Tag: speculation

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Coffee highs

Coffee prices have been soaring in recent months. This applies to the prices of both coffee beans on international markets, coffee in supermarkets and coffee in coffee shops. In this blog we examine the causes and what is likely to happen over the coming months.

As we shall see, demand and supply analysis provides a powerful explanation of what has been happening in the various sectors of the industry and the likely future path of prices.

The coffee industry

The cultivating, processing and retailing of coffee is big business. It is the second most widely traded commodity after oil and around 2.5 billion cups are consumed worldwide on a daily basis. In the UK nearly 100 million cups of coffee a day are drunk, with coffee consumers spending around £4 billion per year on sit-down and takeaway coffees and on coffee bought in supermarkets and other shops for making at home. The average takeaway coffee costs around £3.40 per cup with speciality coffees costing more.

Global production in the coffee year 2023/24 was 178 million 60 kg bags (10.7 million tonnes) and the annual income of the whole sector exceeds $200 billion. Around 25 million farmers spread across 50 countries harvest coffee. The majority of these farms are small and family run. Some 100 million families worldwide depend on coffee for their living.

Brazil is by far the biggest producer and accounts for nearly 40% of the market. A good or poor harvest in Brazil can have a significant impact on prices. Vietnam and Columbia are the second and third biggest producers respectively and, with Brazil, account for over 60% of global production.

Coffee prices are extremely volatile – more so than production, which does, nevertheless, fluctuate with the harvest. Figure 1 shows global coffee production and prices since 1996. The price is the International Coffee Organization’s composite indicator price (I-CIP) in US cents per pound (lb). It is a weighted average of four prices: Colombian milds (Arabica), Other milds (Arabica), Brazilian naturals (mainly Arabica) and Robusta. Production is measured in 60 kilo bags.

Case Study 2.3 on the student website for Economics 11th edition, looks at the various events that caused the fluctuations in prices and supply illustrated in Figure 1 (click here for a PowerPoint). In this blog we focus on recent events.

Why are coffee prices rising?

In early October 2023, the ICO composite indicator price (I-CIP), was $1.46 per lb. By 28 August, it had reached $2.54 – a rise of 74%. Colombian milds (high-quality Arabica) had risen from $1.79 per lb to $2.78 – a rise of 55%. Robusta coffee is normally cheaper than Arabica. It is mainly used in instant coffee and for espressos. As the price of Arabica rose, so there was some substitution, with Robusta coffees being added to blends. But as this process took place, so the gap between the Arabica and Robusta prices narrowed. Robusta prices rose from $1.14 in early October 2023 to £2.36 in late August – a rise of 107%. These prices are illustrated in Figure 2 (click here for a PowerPoint).

This dramatic rise in prices is the result of a number of factors.

Supply-side factors.  The first is poor harvests, which will affect future supply. Frosts in Brazil have affected Arabica production. Also, droughts – partly the result of climate change – have affected harvests in major Robusta-producing countries, such as Vietnam and Indonesia. With the extra demand from the substitution for Arabica, this has pushed up Robusta prices as shown in Figure 2. Another supply-side issue concerns the increasingly vulnerability of coffee crops to diseases, such as coffee rust, and pests. Both reduce yields and quality.

As prices have risen, so this has led to speculative buying of coffee futures by hedge funds and coffee companies. This has driven up futures prices, which will then have a knock-on effect on spot (current) prices as roasters attempt to build coffee stocks to beat the higher prices.

There have also been supply-chain problems. Attacks on shipping by Houthi rebels in the Red Sea have forced ships to take the longer route around the Cape of Good Hope. Again, this has particularly affected the supply of Robusta, largely grown in Asia and East Africa.

New EU regulation banning the import of coffee grown in areas of cleared rainforest will further reduce supply when it comes into force in 2025, or at least divert it away from the EU – a major coffee-consuming region.

Demand-side factors.  On the demand side, the rise of the coffee culture and a switch in demand from tea to coffee has led to a steady growth in demand. Growth in the coffee culture has been particularly high in Asian markets as rapid urbanistion, a growing middle class and changing lifestyles drive greater coffee consumption and greater use of coffee shops. This has more than offset a slight decline in coffee shop sales in the USA. In the UK, the number of coffee shops has risen steadily. In 2023, there were 3000 cafés, coffee chains and other venues serving coffee, of which 9885 were branded coffee shop outlets, such as Costa, Caffè Nero and Starbucks. Sales in such coffee chains rose by 11.9% in 2023. Similar patterns can be observed in other countries, all helping to drive a rise in demand.

But although demand for coffee in coffee shops is growing, the rise in the price of coffee beans should have only a modest effect on the price of a cup of coffee. The cost of coffee beans purchased by a coffee shop accounts for only around 10% of the price of a cup. To take account of the costs to the supplier (roasting, distribution costs, overheads, etc), this price paid by the coffee shop/chain is some 5 times the cost of unroasted coffee beans on international markets. In other words, the international price of coffee beans accounts for only around 2% of the cost of a cup of coffee in a coffee shop.

Higher coffee-shop prices are thus mainly the result of other factors. These include roasting and other supplier costs, rising wages, rents, business rates, other ingredients such as milk and sugar, coffee machines, takeaway cups, heating, lighting, repairs and maintenance and profit. The high inflation over the past two years, with several of these costs being particularly affected, has been the major driver of price increases in coffee shops.

The future

The rise in demand and prices over the years has led to an increase in supply as more coffee bushes are planted. As Figure 1 shows, world supply increased from 87 million in 1995/6 to 178 million 60 kilo bags in 2023/4 – a rise of 105%. The current high prices may stimulate farmers to plant more. But as it can take four years for coffee plants to reach maturity, it may take time for supply to respond. Later on, a glut might even develop! This would be a case of the famous cobweb model (see Case Study 3.13 on the Essentials of Economics 9th edition student website).

Nevertheless, climate change is making coffee production more vulnerable and demand is likely to continue to outstrip supply. Much of the land currently used to produce Arabica will no longer be suitable in a couple of decades. New strains of bean may be developed that are more hardy, such as variants of the more robust Robusta beans. Whether this will allow supply to keep up with demand remains to be seen.

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Data

Questions

  1. Use a demand and supply diagram to compare the coffee market in August 2024 with that in October 2023.
  2. How is the price elasticity of demand relevant to determining the size of price fluctuations in response to fluctuations in the supply of coffee? Demonstrate this with a supply and demand diagram.
  3. How has speculation affected coffee prices?
  4. What are ‘coffee futures’? How do futures prices relate to spot prices?
  5. What is likely to happen to coffee prices in the coming months? Explain.
  6. Why have Robusta prices risen by a larger percentage than Arabica prices? Is this trend likely to continue?
  7. Look at the price of Colombian Arabica coffee in your local supermarket. Work out what the price would be per lb and convert it to US dollars. How does this retail price compare with the current international price for Colombian milds and what accounts for the difference? (For current information on Colombian milds, see the third data link above.)
  8. Distinguish between the fixed and variable costs of an independent coffee shop. How should the coffee shop set its prices in relation to these costs and to demand?
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UK house prices: why are they falling so little?

UK house prices have been falling in recent months. According to the Nationwide Building Society, average UK house prices in September 2023 were 5.3% lower than in September 2022. This fall reflects the increasing cost of owning a home as mortgage rates have risen. The average standard variable rate mortgage was 3.61% in August 2021, 4.88% in August 2022 and 7.85% in August 2023. A two-year fixed rate mortgage with a 10% deposit had an interest rate of 2.48% in August 2021, 3.93% in August 2022 and 6.59% in August 2023. Thus over two years, mortgage rates have more than doubled. This has made house purchase less affordable and has dampened demand.

But do house prices simply reflect current affordability? Given the large increase in mortgage costs and the cost-of-living crisis, it might seem surprising that house prices have fallen so little. After all, from September 2019 to August 2023, the average UK house price rose by 27.1% (from £215 352 to £273 751). Since then it has fallen by only 5.8% (to £257 808 in September 2023). However, there are various factors that help to explain why house prices have not fallen considerably more.

The first is that 74% of borrowers are on fixed-rate mortgages and 96% of new mortgages since 2019 have been at fixed rates. More than half of people with fixed rates have not yet had to renew their mortgage since interest rates began rising in December 2021. These people, therefore, have not yet been affected by the rise in mortgage interest rates.

The second is that interest rates are expected to peak and then fall. Even though by December 2024 another 2 million households will have had to renew their mortgage, those taking out new longer-term fixed rates may find that rates are lower than those on offer today. This could help to reduce the downward effect on house prices.

The third is that rents continue to rise, partly in response to the higher mortgage rates paid by landlords. With the price of this substitute product rising, this acts as an incentive for existing homeowners not to sell and existing renters to buy, even though they are facing higher mortgage payments.

The fourth is that house prices do not necessarily reflect the overall market equilibrium. People selling may hold out for a better price, hoping that they will eventually attract a buyer. Houses thus are taking longer to sell. This creates a glut of houses at above-equilibrium prices, with fewer sales taking place. At the same time, these higher prices depress demand. People would rather wait for a fall in house prices than pay the current asking price. This creates more of a ‘buyers’ market’, with some sellers being forced to sell well below the asking price. According to Zoopla (see linked article below), the average selling price is 4.2% below the asking price – the highest since 2019. Nevertheless, with sellers holding out and with reduced sales, actual sale prices have fallen less than if markets cleared.

So will house prices continue to fall and will the rate of decline accelerate? This depends on confidence and affordability. With interest rates falling, confidence and affordability are likely to rise. This will help to arrest further price falls.

However, with large numbers of people still on low fixed rates but with these fixed terms ending over the coming months, for them interest rates will be higher and this could continue to have a dampening effect on demand. What is more, affordability is likely to rise only slowly and in the short term could fall further. Petrol and diesel prices remain high and home energy costs and food prices are still well above the levels of two years ago. Inflation generally is coming down only slowly. The higher prices plus a rising tax burden from fiscal drag1 will continue to squeeze household budgets. This will reduce the size of deposits and the monthly payments that house purchasers can afford.

Over the longer term, house prices are set to rise again. Lower interest rates, rising real incomes again and a failure of house building to keep up with the growth in the number of people seeking to buy houses will all contribute to this. However, over the next few months, house prices are likely to continue falling. But just how much is difficult to predict. A lot will depend on expectations about house prices and incomes, how quickly inflation falls and how quickly the Bank of England reduces interest rates.

1 With tax thresholds frozen, as people’s wages rise, so a higher proportion of their income is taxed and, for higher earners, a higher proportion is taxed at a higher rate. This automatically increases income tax as a proportion of income.

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Data

Questions

  1. Use a supply and demand diagram to illustrate the situation where house prices are above the equilibrium.
  2. Why does house price inflation/deflation differ (a) from one type of house (or flat) to another; (b) from one region of the economy/locality to another?
  3. Find out why house prices rose so much (a) in the early 2000s; (b) from 2020 to 2022.
  4. Find out why house prices fell so much from 2008 to 2010. Why was this fall so much greater than in recent months?
  5. Find out what is happening to house prices in two other developed countries of your choice. How does the current housing market in these countries differ from that in the UK?
  6. Paint possible scenarios (a) where UK house prices continue to fall by several percentage points; (b) begin to rise again very soon.
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Used EV prices fall

Prices of used fully electric cars (EVs) are falling in the UK, even though prices of used internal combustion engine (ICE) cars are rising. According to Auto Trader (see the first two articles below), in February 2023 the average price of used petrol cars rose by 3.3% compared with January and the price of used diesel cars rose by 1.4%. But the price of used EVs fell by 9.1%. This follows a fall of 2.1% in January.

But why are used EV prices falling? After all, the last few years has seen a drive to replace ICEs with EVs and hybrids, with many consumers preferring electric cars to petrol and diesel ones. What is more, vehicle excise duty is currently zero for EVs (and will be until 2025) and the sale of new ICEs will be banned from the end of the decade. The answer lies in demand and supply.

On the demand side, many existing and potential EV owners worry about the charging infrastructure. The number of EVs has grown more rapidly than the number of charging points. In 2020 there was one charging point per 16 cars; by 2022 this had worsened to one per 30 cars. Also the distribution of charging points is patchy and there is a lack of rapid and ultra-rapid chargers. Increasingly, people have to queue for access to a charger and this can substantially delay a journey and could mean missed appointments. There were many pictures in the media around Christmas of long queues for chargers at service stations and supermarkets. Poor charging infrastructure can be more of a problem for second-hand EVs, which tend to have a smaller range.

Also on the demand side is the price of fuel. After the Russian invasion of Ukraine and the rise in oil prices, the price of petrol and diesel soared. This increased the cost of running ICE vehicles and boosted the demand for EVs. But the war also drove up the price of natural gas and this price largely determines the wholesale price of electricity. With government subsidies for electricity, this constrained the rise in electricity prices. This made running an EV for a time comparatively cheaper. More recently, the price of oil has fallen and with it the price of petrol and diesel. But electricity prices are set to rise in April as government subsidies cease. The cost advantage of running an electric car is likely to disappear, or at least substantially decline.

Another substitute for second-hand EVs is new EVs. As the range of new EVs increases, then anyone thinking about buying an EV may be more tempted to buy a new one rather than a used one. Such demand has also been driven by Tesla’s decision to cut the UK prices of many of it models by between 10% and 13%.

The fall in demand for used EVs is compounded, at least in the short term, by speculation. People thinking of trading in their ICE or hybrid car for a fully electric one are likely to wait if they see prices falling. Why buy now if, by waiting, you could get the same model cheaper?

On the supply side, EV owners, faced with the infrastructure problems outlined above, are likely to sell their EV and buy an ICE or hybrid one instead. This increases the supply of used EVs. This is again compounded by speculation as people thinking of selling their EV do so as quickly as possible before price falls further.

In many other countries, there is much more rapid investment in charging infrastructure and/or subsidies for purchasing not only new but used EVs. This has prevented or limited the fall in price of used EVs.

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Questions

  1. Draw a supply and demand diagram to illustrate what has been happening in the market for used EVs.
  2. How has the price elasticity of (a) demand and (b) supply affected the amount by which used EV prices have fallen?
  3. Identify substitutes and complements for used electric vehicles. How relevant is the cross-price elasticity of demand for these complements and substitutes in determining price changes of used EVs?
  4. Draw a diagram to illustrate the effect of speculation on used EV prices.
  5. What is likely to happen to used EV prices in the months ahead? Explain.
  6. How are externalities in car usage relevant to government action to influence the market for EVs? What should determine the size of this intervention?
  7. Devise a short survey for people thinking of buying an EV to determine the factors that are likely to affect their decision to buy one and, if so, whether to buy a new or used one.
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The surging price of oil: a question of supply and demand

Global oil prices (Brent crude) reached $128 per barrel on 9 March, a level not seen for 10 years and surpassed only in the run up to the financial crisis in 2008. Oil prices are determined by global demand and supply, and the current surge in prices is no exception.

A rise in demand and/or a fall in supply will lead to a rise in the price. Given that both demand and supply are relatively price inelastic, such shifts can cause large rises in oil prices. Similarly, a fall in demand or rise in supply can lead to a large fall in oil prices.

These changes are then amplified by speculation. Traders try to get ahead of price changes. If people anticipate that oil prices will rise, they will buy now, or make a contract to buy more in the future at prices quoted today by buying on the oil futures market. This then pushes up both spot (current) prices and futures prices. If demand or supply conditions change, speculation will amplify the reaction to such a change.

What has happened since 2019?

In 2019, oil was typically trading at around $60 to $70 per barrel. It then fell dramatically in early 2020 as the onset of COVID-19 led to a collapse in demand, for both transport and industry. The price fell below $20 in late April (see charts: click here for a PowerPoint).

Oil prices then rose rapidly as demand recovered somewhat but supply chains, especially shipping, were suffering disruptions. By mid-2021, oil was once more trading at around $60 to $70 per barrel. But then demand grew more strongly as economic recovery from COVID accelerated. But supply could not grow so quickly. By January 2022, Brent crude had risen above $80 per barrel.

Then worries began to grow about Russian intentions over Ukraine as Russia embarked on large-scale military exercises close to the border with Ukraine. People increasingly disbelieved Russia’s declarations that it had no intention to invade. Russia is the world’s second biggest producer of oil and people feared that deliberate disruptions to supply by Russia or other countries banning imports of Russian oil would cause supply shortages. Speculation thus drove up the oil price. By 23 February, the day before the Russian invasion of Ukraine, Brent crude had risen to $95.

With the Russian invasion, moves were made by the EU the USA and other countries to ban or limit the purchase of Russian oil. This increased the demand for non-Russian oil.

On 8 March, the USA announced that it was banning the import of Russian oil with immediate effect. The same day, the UK announced that it would phase out the import of Russian oil and oil products by the end of 2022.

The EU is much more dependent on Russian oil imports, which account for around 27% of EU oil consumption and 2/3 of extra-EU oil imports. Nevertheless, it announced that it would accelerate the move away from Russian oil and gas and towards green alternatives. By 8 March, Brent crude had risen to $128 per barrel.

The question was then whether other sources of supply would help to fill the gap. Initially it seemed that OPEC+ (excluding Russia) would not increase production beyond the quotas previously agreed by the cartel to meet recovery in world demand. But then, on 9 March, the UAE Ambassador to Washington announced that the county favoured production increases and would encourage other OPEC members to follow suit. With the announcement, the oil price fell by 11% to £111. But the next day, it rose again somewhat as the UAE seemed to backtrack, but then fell back slightly as OPEC said there was no shortage of oil.

This is obviously an unfolding story with the suffering of the Ukrainian people at its heart. But the concepts of supply and demand and their price elasticity and the role of speculation are central to understanding what will happen to oil prices in the coming months with all the consequences for poverty and economic hardship.

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Data

Questions

  1. Use a demand and supply diagram to illustrate what has happened to oil prices over the past two years. How has the size of the effects been dependent on the price elasticity of demand for oil and the price elasticity of supply of oil?
  2. Use a demand and supply diagram to show what has been happening to the price of natural gas over the past two years. Are the determinants similar to those in the oil market? How do they differ (if at all)?
  3. What policy options are open to governments to deal with soaring energy prices?
  4. What are the distributional consequences of the rise in energy prices? (see the blog: Rise in the cost of living.)
  5. Under what circumstances are oil prices over the next six months likely (a) fall; (b) continue rising?
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The economic fallout from war

The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.

Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.

Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.

Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.

Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.

Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.

The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.

The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.

These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.

An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)

A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.

In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.

Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.

Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.

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Questions

  1. If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
  2. How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
  3. Why did stock markets rise on the day after the invasion of Ukraine?
  4. Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.