Thursday, August 4, 2016

Something about hop contracts you should know

Last Friday, we attended the International Hop Growers Convention (IHGC) in Freising, Germany. Representatives from hop producing countries around the world shared their expectations and estimates for the coming crop.  The meeting was a bit on the dry side until it came time for the American report. Most of the crowd was sitting quietly in a mix of awe and disbelief at the acreage figures before them. The statistics showed that the American growers planted an additional 8,000 acres! American aroma acreage increased by 38%!! To put that into perspective, most European hop producing countries do not even have that much acreage.

When I asked the American representative at the IHGC, a friend of mine, what he thought of the numbers. He responded, “Well, it’s all contracted.” That reveals another problem. Contracts should be fixed in stone, reflect the actual demand, difficult to enter into, paid in a timely manner and never open to renegotiation. Nothing could be further from the truth. The hop industry is having a cash flow crisis caused by contracted brewer inventories sitting in storage awaiting payment. This should scare everybody. The hop industry needs a stable foundation on which to plan its future. Contracts should be that foundation. There is no cost to a brewery wishing to renegotiate its contracts so they enter into them easily and try to walk away from them when they want. To be fair, not all breweries do that, but a lot try. All too often, the merchants are too accommodating. After all, the brewers are the ones who pay for the hops. They’re the customers. The customer is always right isn’t he? Not always!

While there are some brilliant hop growers, many have no clue what is going on in the market because they’re not in the market every day. Some even base their business plans on coffee shop gossip and rumors. At the end of the day, forward contracts are the only guidance growers receive about what they must grow. Merchants have the advantage to see inventory and delivery flow and can best gauge how closely the contracts they have are related to actual demand. Although this seems obvious to any grower or merchant, many brewers may not realize this. Contracts serve many important functions. One big craft brewer, who subscribes to this blog, regularly contracts 10% more hops than they need. They’re contracting the most desirable varieties. They sell the excess hops back into the market when they know they don’t need them anymore. Those hops are all contracted every year.

When everybody is acting responsibly, the grower grows a little extra to make sure he fulfills his contracts in full.  Those hops are all contracted. The dealer most likely contracts a little more to be sure they fulfill their contracts. The brewer probably also contracts a little more than they need to be sure to cover any growth. Are you starting to see the problem?

Let’s lighten up the mood a bit.  Below are the type of requests we regularly hear from brewers regarding their hop contracts and why they think they should be renegotiated. We thought it would be fun if we reversed the roles of the conversation (for the purposes of this blog) to see how the same things would sound if they came from the merchant to demonstrate the absurdity of the requests. The result is funny.

How to read the comments below:
The Brewer comments below are things we actually hear from brewers.
The Merchant comments are how the same thing would sound coming from a merchant.

Brewer:  Prices on the spot market are lower than all my contracts now so we’d like to see what we can do about those contracts.
Merchant:  Prices are much higher on the spot market now so we don’t want to honor those contracts we signed with you anymore.

Brewer:  It seems we contracted more than we need so I’d like to make some adjustments to our contracts.
Merchant: It seems we have some extra hops on hand so we’d like to increase the amounts in your contract to make up for our mistake.

Brewer:  We already have a few years worth of Cascades sitting in our cooler so we want to take a look at those contracts we have with you.
Merchant:  We bought too many Cascades for the next few years so we need to increase the amount of Cascades you’re buying.

Brewer:  I’d appreciate it if we could take a look at those contracts again. I can find the same thing from your competitors today at a lower price.
Merchant:  We’ve been talking with your competitors and we can get more money for those hops we sold you so we’d like to get out of those contracts.

Brewer:  We’d like to have 120 days to pay for our hops. That’s our standard and all your competitors are OK with that.
Merchant:  Happy 4th of July.  We’ll be shipping you your hops the first week of November but we need to be paid for them now. That’s our standard. We require that of everybody.

Brewer:  The market has changed. I can get those hops for less today. I’d like to see what we can do about those contracts.
Merchant:  The market has changed.  We can get more for those hops today.  We’d like to increase the prices in your contract.

Brewer: We’ve been busy putting in some new fermenters for our big expansion so we can make more beer. Unfortunately, we can’t afford to pay for our hops right now.
Merchant:  We just put in a new pellet mill and are kind of low on cash. We need to you buy some more hops to help us pay for that.

We are thankful for the brewers who contract responsibly, who understand the importance of the contracts they sign, and who pay their bills on time, which is about 80% of the brewers with whom we do business. Without your commitment to the hop industry, none of this would be possible. We would like to ask you to have a word with some of your brewer friends who fall in the 20% though. The hop industry is very fragile. They can break it. Higher prices could alleviate the problem, but I doubt anybody wants prices that are higher than they currently are. It costs a lot to put in new hop yards and warehouses. It also costs quite a bit to wait a year to get paid for hops that are contracted.

For the past few years, the craft market has absorbed all the “extra” hops that have been produced, but ‘sold’ doesn’t necessarily mean ‘paid for’. There are a LOT of hops piling up in warehouses around the world that have been contracted, but not paid for. The value of those hops is growing to a troublesome level … and it all is financed and accruing interest.

Some brewers are well informed and have given great consideration to how many hops they need. They contract responsibly and understand that contracts are binding agreements. Others, based on their later renegotiation requests, seem to consult the magic eight ball and contract for what they hope will come true. Merchants and the growers need to take these contracts to the bank … literally. Banks view hop contracts as binding agreements.

Some brewers act as if hop contracts are like hotel reservations,
Something that can be canceled a day prior to their arrival.

No brewer likes to see cheap spot hop prices when they have expensive contract prices. Price is not the sole function of a hop contract. When some brewers see cheap spot prices, they want to cherry pick expensive hops out of their contracts or cancel them outright. A falling spot market price does not mean the investments made in the industry have been repaid. It’s just a reflection of the current supply/demand situation.

At this point, maybe not everybody in the industry remembers the 2007-08 hop shortage and the resulting price spike followed by the crash of 09. The past 5 years have been unique and represent an unprecedented time in hop history. Demand has grown more quickly than hop growers can accommodate. Hop growers are quickly catching up though. The fundamentals of the market have not changed just because everybody is drinking craft beer. The hop market is just as sensitive to over supply as it ever was. Proprietary varieties create silos that isolate information and mask the effects of the market as a whole from other participants. Brewer hoarding of them only makes the problem worse. This makes an already opaque market even more opaque if that is possible.

1) Let’s be blunt. Money is the root of the hop problem. Money is the grease that keeps the wheels of the hop industry moving. The American hop industry is completely debt financed. The group that has the most power to effectively regulate the market, therefore, is the bank. The expansion and production all starts and ends with the banks. Bankers literally hold the keys to the future. In the U.S., they don’t see it as their responsibility to judge the merit of deals, and they’re not experts in the hop industry, but they have the capacity to do that if they choose. They could more tightly regulate the funds flowing to the industry and help growers and merchants manage their future. Something needs to be done before we reach a surplus situation because it will be impossible to fix it after.

When did Noah build the ark?
Before the flood.

The consequences of not finding a proactive solution will be enormous. Nearly all those nice small local hop farms that have popped up around the United States will be gone. A lot of established farms in the Pacific Northwest will go bankrupt due to their debt burden. Some merchants who have bought long, but do not have corresponding sold positions could go out of business.  In short, the Hopocalypse, a complete restructuring of the industry.  Let’s hope craft beer demand does not slow too quickly and that that time is still several years away.

2) Here’s a novel idea … everybody should grow and buy only what they need. If we assume brewer behavior remains the same, they can provide the buffer against shortage with the excess inventories they have been contracting. There are Force Majeure clauses written into every contract to protect growers and merchants if the supply side of the industry is short. There’s no reason for growers to produce extra or for merchants to have a reserve if the contracts do not reflect actual demand. They need to be concerned about the long game rather than the short game! Maybe it’s easier and less risky to just call up and say, “sorry, but the crop didn’t come in as expected.” This is a huge change in thinking from the norm today for most merchants and would shift the burden of risk from the grower and the merchant to the brewer. If you think this is just some tactic to try to maintain high prices so as to make more money, go back to the top and read this again. This is a call for responsible contracts and responsible production that reflects actual demand. Brewers should want that.

Prices go up or down as the hop industry responds to demand represented by brewery contracts the best it can. Right now, the contract system does not accurately reflect actual demand based on beer sales due to a minority of the brewers who do not seem to understand the full function of the forward hop contract.  The current contract system and the way the hop industry responds to it is flawed. The market is very cyclical as a result. At this point, due to the growth in the craft beer world, only adjustments are necessary. On the demand side, brewers need to contract only for what they need. Nobody needs to cut anything yet. On the supply side, the hop industry needs to take its foot off the accelerator so it can better navigate the road ahead. 

Wednesday, July 27, 2016

5 Things that can Destroy the Hop Industry

You would think times are good in the hop industry with prices at their current level. Hop growers are rock stars. People buy beers with the names of hop varieties on the label just because they love that variety. Being involved in any way in the hop industry makes you instantly the person with the coolest job in the room. In fact, I’m sitting in a hotel breakfast area as I write this wearing my 47Hops shirt and a stranger just asked me what the shirt was about. When I told him, he thanked me for doing my job. We proceeded to talk about hops for the next 10 minutes! I love talking to hop enthusiasts! This happens more and more lately. It’s easy to get distracted by the popularity of hops these days. Despite the positive juju out there and the high prices, the future of the hop industry has quietly slipped deeper into jeopardy than ever before. The only time in recent history when the industry was in a similarly precarious position was about 12 years ago when nobody wanted hops and they sold for less than the cost of production.  Let’s take a look at five of the most serious threats to the industry today.

How can the glory days of 2016 and the biggest craft beer boom ever possibly be compared to 2004, a time when few people knew or cared about hops? One word … DEBT. The hop industry is spending money like a drunken sailor to keep up with brewers who are trying to keep up with the public’s craving for craft. One of our competitors reportedly just spent $4 million on a pellet mill! All of the infrastructure development in the hop industry costs millions of dollars. Because of the chicken and egg nature of the hop industry somebody has to take a blind leap of faith, take a risk and go first. Back when nobody appreciated hops, everybody was losing money in a neglected industry, and it showed. Expectations were low and the future of the industry looked grim. Today’s industry is managing the biggest expansion in history. All that growth has caused a lot of financial stress. It is just well hidden from view behind a flurry of expansion projects and high prices.  There’s a lot of money coming in, but there’s a lot of money going out too.  There is more debt in the industry today than at any time in its history. Nobody is going broke today, but all that is keeping that from happening is the stability and durability of high priced contracts. 

Right now, you’re probably thinking, “Oh geez, an article from a hop dealer supporting high prices. Surprise surprise! Of course he’s saying that. This guy wants high prices because he can make more money.” I hear that a lot. Actually, that’s not true at all though. In today’s market there are no opportunities to find bargains.  Today, every grower wants top dollar for their hops. With low contract prices, there’s much less risk involved with taking a speculative position. With low contract prices, the ROI is much higher than it can possibly be today. Some brewers and most growers seem to think that hop merchants just take hops from growers at dirt cheap prices and sell them to brewers while adding a $h!t ton of margin along the way. If it were that easy, a LOT more people would be doing it.

It will take years of stability to repay the debt the industry has amassed. In theory, that’s why we have hop contracts, so everybody can estimate who needs what and when and so they can agree what they will pay for them.  That’s hops 101.  The American hop industry is more heavily contracted today than ever before, which on the surface seems like a great thing. So, what’s the problem? A lot of brewers don’t seem to understand or don’t care about the effects of a contract beyond fixing the price of hops for both parties. Some are hoarding quantities they don’t need and later ask to renegotiate the contract or sell them on secondary markets. For the moment, there’s no cost to sign a contract. Some brewers have figured out they can get the merchant to reserve their hops for them at no cost.  One problem with this strategy is that hoarding and over contracting sends the wrong signals to the market, cost hop growers millions of dollars and can cause result in low spot market prices, which can be a dangerous thing.

Renegotiating Contracts
Why are low spot market prices so dangerous? Everybody likes a good deal. The problem is that nobody wants to think they are paying more than their competitor. When breweries with relatively high contracts prices see the price on the spot market decrease, which it does when there is even a slight surplus of hops, naturally, they want to escape from their high-priced contracts to save a buck. In a market as opaque and unregulated as the hop market, a contract serves the purpose of creating stability, price discovery and guides the market so growers and merchants can know how to scale their businesses. All of those things are actually of greater value than the money received from the contract. Stability helps the hop industry to finance the creation of all those fun new hop varieties everybody seems to enjoy today. It finances the high quality of the hops brewers receive. It pays for the thousands of people who work in the industry to produce the hops. If you’re a brewer and you want to contract for hops, you should only contract for what you need. It’s a contract after all. It’s a binding agreement. 

The instability created by contract renegotiations and unsustainable prices has a ripple effect all the way to the bank. Why?  Infrastructure and debt! The US hop industry collectively invested over half a billion dollars in infrastructure during the past 3-4 years. To keep pace with the craft industry between now and 2020, another $500-700 million investment is necessary. Most of that money will be borrowed and must be repaid with interest. Everybody is banking on the current prices sticking around for a while and for existing contracts to be honored. If you’re a brewer and want to renegotiate your contract because you see lower prices for the varieties you have contracted, keep that in mind.

Short-Game Players
Traditionally markets that create high hop prices don’t last long. Like kids grabbing candy as it falls from a piñata, hop growers and merchants are used to grabbing all they can while it lasts. Nobody in the hop industry is accustomed to being the prettiest girl in the room and having all the boys chasing them. It seems to be a new reality that will take some time to which to acclimate. When you’re the prettiest girl in the room, you don’t just share your cookies with everybody who comes along. You also don’t go walking around on every corner asking people if they want some of what you’ve got. You let the people who want what you’ve got come to you and sort through the noise. What does all this have to do with hops?  Plenty! The hop industry needs to adjust from a one-night stand mentality to a long-term relationship. If I were still Executive Director of Hop Growers of America, the theme for the 2017 convention would be PLAY THE LONG GAME.  We would have a mix of economists, football and baseball coaches who can talk about the value of playing the game all the way to the end. I’d invite bookies and professional gamblers in to talk about how to evaluate the risks of gambling, strategy and how to read your opponents. I’d bring in archeologists … what?!? What? No, I’m not smoking recreational marijuana. Archeologists are masters of patience! Imagine you’re an archeologist and you’ve just found what seems to be a lost city from ancient Sumer.  What do you do? You painstakingly scrape away each layer of dirt revealing the city beneath in an operation that could take decades. It’s definitely not as dramatic as Indiana Jones grabbing the gold statue and making a run for it, but in the long game the short term gain is not the goal. Imagine the patience and vision necessary to restrain yourself like that. It’s the long game that counts. Why?  The long game is infinitely more valuable than the short game.

This is a common theme you’ll see when you start looking for it. There’s a great scene from the movie Colors in which experienced cop Robert Duvall tells new cop Sean Penn a joke to convey to him the value of focusing on the long term goal rather than being distracted by short term gains. It’s an awesome lesson and reflects the thinking hop growers and merchants need to have in today’s hop market.  Check it out. 

Speculators & Hoarders
Does it sound bad to suggest that everybody in the hop market should forego their own personal greed in the short term and work to keep prices stable in the long term by only planting and selling for the demand in the market, and not an additional pound? No, I haven’t been reading Das Kapital, but a little unity among growers would make a huge difference. Does it sound bad to tell brewers they shouldn’t hoard hops and should only buy what they plan to use and not a pound more? Do what you want, but you’re destroying the hop industry if you’re a hoarder.

During the 2016 CBC, several hop growers approached us asking if we wanted to buy any hops.  I told them all that we are just fine for now. Growers offering hops was a change from the pattern of the past few years so I did a little digging. What I learned is that some growers have planted a little more than they had contracted. They are starting to speculate on the market, which is why I am writing this article today.

If you’re a hop grower and produce a little extra to speculate on the market, you’re sawing off the branch that you’re sitting on.

A potentially good crop in Europe and articles proclaiming slow growth of the craft beer industry and the return of equilibrium to the hop market can create the perception among brewers of surplus all by itself, regardless of the facts. That, in turn, could create isolated opportunities for discounted hops. The perception of a shortage or deficit can cause as much damage as the real thing.

During the time of low hop prices, some growers left hops hanging in the field.  They couldn’t afford to pick them so they didn’t. When times are good, growers harvest extra hops because they believe they can afford to. They figure they have made their money on that field with what they’ve already sold and that anything else they get from it is like icing on a cake. Harvesting that over production is more costly than harvesting hops when prices are below the cost of production. What if they just left them hanging? That sounds like a crazy idea, but why should a farmer produce a surplus for a market that will punish him later when they can afford to regulate his own production.

The Irony of the situation is that $h!T rolls downhill. Low prices are attractive and we are designed to respond to them. The money in the industry comes from one source and flows in one direction. If low prices emerge on the spot market in today’s market, it will have a ripple effect and there will be less money flowing through the industry. Those low spot prices will act like a cancer undermining the strong contracts financing the growth and variety of the industry. If you’re a grower or a merchant, that means you can’t pay your bills.  If you’re a brewer, you are jeopardizing the source of a very important raw material. Either way, it’s a lose-lose. If people can’t resist the temptation of low prices, that will be the fall of the hop industry.