WARNING: In this article, I dive deep into the hop market and the alpha cycle and explain why the same things keep happening over and over throughout history. If the hop market is not your cup of tea, stop reading now. I hope there are a few brewers out there who care how the hop market works and why prices spike every so often.
There are parts of the hop market that are very predictable and others that remain a mystery. About 9 years ago, I gave a presentation to Canada Malt in Calgary, Canada, during which I shared my predictions for the hop market for the next 10 years. Those who attended will certainly remember. During that presentation, I told the group assembled that between the 2016 and 2017 crops another alpha shortfall was very likely. At the time, we weren’t competitors in the hop space as we are today. I was actually involved in talks of cooperation with Country Malt Group regarding the marketing of hops so it made sense to share my views with them at the time. My calculations and predictions over the past 9 years have since played out. Only this time we may be facing a situation unlike any other in anybody’s living memory.
For all you out there who see record hop acreage and production in the U.S. and around the world and think there’s no way on Earth there could possibly be a hop shortage now, there’s something big you’re missing. The hop market is much more complex than it appears. There are multiple markets within the hop market. On the macro scale, there is an alpha market and an aroma market. On a micro scale, every variety creates its own unique market that reacts to supply and demand. As we have seen in recent years, there can be shortages of aroma varieties that are easily substituted with other aroma varieties. Aroma market shortages are relatively easy to solve through substitution. After all, how much of a variety do you really need in a beer to say it contains that variety? The alpha market is a different beast all together.
In a nutshell, the alpha market cycle works like this:
- At some point the market responds to shortage by creating enormous oversupply. Usually, this happens quickly as farmers in Washington and Idaho can plant hops in the spring and expect a decent yield that fall. The rest of the world cannot respond so quickly. It takes 2-3 years to get a full crop in other growing areas. This quick response is both a blessing and a curse in that it enables a quick response time to shortages, but also enables a quick development of a structural overcapacity.
- With no significant customers other than brewers, an oversupply of alpha typically results in crashing spot market prices as farmers dump excess inventory rather than store it beyond the next crop, which will bring more unnecessary inventory, creating the perception that it should be discounted. Every brewer I have ever met is very focused on price, and getting the lowest possible price. Maybe that’s human nature, but with no outlets farmers compete against each other for limited market share driving prices down quickly in a anything other than a short market.
- Gradually, after prices settle far beyond the growers’ pain threshold and there is no hope of a possible market recovery, hop acreage and production decline. That pain occurs at a different level for each farmer prolonging the period of over production and adding to the stockpile. That pain threshold depends upon a farmer’s efficiency, but also by the debt load they carry. Today, the industry is deeper in debt than it has ever been, which will give farmers few options the next time prices plummet.
- One unfortunate fact for the hop market is that hop acreage is never removed as quickly as it is planted. Farmers try to outlast their neighbors (i.e., competitors for limited market share). The lingering structural over capacity insures surplus production continues well beyond the point of equilibrium that should result in acreage reductions. This creates a stockpile of inexpensive surplus alpha inventory, which if processed correctly, can be stored for over a decade.
- Finally, after widespread pain across the industry, necessary acreage reductions happen. By now, it is too late to bring the market back into balance.
- The awareness of the existence of a stockpile of surplus inventory continues to suppress prices. The market does not reveal when equilibrium occurs. It is possible to calculate when that happens, those numbers are just not made public. Price does not respond to the acreage reductions at this point due to awareness that an oversupply of alpha acid exists. Therefore, there are no market signals to the farmer exactly when to stop removing acreage. The signals of oversupply continue until annual production is well below annual demand.
- Growers continue to remove acreage because prices stay below the cost of production. Prices continue to be pushed down both by the farmers’ need to liquidate inventory. Things are getting desperate by this point. A lack of alternate markets and brewery demands for the cheapest prices possible exacerbate the problem.
- An increasingly large annual production deficit develops, which erodes the stockpile.
- After several years of this gradual erosion of the stockpile, the stockpile of inventory gets tight. During this time, annual production may still decrease because price signals continue that might signal to the market it is oversupplied. Some early market watchers will begin buying alpha because they know what is around the corner. At this point, annual production is far below annual demand. A severe crop failure could create the perception of a shortage. Average crop yields, will, on the other hand, continue to disguise the problem for several more years.
- That tightness, and the return of buyers into the market for fresh crop at slightly stronger prices, is a signal that shortage, or at least the perception of potential shortage, is approaching. Merchants act quietly behind the scenes to secure alpha while prices are reasonable hoping to bring the market closer to equilibrium and avert a crisis. Once farmers sense what is happening, they will slowly demand higher and higher prices because they feel the opportunity is there.
- To pull off this strategy and avoid a crisis assumes reliable average yields year after year and the absence of crop failures. If yields are short, however, it can send the alpha balance into short supply. Every brewer carries inventory to carry them through to the availability of the next crop based on their comfort level. That means that there is never really a time when there is NO product available. Every product just has its price. When the awareness that a potential shortage exists and when it begins to spread, companies that do not have enough alpha purchased to get them through until the availability of the next crop, begin to search for inventory. They search for inventory with all the usual suppliers to bring them back to their comfort level. Companies that have inventory typically start to hang on to it for fear of further rising prices in future years. Due to the lack of a formal exchange mechanism and the opacity of the hop market, this all happens quietly behind the scenes. The search happens by brewers with multiple merchants simultaneously, which can send misleading signals to the industry regarding the size of a potential shortage. The demand signals can appear much larger than any shortage (real or perceived) actually is.
- At first, the signals of an impending shortage are limited to the merchants. Today, many farmers are also merchants in that they sell direct to breweries. How that will affect the next shortage will be interesting to see. There many more sources for hops for brewers today than in the past making the market more fragmented, less organized and therefore, in my opinion, more vulnerable. When the perception of a surge of sudden demand reaches the farmer level, farmers and some merchants may hoard inventory for fear of an all out shortage. Some legitimately hang on to inventory to secure their perceived needs. Others do this to capitalize on rising prices.
- Of course, hoarding worsens the supply situation creating the perception of a shortage that is bigger than it actually is. This causes a vicious upward spiral of pricing that ends only when the market is convinced it has been fully satisfied. I have heard speculation by farmers and merchants that brewers intentionally over contract to push the market into surplus territory again, but I have never seen any proof of this. I suspect they haven’t either. Still … who doesn’t love a good conspiracy?
- Eventually, the demand is satisfied. Some people who held out for higher prices will be left with hops they cannot sell as the market moves back into an oversupply situation.
- Rinse and repeat
The last time this cycle began was in 2007. Prices increased gradually in the spring and summer of that year after a second poor crop in a row at a time when the stockpile was low. Prices spiked quickly in November at the Brau trade show. Prices continued to increase until February of 2008, by which time brewers signed hundreds of millions of dollars of contracts. Those contracts resulted in over 10,000 additional hop acres in the United States in 2009, quickly creating a very real surplus of alpha acid. Fortunately for farmers, the craft beer industry began to surge enabling them to lessen the pain of switching from alpha hop acreage to aroma hop acreage. The lack of cooperation within the hop industry makes a coordinated effort to manage acreage and avoid shortages impossible. Today’s fractured market dynamics mean that today no merchant can reasonably expect to singlehandedly control the market.
So … Where are we now in this process? Based on my calculations, I believe the hop industry passed the point of equilibrium with regards to alpha acid several years ago. With all the attention in the hop industry on aroma varieties, the alpha balance has gone largely unnoticed except to those deep on the inside tracking those sorts of thing. You won’t read much about that anywhere.
The balance of inventory now sits at that same crucial point at which it found itself prior to the 2007 crop. What all this means is that the alpha balance and the pricing of alpha hops for the next year or two depends largely on performance of the 2017 crop. If the 2017 crop produces an average yield, a potential crisis will be delayed giving one more year to fix the problem before it emerges. There is one significant difference from the alpha market of 2007 relative to the 2017 market. Due to the recent preference for American aroma varieties, the German hop industry supplies an enormous amount of alpha hops to the brewing industry today. German hops are susceptible to drought. At the time of this writing, due to an unusually hot summer, the 2017 German crop estimates, which are becoming increasingly more common say that Germany will produce 23% fewer hops than it did in 2016. The long-term weather forecast for Wolnzach, Germany is for more heat combined very little rain.
There is a point at which irreparable harm has been done and the crop cannot improve regardless of weather conditions going forward. That date depends on whether a variety is harvested early or late. A double whammy can occur in a very bad crop year. Not only can crop yields be low. Reduced alpha yields in the remaining crop can further reduce the amount of alpha acid production at the last minute. Alpha acid production is affected by adverse weather conditions and by attacks of pests and diseases that accompany it. Alpha yields cannot be reliably known until much closer to the time the crop is harvested. That has the potential to deliver an unfortunate one-two punch during the last round. That was the case in 2007/08 and the potential is there for that to happen again in 2017.
The current alpha balance is in a very precarious position. There are no data that show this because it is something that is not officially tracked, but it can be calculated. IF the 2017 German crop is as short as current estimates indicate, and IF alpha yields in the rest of the crop are also reduced, a very serious alpha deficit situation can occur at a time when there is not a surplus inventory available worldwide to offset it. IF that happens, and IF a significant number of brewers believe they need to purchase alpha acid to make it through until product from the 2018 crop is available, the result can be sudden increases in demand for alpha hops. If that happens, prices will respond accordingly.
None of this takes into account the potential challenges faced in the U.S. growing region. This week the Yakima valley is experiencing a heat wave with record breaking temperatures that has mite populations soaring. Mites can cause serious damage to the crop resulting in lower yields. For the U.S. growing region, the next couple weeks will also be crucial in determining the size of the crop. It’s not over until the final buzzer. This year, it’s like watching your favorite sports team fighting their archrivals in the final minutes. We’ll have to wait to see what happens next.
In 2007 and 2008 brewers who were able temporarily shifted to more efficient hop products to gain brewing efficiency thereby reducing their demand for alpha acid. Those products, however, still require hops and alpha acid, which were in short supply at the time. In 2007/08, there was not enough alpha acid in the market to quickly bring brewers to their comfort level. Once traditional sources for alpha acid were exhausted, demand for aroma hops containing high levels of alpha acid followed. The price spikes of 2007/08 affected brewers who did not traditionally rely upon alpha hops. Prices for varieties like Willamette and Saaz, which have less than 5% alpha acid, increased to several times their normal price levels. At that time, they could only be purchased together with long forward contracts.
Once again, there are strong signals in the market that the alpha market will be undersupplied. Will 2017 be a repeat of 2007? It is impossible to say exactly how the market will react at this time. With enormous surplus of aroma hops in the market, 2017 will definitely play out differently than 2007. It is doubtful a shortage of alpha acid in 2017 would result in the extreme price spikes we saw in 2007, but the possibility certainly exists. There are too many variables to accurately predict future prices in a situation like this. IF the German crop continues to worsen due to extreme heat and a lack of rain, the situation could be much worse. The crop condition and the situation with the alpha acid balance demands the attention of any brewer who needs to purchase hops in the next 12 months. Stay tuned in the coming weeks to find out how the situation develops.