Smell the Coffee... Before Prices Climb

Coffee is a curious commodity. Back in August 2003, when 55 million people in eight US states and one Canadian province were plunged into the second most widespread blackout in history, it was the single most important thing on my mind.

Sure, it was hot. There was no TV or Internet. Ice cream and popsicles were dripping down the freezer door like Salvador Dali pocket watches. And most of the food from the refrigerator was destined for the garbage can.

But the only thing I could think about over and over again as I fell asleep on the first night of that 72-hour blackout was the fact that there would be no coffee brewing in the kitchen in the morning.

So it's hardly surprising that I take the volatility of coffee prices in stride. Whatever it costs, I'm still drinking it. And last year, it started to cost quite a bit.

Poor growing conditions in South America and other coffee-growing countries led to fears of a supply crunch, caused coffee futures to soar. Prices on the futures market climbed 95% in 12 months, hitting a 10-year high in May.

J.M. Smucker (NYSE: SJM), the owner of Folgers, Dunkin' Donuts, and Millstone, and Kraft Foods (NYSE: KFT), owner of Maxwell House Coffee and Yuban, raised prices multiple times last year.

Then Starbucks (Nasdaq: SBUX) hiked the packaged brand that's sold in grocery stores 12% in March and boosted the price of the packaged coffee sold in its US retail stores by an average of 17% in July. And in a matter of weeks, it cost more for a cup of coffee -- no matter where you bought it.

As David Krein explains, Starbucks is the 800-pound gorilla. Once it made the decision to increase prices, the door was open for everyone else to follow.

But the market has declined as quickly as it climbed. Krein, senior director of product development and analytics at Dow Jones Indexes, says the Dow Jones-UBS Coffee Index fell 37% between its high last May and the end of February. Year-to-date (as of March 26, 2012), the index is down 22.04%.

He attributes the decline to expectations of a surplus in Brazilian coffee beans, following a run-up amid a significant supply-demand gap in early 2011.

The recent drop in prices has benefitted coffee roasters, who some experts suggest may purchase better-quality coffees as a result. However, it hasn't done much to help consumers.

Although coffee futures have declined, there has been no corresponding drop in retail prices. As with many foodstuffs -- or other commodities, like the oil that's used to make gasoline -- "retailers and middlemen aren't always quick to pass along cost savings in the form of lower prices," Krein notes.

In fairness, he adds, Starbucks and other coffee retailers "waited quite a while" to raise prices. "Then they blinked, and prices fell. Now it's a matter of speculating what will happen next."

Odds are, prices will not stay low for long. The popularity of coffee shops continues to grow in emerging markets, such as India, where consumers with growing disposable incomes are thronging coffee shops in increasing numbers, Krein says. So unless there is a major increase in coffee supply from Latin America, the biggest source of coffee beans, a shortfall could develop, setting the stage for a rebound in prices over the longer term.

The following chart shows the 10-year performance of the Dow Jones-UBS Coffee Subindex.