wider ramifications may yet be unclear, the coffee supply chain is long, complex, and interconnected. What happens today could cause ripple effects in the industry that we see months or years down the line.
Enjoyed this? Then read our article on why frost in Brazil is causing global coffee prices to increase.
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