There’s No Such Thing as a Free Hedge

Starbucks photo via Flickr user Abllo, Creative Commons.

Matt Yglesias had an interesting post last week on Starbucks’ impending price increase:

The fact that Starbucks is poised to raise coffee prices in most American markets is not all that interesting, but the underlying cause is. Basically last year Starbucks saw that coffee prices were on the rise, so they made an advance agreement to purchase coffee for the fiscal year that started in October to lock in the then-prevailing prices. Unfortunately for them, the coffee market fell soon after that leaving Starbucks locked in to paying higher prices than what you can get on the spot market.

I’m not sure that you can attribute Starbuck’s price increase to the fact that Starbucks locked in the price they pay for coffee beans only to see the price fall.  Sure, Starbucks is now paying a higher price for their beans than their competitors, but they’re still paying the same for their coffee beans as before, so, all else equal, they shouldn’t need to raise their prices.  If a cup of coffee cost you $1 to make last week and you sold it for $2 and it costs you a $1 to make this week, then you should still be able to sell it for $2, even though it only costs your competitors $0.80 to make that cup now. It seems there’s got to be some other cause for the price bump (other costs have gone up, sales are down, etc.) and either Starbucks is using this as an excuse  to raise prices or the WSJ is getting it wrong.

But on a broader level, I think Matt is a bit off when he says that “it doesn’t really make sense for the Starbucks management team to be speculating on coffee prices” and “people who are good at [managing coffeehouses] may turn out to be pretty bad bean speculators, as we see here.”  The thing is, Starbucks’ management was doing exactly what Matt says they should have been doing: eliminating the speculative aspect of the business by hedging the volatility of coffee bean prices so they could run their business as if the price were flat.  Unfortunately for them, coffee bean prices declined after they locked in their price, but that doesn’t mean they were bad speculators or that the hedge was a bad idea.  That’s the cost of a hedge.  The reason you lock in your prices in the first place is to eliminate the uncertainty that comes with dealing in a volatile market like coffee beans.  In theory, the certainty you gain from knowing how much you’ll be paying over the next year is worth the probability that prices will go down and you’ll pay more than you otherwise would have.

As for the need for speculators, I agree that it’s important for Starbucks to be able to find a counterparty to take the other side of the bet when they want to lock in their prices.  If that counterparty is a speculator, so be it–there’s nothing inherently wrong with speculating.  To the extent that there is no natural counterparty for Starbucks (a coffee farmer who wants to lock in the prices at which he’ll sell his coffee) then the existence of speculators is critical.

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