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The Future of Food Prices: Coffee

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"How high does coffee have to go in order to tell really diehard coffee drinkers to drink less?" Here's one analyst's estimate.

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The world's collective coffee machine is woefully low on brew, and there's nothing to refill the dregs. Arabica futures, which cover the world's most popular kind of coffee bean, are up 85% from June 2010 .

This 14-year high shows no sign of waning. Coffee supplies around the world are the lowest on record. The past ten years' booming demand for Arabica coffee caused Brazil, the world's biggest producer, to fill supply gaps with surplus inventory from warehouses. "We had an artificially supplied market for a decade that's now run its course. We were not producing enough coffee to meet demand," says commodities researcher Shawn Hackett. "Over the last year, Brazil has basically run out of those excess inventories."

Brazilian farmers weren't making enough money to invest in new crops to cover demand. "Now the prices are getting high enough that the coffee farmer is starting to make enough money to invest in his farm," Hackett tells Minyanville.

This is a good thing for the roughly 20 million people in more than 50 developing countries who grow coffee as a cash crop. It's less positive for coffee drinkers. A coffee tree takes up to five years to mature and start producing. "Even if acreage were expanded today, you're not going to get a supply response for several years," Hackett warns.

Things could get even worse if unusual rainfall patterns wash out crops the way they did last year in Colombia, the world's second largest Arabica producer. Other producers, like Ethiopia, could face water shortages. Even if the weather cooperates, increased demand from BRIC countries-Brazil, Russia, India and China-compounds the supply stress. Oil prices have raised shipping costs. Brazil and Vietnam are considering hoarding to steady supplies during the upcoming shortage.

Speculators are also aggravating the situation. "Since the bank and housing failures two years ago, much…speculative money has poured into commodities, including coffee, bringing that frenetic trading mentality to the coffee world," writes analyst Dr. Duru Ahanotu.

"The market's only option is to take prices high enough to knock down demand," says Hackett. "How high does coffee have to go in order to tell really diehard coffee drinkers to drink less? Assuming good weather, $4 per pound is a conservative estimate," he says.

Until recently, companies have been absorbing higher costs to avoid shell-shocking consumers. Now coffee prices are so high that they're finally passing the baton to shoppers. J.M. Smucker Co. (SJM) has raised the average prices of its coffee products by 23% since 2010. Farmer Bros. (FARM), Green Mountain Coffee Roasters (GMCR) and Starbucks (SBUX) have also increased prices for select products.

Smuckers and Kraft (KFT) are basing their 2011 earnings growth on higher prices rather than sales volume. Coffee shop customers, generally willing to spend more for their coveted cup of joe, could also boost profits for Starbucks or Peet's (PEET).

Investors are snapping up the companies' stock in anticipation of these earnings increases. Starbucks is up 45% between February 2010-2011, and Green Mountain Coffee Roasters is trading "at 295 times cash flow, more than any company in the Standard & Poor's 500 Index," writes Bloomberg BusinessWeek.

How much price increases benefit each company depends on its strategy. Starbucks, looking to gain grocery market share by keeping store product prices low, has a conservative 2011 profit forecast. Green Mountain Coffee Roasters has been destabilized by an accounting scandal and uncertain Keurig cup sales, so it won't be buoyed by increased earnings the way, say, Peet's will.

Unfortunately, the ultimate losers stand to be Arabica-addicted consumers, who are basically waiting around for the market to price them out.
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No positions in stocks mentioned.

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