Transactional costs & the hop market

Hop growers and merchants are having trouble keeping up with the craft industry because it’s growing so fast, but not for the reason you may think. The American hop industry is big. Americans like things big, so this should come as no surprise. The farms are big. The picking machines are big. Growers like to sell in big quantities when they sell their hops. Merchants like this too. Bigger is not always better. Most hop merchants try to optimize their business focusing on transactional costs … which is the fancy way to say that they prefer to work with big customers because it costs less to work with them. The result is that some merchants screen out brewers that need less than a certain volume of hops. Those brewers are not worth their time.

It’s true that it can take as much time, effort and paperwork to sell 44 pounds of hops as it does to sell 44,000. In fact, it can be more difficult to sell 44 pounds. The company buying 44,000 pounds probably has somebody dedicated to the job of buying raw materials. The brewer who needs 44 pounds of hops is also probably the accountant, the janitor, and the bartender. For that reason, it is easier for merchants to focus on big customers … transactional costs. That’s the way the hop industry has worked traditionally. The infrastructure to handle smaller and medium sized orders doesn’t exist among the largest companies. It’s a different business model. That has fit well with the way big breweries bought hops in the past. It has worked well for the craft industry so far. Third party retailers, traditionally buy hops from bigger merchants and service smaller brewers. There’s nothing wrong with that business model. The problem is while they demand a higher price, not all of them provide a high level of service. All that will change in the coming years with the rise of the long tail.

If you didn’t read our previous blog, you can read it now 47hops.com/revolution so you know what we’re talking about when we talk about the long tail. Growers and merchants will find new ways of dealing with smaller brewers around the world because they want to continue growing their market share. The same old ways of doing things won’t be good enough in a world with 10,000+ craft breweries. We’re likely to see more hop merchants and growers satisfying the demand of smaller brewery customers. We may also see the pooling of orders from the brewer side. If they can organize, brewers can act collectively to get the size necessary to fit the current system. We have already seen both of those things happening. Meanwhile, the merchant companies that once enjoyed a strangle hold on the hop industry are losing their power and influence. Some have yet to realize that there’s a hop revolution happening too.

The old guard will fight to maintain the status quo like empires always do. That’s as true in the hop industry as it is in the beer industry. The hop empires of the past still possess a lot of power and money, but they lack entrepreneurial spirit. How will the market change in a world where smaller breweries become the norm? The focus on quality hops is no less important than it ever was. In the long run, the fight is not just about quality hops. Quality of service and the quality of the experience will be vital to success. Smaller brewers will not accept being treated like second-class citizens once they realize they comprise the majority of the industry. The next several years will be a particularly chaotic time as both the hop and craft beer industries struggle to come to grips with their new future.

Everything you read about the craft revolution being over is wrong

There is no shortage of brewers who, in recent months, have the courage to claim a day of reckoning is coming, the sky is falling, or a shakeout is happening in the craft beer industry. Jim Koch’s infamous interview in which he stated, “The end of the craft beer revolution is near” got a lot of attention. From where Jim sits, I imagine it looks that way. Jim’s empire is worth less than $2 billion today. Only a couple years ago, it was worth nearly twice that. Given that perspective, It’s not hard to imagine why he and other corporate craft brewers at the top of the game think the revolution is ending. With all due respect to Jim and the others, they are all wrong. The real revolution is just beginning.

From where Jim and other corporate craft brewers sit, their world is definitely changing. They take that to mean that preferences for craft beer are also changing. They can’t see the forest for the trees. Today’s big craft breweries strayed a long way from what originally fuelled the craft revolution. The most successful craft breweries today are not so different from the big multinationals. They just don’t have the Super Bowl commercials … yet. Maybe that’s what they aspired to be all along, or maybe they let opportunity get the best of them. What does it mean to drink an 805 in Berlin, Germany? I grew up in the 805. Back then, most people in Southern California didn’t even know what that meant, but times are changing.

Craft beer is also changing. There are 5,300 craft breweries today. That’s an awfully long tail that gets longer with each passing day. It’s the rise of the long tail. I can imagine a day when there are 10,000 craft breweries in the U.S. For that day to come, not everybody who starts a brewery can be the next nationally or globally distributed beer. If that’s the reason people get into the business, then the revolution is already over. The first generation followed a well-worn path of getting as big as they possibly could until what they produced became commonplace. Spins data, grocery store shelf space and the other macro statistics collected by companies like IRI and Nielsen reflect their sales well. That data won’t accurately measure when craft continues to grow from the bottom up. The revolution is far from over. It’s just evolving.

 

Photo: www.craftbeer.com 

Of course, nothing is guaranteed. For the craft revolution to continue to evolve and flourish, it must be filled with brewers who don’t have ambitions of world domination. To survive, the next 5,000 craft breweries will need passion, and lots of it. They will need to aspire to have 2,000-3,000 loyal customers who stop by for a beer or two a couple times each week. If they get more than that … great! Their sales will cannibalize sales of the big craft beer companies that make the news. That will continue to create the impression that the craft revolution is dying. It’s in the interest of every big craft brewer to perpetuate that myth that the craft revolution is over so they can draw new borders, circle the wagons, protect the empires they’ve built and prepare for a period of greater stability. The same is happening in the hop industry. It’s never in the big guy’s interest for the little guys to get stronger and more numerous. Think American Revolution and the success story that followed.

The best time to kill any revolution is in its infancy. The next generation of craft brewers threatens to jeopardize the existence of the current empires in the same way that corporate craft brewers threaten the existence of the multinational brewery empires. Economies of scale allow the biggest guy on the block to produce for the cheapest price. The smaller players have something with which the big guys can’t compete … local. You can’t scale local. That is a trend that will disrupt the craft beer market. It will disrupt the hop and malt industries along with it. We’ll talk more about that in an upcoming blog.

Private equity firms don’t like to invest in local business with no prospects for hockey stick growth. Famous business journals don’t usually report on local success stories. Being local isn’t a business model that will make anybody a billionaire. To be successful, the next generational of craft brewers must bring craft back to its roots or be content drinking somebody else’s beer. Thousands more craft breweries will create hundreds of thousands of jobs, resurgence in locally produced quality products and a sense of community for millions of people. That’s a real revolution!

Brewer question: hop pellets vs. bales

Question:  Doug & Crew; Can you comment on the shift in the industry from whole hops to pellets? In the old days, I have been brewing for 20+ years, all that was available was whole leaf hops. In the last couple of years the industry seems to have completely embraced pellet hops to the point where I have to seek out online sources of whole leaf hops. It’s a hassle dealing with pellets at the homebrew level and yet, it’s the only thing that’s available now at my local home brew shop. Is it just the stability and commercial use of hops tha is driving this shift? Your insights are always appreciated.

 

Dear Steve,

Thanks for your question.  There are still some commercial brewers who use baled hops, but you’re right, with each passing year the trend toward using pellets and other processed hop products grows. That is definitely a trend, but it is not necessarily driven by brewers looking for the best quality experience with their hops.

With 47Hops, for example, we sell hops in bales to some brewers. The volumes are small, but they’re out there. We need to know about the order before harvest is finished in September for us to be able to offer that product. Once we begin pelleting in October, we like to pellet everything we can. We prefer not to leave bales sitting around in the warehouse in the hopes that somebody will come along looking for bales to buy. That’s risky. Hops degrade quickly and they would soon be worthless. Strictly from a business standpoint, that doesn’t make sense. You can’t use old hop bales for much once they have no brewing value. 

There are plenty of reasons why the industry has shifted to using pellets. They are not all what you might imagine though. Shifting to pellets simplifies storage and shipping due to reduced volume and an easier form factor relative to bales. That’s particularly important when you consider that hops are grown primarily in the Pacific Northwest of the US and in Bavaria, Germany, but they travel all over the world. 

Pellets also make brewing a less technical process in that people can more easily just follow a recipe. Not all brewers today have 20+ years of experience. Many don’t understand, or care to understand, all the nuisances associated with using raw hops. I was recently talking with a very talented brewer friend of mine who mentioned that he prefers to use pellets and whole cone hops rather than oils or extracts because the complexity and fullness of the flavors are much greater and richer the closer you get to the raw product. There are hundreds of oils interacting with one another in raw hops and you may not even know which is acting with which to give you that special something you’re looking for. The more processing that takes place, at least with today’s processing methods, the fewer of those oils remain. In some cases, that might be the desired outcome, but it’s more likely a negative, but accepted, side effect of a process that offers many other benefits.

The most common reason stated for using pellets is that they preserve the characteristics of the hop due to the ability to package them in inert gasses. You don’t need to pellet hops to get that effect though. You could pack raw hops in Mylar foils with inert gasses and have a similar result. We have done that for customers. Again, if we find out about the order at the right time of year, we can do that sort of stuff.  It just takes a little planning ahead. Raw hops packaged in boxes and foils takes up quite a bit of space, but it can be easily palletized and moved around the warehouse and shipped.

I’m not trying to make the case for pellets … or bales. Honestly, as a hop merchant, we just respond to the demands of our customers. In fact, every hop grower and merchant would probably prefer that all brewers use raw hops. Having a more perishable product would make the hop industry less prone to over supply problems that can linger for years. Everybody will tell you that raw hops are less efficiently utilized in the brewing process. I suppose that depends on what you’re using to measure efficiency. The Apple industry has made the red delicious apple variety much more efficient over the years. They stay red longer and can ship across the country without spoiling, but while they are red, but they are not very delicious! In my opinion, you’re better off eating the box they come in. The flavor you can get from some heirloom varieties is much better! Of course, that’s a subjective opinion and not the metric the industry is trying to optimize for in apples. Hop varieties and products have also been optimized for a process, but what or who is driving that process and is that in line with your goals?

Considering the fact that raw hops would make the hop industry much less volatile, it’s ironic that hop merchants have been the ones responsible for all the innovation in the industry. Of course, they’ve done all that to get the attention of the big brewers over the years. Due to fierce competition with one another, they are constantly inventing more and more ways to process hops better or more differently than their competition. 

At the end of the day, the customer dictates what the market offers. If everybody wants 20 pound boxes of raw hops packaged in Mylar foils in inert gas, and they are willing to pay the costs associated with packaging the hops that way, that’s exactly what we and everybody else will provide. As the customer, you need to make your demands known. If your usual homebrew shop or merchant won’t give you what you want, look somewhere else. Just because it’s not out there now doesn’t mean it can’t be. Anything is possible! Maybe you’ll start the trend of using raw hops in beer again.

Regards,

Doug

 

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2017 State of the Hop Industry

April 2017

Today, the hop industry enjoys a popularity the likes of which it has never before enjoyed. Hop varieties appear on beer labels. Brewers swarm to hop farms at harvest time to catch a glimpse of hop harvest. Nearly the entire crop is contracted. Craft brewers talk of sustainability of the hop industry. On the surface, it would seem that the state of the hop industry has never been better. The truth is quite different. The hop industry sits at a point of equilibrium, something many have idealized for decades. Equilibrium has not brought stability and balance to the industry as the word might suggest. Instead, it brings uncertainty and the continuous fear of shortage. The state of the hop industry is fragile. Just beneath the surface the seeds of a potential crisis are being sewn.

 

The Backstory

Many larger craft brewers contracted significant amounts of hops for sustained growth in the craft beer market, which did not materialize. Fueled by the ambitious goals of 20% of the American beer market by 2020, craft brewers and hop industry members fell victim to confirmation bias. The craft industry has grown beyond anybody’s wild imagination in just 10 short years. The possibility of craft reaching 20% of the domestic beer market by 2020 is dead. Brewers contracted hops for that growth. Growers expanded infrastructure based on that projected growth. The hops contracted to reach that goal are no longer necessary. A fully contracted oversupply exists. Most craft brewers continue to honor their contracts in 2017. Most are working closely with merchants and growers to renegotiate more favorable conditions for future years to lessen the impact of a potential future surplus. The problem exists today, but there is good reason to believe that in the coming years continued growth in the craft industry will alleviate the pressure.

For anybody involved with hops for less than 10 years, this might seem like something new. To those who have been around a while, it’s like watching an old familiar movie again. They know how it ends, but hope the ending will be different this time. Craft brewers say they are interested in the sustainability of the hop industry. That attitude alone may make a difference. When times are good, it’s easy to talk that way. When money gets tight, will they abandon those ideals? Several craft brewers and smaller merchants are already showing their disregarding for contracts. If the ugly side of human nature takes over and hops once again become just a commodity sold to the lowest bidder, the movie will, again, end the way it has so many times before. Something is different in 2017. 

 

Sit Rep

In the aroma hop market in 2017, supply and demand are tracking well save for the recent decline in the growth of craft beer. Although the corresponding adjustment needed in the hop world today is less than ideal, it is not so dire as in the past. The difference is the growth. The worldwide preference toward craft beer continues to grow bringing a disproportionate demand for American aroma hops. That growth provides the unprecedented opportunity for the hop market to navigate the current situation avoiding extreme surplus and shortage and the price fluctuations of the past. We are, however, in uncharted territory. Anything is possible, but there are no guarantees.

The hop and craft market today is more segmented than ever before. Although many brewers are long on hops, there is not a surplus of hops in general. Many brewers still need to buy hops. Then there is the alpha market, which is on the verge of deficit. For craft brewers who were proactive and already renegotiated contracts, future supply problems are largely resolved. For those who chose to kick the can down the road or were not flexible, the options remaining are greatly reduced. Excess inventories from the 2015 and 2016 crops linger, but brewers are slowly working it into their production. Others are quietly selling their surplus, careful not to dump prices so as not to harm the hop market or the value of the inventory they purchased. We’re all hop merchants now.

 

If there enough hops, why are farmers planting more?

The simple answer is because there are breweries that still need hops. The market is much more complicated than it appears on the surface. Some merchants will not allow breweries that over bought to renegotiate contracts. Rather than shuffling existing inventory between the “haves” and the “have nots”, they keep contracts in place. They sign new contracts with new customers. In theory, there is nothing wrong with this, except that it delays the problem of dealing with excess inventory until another day. On paper, this creates the perception that sales are growing. This looks great to investors and banks. Sustaining massive lines of credit to finance hop inventory for longer periods, now commonplace among hop merchants, is the likely reason.

Brewers are also throwing up roadblocks in the renegotiation process. It takes two to tango after all. Brewers must be willing to let go of current inventory. Many are not. They must be willing to extend contracts further into the future in exchange for relief of current obligations and think they can dictate the terms of their contracts now that they don’t need the hops. Many don’t want to seek a compromise that works for both sides. They fear they will not find the varieties they need again so easily in the future and want to completely abandon the hops they contracted believing they can just buy them on the spot market for less.  Every year, due to the hop industry producing at capacity, there are variety specific shortages and no way to predict from year to year which variety may be short as that depends largely on the weather. The certainty and stability of the supply of a variety is jeopardized while the market is so near the point of equilibrium, as it is today. When brewers move away from contracting, which is already happening, it leaves growers with no guide as to the varieties the market needs. 

 

The Catch-22

Prices for hops remain stable at a historically high level due to the cost of expanding infrastructure. Coincidentally, many breweries feel that pain too, having recently finished financing expansions of their own. The market for which they expanded, however, has not materialized meaning many will be laden with debt and producing below capacity. Revenue from beer sales has slowed in 2017 further restricting cash flow causing many brewers to withhold payment for hops until absolutely necessary.

Brewers’ lack of payment for contracted hops increases the costs and risks associated to carry each crop from the time it is produced until the time it is delivered. Despite the slowdown, growers still expect to be paid on time. Many brewers do not take this into consideration, or simply don’t care. If this additional expense continues, hop prices to brewers should increase. That is not likely to happen due to the competitiveness of the hop market. Prices, however, are also not likely to decrease anytime soon due to the additional expenses inherent in the industry today. 

 

When perception is not reality

To a Koi in a shallow pond the world is very simple. She doesn’t perceive the world on the other side of the water. She may not even realize she is swimming in a manmade pond. Similarly, many brewers believe they understand the hop market. They are convinced hop prices will plummet soon because they hear oversupply exists. After all, that is how the market behaved in the past. That perception is overly simplistic. They see the market in two dimensions, supply and demand. The hop market has at least a few more dimensions. Cost of producing a crop and the debt associated with it provides depth to the picture. How the market behaves over time adds breadth. The increased complexity introduced by the larger number of players growing, selling and buying hops increases the randomness of the path forward making the path forward less predictable. Sustained growth and a state of equilibrium has never existed in the hop industry before and it is proving to be a very precarious place. 2017 will be a pivotal year for the hop industry. Beyond 2017, the future of the hop industry is murky and unpredictable.

 

 

 

 

 

The ROI of CBC

If we’re being honest isn’t the purpose of a hop merchant having a booth at the trade show to sell hops? If you think it’s just to say hi to everybody and shake hands with customers, I’ve got some Hopi Luwak™ to sell you. This year, we took a second look at whether there could be enough hop sales resulting from the CBC to pay for a cool booth. With so many large brewers well stocked on hops, the chances of them buying much more are virtually non-existent. The odds of paying for CBC by making sales to small brewers who can afford to attend are slim. Three days just isn’t enough time to do so many deals. A lot of small brewers can’t even afford the thousands of dollars it would cost to attend. We don’t want to do CBC just because everybody else is doing it. It has to pay for itself one way or another.

We asked ourselves, “How could we do this whole CBC thing better than we’ve been doing it?” The answer we came up with was fun and a little crazy. We decided it might be possible to chuck the whole idea. Why mess around with baby steps, right? Go big or go home. To figure out if we were on the right track, we asked some brewer friends if they thought the booth was a necessary part of the merchant / brewer relationship. We searched for a compelling reason to spend several times the average American’s annual salary in just three short days. For the 2017 show, we couldn’t find one.

Responses from our brewer friends varied. Some were surprised. Others were encouraging. In general, they supported our plan. Most take it for granted that every merchant will have a booth at the show. Nobody seemed to think that having a booth at the CBC was all that important. The consensus was that it was just nice to see your hop supplier. Brewers with whom we have the most candid relationships shared with us that they had always wondered, how much they were over paying hop dealers so they can afford those booths. We decided that there was so much more we could do with that CBC booth money.

“How much are we over paying hop dealers

so they can afford those booths?”

So … We’re experimenting in 2017. Whether we exhibit at the 2018 CBC will depend on how it all goes. We’ll be at the show. We’ll attend the presentations. We plan to roam the show like gypsy hop merchants. If you see one of us walking around in a 47Hops shirt and want to talk hops, say howdy. The deepest discounts and opportunities are reserved for people who buy online or who stop us in person at the show. We’ll still offer sale prices during CBC week for people stuck in the 20th century who prefer to email or call. So … If that’s how you roll, don’t worry. Since we’re not blowing a small fortune on a booth this year, we can offer a metric butt load of discounts. Take advantage of that! 😉

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