CRISIS IN A COFFEE CUP
The price of beans has crashed. Growers around the world are starving. And the quality of your morning cup is getting worse. So why is everyone blaming Vietnam?

By Nicholas Stein
FORTUNE   December 9, 2002

NESTLED AMONG THE RUGGED HILLS OF VIETNAM'S CENTRAL HIGHLANDS, 200 miles north of Ho Chi Minh City, Buon Ma Thuot is a remote and isolated village in a remote and isolated land. The only road in and out of town is a narrow, winding, muddy track interrupted by gaping potholes and meandering yaks. Until the mid-1990s the region was notable only for a key battle in the final days of what Vietnam calls its American war. A replica of the first North Vietnamese tank to roll into Buon Ma Thuot sits in the center of town as a monument to South Vietnam's "liberation." But in the past decade almost everything else here has changed. The rain forest that once blanketed the region is gone--pulled up and burned down to get at the fertile soil beneath. The population has exploded. And the streets now reverberate with the buzz of motorcycle traffic and the hum of commerce. The development is exemplified by Phuc Ban Me, a gaudy resort complete with a hotel, a sprawling water park, and a karaoke bar built in the shape of a cave.

The catalyst for Buon Ma Thuot's growth was a plant associated more often with the lush climes of Latin America than the jungles of Southeast Asia: coffee. Between 1990 and 2000, Vietnamese farmers planted more than a million acres of the crop. Annual production swelled from 84,000 tons to 950,000, enabling Vietnam to surpass Colombia as the world's second-largest producer (Brazil is the first). Vietnam may not have Juan Valdez, but its coffee is probably in the can in your kitchen pantry.

In 1997, after a frost in Brazil sent the price of green (unroasted) coffee on New York's Commodities Exchange soaring above $3 a pound, Buon Ma Thuot's coffee sector suddenly had more money than it could spend. But the coffee renaissance in Vietnam proved short-lived. In 1999 prices began to fall, sinking last December to 42 cents a pound, their lowest level in a century. For three consecutive years prices have not even covered the cost of production. Many of the region's farmers are heavily in debt. Some have replaced their coffee plants with corn or pineapples. Others have simply abandoned their farms. Phuc Ban Me gets few visitors these days, and its water park stands vacant, a reminder of the excesses of the boom.

Vietnam's coffee industry is not the only one suffering. The prolonged price slump has ravaged many of the world's 25 million coffee growers. In Central America, where the costs of production are triple those of Vietnam, the repercussions have been particularly severe. The U.S. Agency for International Development estimates that at least 600,000 coffee workers have lost their jobs. Conditions are equally dire in Africa, where impoverished nations such as Uganda, Burundi, and Ethiopia rely on coffee for the majority of their export revenues. Nestor Osorio, executive director of the International Coffee Organization, calls this "the worst crisis ever" for coffee, the second-largest globally traded commodity, after oil.

Vietnam is not just a victim of the crisis. For many, it is also the chief culprit, responsible for flooding the market over the past five years with millions of bags of unwanted coffee, upsetting the fine balance between global supply and demand for its own short-term gain.

But the depressed prices plaguing coffee growers are not simply the result of a cyclical glut. They are also caused by two systemic changes within the global coffee world: the collapse of the cartel that kept prices at sustainable levels for nearly three decades, and the development of new coffee-processing technology, which prompted a shift away from high-quality arabica beans to cheaper, lower-quality robusta. The former was brought on by complex geopolitical developments. The latter can be traced to the coffee divisions of four multinational conglomerates--Nestle, Kraft, Procter & Gamble, and Sara Lee--which buy nearly half of the world's coffee and own some of the best-known brands, including Nescafe, Maxwell House, Folgers, and Chock Full o' Nuts. In the past, these Big Four coffee roasters blended small amounts of robusta with arabica to pare their purchasing costs. But technological advances have allowed roasters to neutralize robusta's harsh, unpleasant taste. To reduce costs further, the Big Four have significantly upped the percentage of robusta in their blends, substituting it for arabica they once purchased from small farmers in Latin America and Africa.

Most of the robusta comes from Brazil and Vietnam, which together have seized a greater share of global exports, up from 29% in 1997 to 41% last year. "Brazil and Vietnam offer excellent coffee at very reasonable prices," says Frank Meysman, head of Sara Lee's worldwide coffee business. "It will be difficult for other countries, particularly in Central America, to compete."

The switch to cheaper beans in the past five years has provided a windfall for the Big Four. Though none of the companies releases financial results for its coffee divisions, all acknowledge they have enjoyed record coffee profits.

But the short-term economic advantages of robusta are overshadowed by long-term costs--for growers, drinkers, even the Big Four themselves. In the past ten years, as the global coffee market swelled from $30 billion to $70 billion, the revenues of growers have dwindled. Coffee drinkers, meanwhile, have had to contend with declining quality: The java at your local grocery store or deli now contains more robusta, and gourmet purveyors, which rely exclusively on the high-quality arabica growers in Latin America and Africa most damaged by the crisis, are having a tougher time sourcing beans. When quality drops, people tend to drink less coffee. Over the past decade, even as the gourmet coffee sector enjoyed tremendous growth--symbolized by Starbucks--per capita consumption of the regular and instant coffees sold by the Big Four declined. For the moment, low coffee prices have allowed them to hide the shortfall with higher profit margins. But eventually they face a shrinking pile of beans.

Despite the emergence of Vietnam as a coffee power, Brazil continues to dominate the global market. Last year it exported 1.4 million tons, more than a quarter of the world's supply. If Brazil experiences a frost, coffee prices move skyward. If the harvest is bountiful, prices fall.

That hasn't always been the case. Coffee was discovered in Ethiopia sometime before the tenth century, and its use was confined to the region for hundreds of years. With the rise of the Ottoman Empire, the drink acquired a devout following throughout the Muslim world. In the 16th century a group of priests tried to persuade Pope Clement VIII to ban the drink. But after tasting it, the Pope had other ideas. Coffee soon became popular across Europe, and each colonial power sought new areas suitable for its cultivation.

The plant arrived in Brazil in 1727. The soil, climate, and elevation proved ideal for the cultivation of all types of coffee, and the country soon became the world's leading grower. The original coffee exchange still stands in the old quarter of Santos, a sleepy port 45 miles from Sao Paulo. Packed into a half-dozen office buildings, a small community of traders handles the sale and export of most of the nation's production.

Marcio Hazan is one of them. Tall and lanky, with closely cropped hair, Hazan monitors the quality of the 450,000 bags of coffee his family firm, Comexim, sells each year to Kraft, Sara Lee, and other roasters. Until recently most of it was arabica. But spurred by the explosive growth of Brazil's robusta production, which now rivals Vietnam's, the firm exports a large volume of robusta as well.

On a table at Comexim's headquarters, Hazan arranges coffee samples into orderly piles, passes the beans through screens to gauge their size, then counts the defective ones--those that are black, broken, or unripe. (The best coffee has defects of 1% or less in a 300-gram sample; the commercial grade that forms the bulk of Comexim's business can have up to 10% defective beans.) Finally Hazan and the firm's specially trained tasters, known as "cuppers," taste several cups from each sample to check flavor and consistency. The sessions resemble wine tastings: Cuppers slurp the coffee loudly from spoons to distribute it across their taste buds, swish it around in their mouths, then spit it out in a long, practiced stream.

Classifying coffee requires the precision of a scientist and the imagination of a painter, as the slightest change in ecology, topography, or climate can influence the quality of the bean. Even the best arabica, grown under ideal conditions, can be destroyed during the long journey from farm to cup. The bean is half of the two-sided seed of the coffee cherry. Processing, which must be done immediately after the harvest to prevent spoilage, involves extracting the beans from the fruit and reducing their internal moisture. The traditional method is to dry the cherries in the sun before removing the pulp. The moisture in the beans slowly evaporates, resulting in a coffee rich in body and flavor. But coffee ferments if exposed to water. In Colombia and much of Central America, where it rains during the harvest, the beans are mechanically removed, then dried in large air dryers. This "washed" method results in a milder, more aromatic coffee.

Although Brazil is an anomaly among producers, with several 10,000-acre farms, most growers own fewer than ten acres. So Hazan often must combine coffee from hundreds of samples. "Everyone likes coffee with slight differences in size, acidity, and flavor," says Rasmus Wolthers, a coffee trader whose firm, Wolthers & Associates, supplies Dunkin' Donuts.

Until the collapse of the coffee cartel in 1989, the dramatic swings in the price of coffee so prevalent in the past decade were more muted. The cartel was created by an agreement between producing countries that kept prices at sustainable levels by limiting supply. Producers employed a quota system similar to OPEC's. When prices rose above an agreed-upon range, quotas were increased to bring supply and demand in line. When prices fell below the range, quotas were reduced. The system kept coffee prices stable throughout most of the '60s, '70s, and '80s. But unlike OPEC, the agreement required the participation of consuming countries as well, particularly the U.S., which imports a quarter of the world's supply. During the Cold War, the U.S. supported the cartel for political reasons: It didn't want disgruntled coffee farmers joining communist movements in Latin America. After the demise of the Soviet Union, the U.S. pulled out, the cartel unraveled, and prices plummeted. Unfortunately for coffee growers, the collapse coincided with Vietnam's decision to expand its production.

Six hours north of Ho Chi Minh City, deep in Vietnam's Central Highlands, the rubber forests and pepper trees that line National Road 14 suddenly give way to piles of drying coffee cherries. Behind them, modest cottages preside over small plots of leafy green plants. On a warm August afternoon, coffee trader Jens Nielsen pulls up unannounced at one of the cottages.

Nielsen has both witnessed and participated in the remarkable development of Vietnam's coffee industry. For much of the past decade the square-jawed Dane worked in the Asian offices of several large European traders. Last summer he opened a coffee-trading division in Vietnam for Noble Group, a Hong Kong commodities firm.

Traders are the middlemen who transfer coffee from millions of small farmers to a handful of multinational roasters. They source, classify, and deliver the beans in exchange for a commission. Since most coffee is purchased on the futures market, traders can increase their take if they bet correctly on the spread between what the price is today and what it's likely to be in six months. To improve his odds, Nielsen talks frequently with farmers about their expectations for the coming harvest.

The cottage's inhabitants, 54-year-old Vi and his wife, Hue, invite Nielsen inside. There's no electricity, and the only light streams through an opening, illuminating two sparsely furnished rooms. As Nielsen peppers Vi with questions, Hue pours steaming green tea into mismatched glasses.

Vi's story is the story of Vietnam's coffee miracle: how the country transformed its fledgling coffee industry into a global behemoth. It is also the story of how that miracle became a nightmare.

Vietnam grew coffee before the 1990s--the plant was introduced by the French 100 years earlier. But they were never able to produce much because Vietnam was not ecologically suited to growing arabica. In 1975, the year the U.S. withdrew its last troops, fewer than 20,000 acres were under cultivation. But by 1990, after the hardier robusta plant was introduced, that figure had grown to 200,000 acres.

Vietnam's communist government concentrated its postwar rebuilding efforts on agriculture, paying special attention to coffee. The government resettled millions of Vietnamese from crowded urban areas to the underpopulated Central Highlands, where more than half of Vietnam's coffee is produced. When Vietnam liberalized its economy in 1986, many of those new residents bought their own farms. The government provided more than $233 million in loans through its Bank for Agriculture & Rural Development. After ownership of the state farms was transferred to growers, yields jumped by 400%.

Vietnam's coffee miracle also received the enthusiastic support of outsiders. Prior to 1990, the Soviet Union provided equipment and expertise in exchange for coffee. In the years since, the French, German, and Swiss governments have contributed an estimated $100 million, while the World Bank, through loans to Vietnam's agriculture bank, provided at least $16 million more. Nestle, Kraft, Sara Lee, and several large trading firms also sponsored coffee-related development projects.

Word of the coffee renaissance happening in the Central Highlands spread, luring workers from around the country. Some purchased land legitimately. Others simply selected a vacant tract of rain forest, burned or cut down the trees, and planted coffee.

Vi and Hue came to the area in the early 1990s. They bought three acres of land for ten million dong (about $700) and planted robusta. It takes two to three years for the trees to flower. To carry them over, Vi borrowed ten million dong from the state's agriculture bank.

At first their business flourished. Prices were at an all-time high, and Vi sold the 4 1/2 tons he produced annually for 67 cents a pound. His cost was 24 cents a pound, leaving him more than $4,000 a year in a country where the average annual salary is $370.

In 1999, partly because of the Vietnamese robusta flooding the global market, prices began to drop, eventually plummeting to 12 cents a pound, well below Vi's cost of production. To reduce his labor costs, he and his wife now harvest their crop themselves. He also stopped buying fertilizer. As a result, his production has fallen to less than half of what it was just three years ago. "Farmers grew first and looked for the market later," says Nielsen. "It turned out to be an expensive lesson."

Vi has also been forced to borrow at a steep rate of 5% per month from a private money lender, who happens to be the local coffee baron who buys his crop. To raise cash he sold this year's production in advance of the harvest--at half the market price.

Now that irate coffee growers and industry officials blame Vietnam for the global crisis, those who contributed to the sector's growth have sought to minimize, and in some cases deny, their involvement. The World Bank has issued a strongly worded statement disclaiming any direct investment. Even the Vietnamese government has waffled about its role.

Of course, without a market for cheap, low-grade robusta, there would never have been a coffee boom in Vietnam. And that's exactly what the Big Four, along with other large European roasters, provided. They took advantage of new steam-cleaning technology to eliminate the coffee's harsh flavor. They introduced flavored coffee--hazelnut, Irish cream--to disguise robusta's inferior taste. And they benefited when the London Commodities Exchange lowered its quality standards so that Vietnamese coffee would qualify for futures trading.

But in places where the taste isn't steamed away, including much of the developing world, most robusta remains largely undrinkable. It's not surprising that the Vietnamese saturate their freshly roasted beans with butter and fish sauce, then drown out the brew's flavor with copious quantities of sugar and condensed milk. Or that when you enter a coffee shop in Buon Ma Thuot, you are immediately served a pot of tea.

Yet Vietnam's apparent indifference to drinking coffee is deceptive. While per capita coffee consumption in the developed world has been declining for decades, consumption in the developing world is growing. The Big Four recognize that their future may be in markets immune to the $4 latte. They hope to reach potential coffee drinkers through their wallets, not their taste buds, and to achieve that they need a ready supply of robusta. "Less than 20% of the world's population is drinking 65% of the coffee," says Gordon Gillett, a senior vice president at Nestle. "We think there is a huge opportunity to reach out to that other 80% and deliver them a coffee beverage they can enjoy at a cost they can afford."

The men who gathered for lunch in June at a farm on the outskirts of Monte Carmelo were doing something unusual for coffee growers these days. They were celebrating. And judging from the surroundings, it was easy to see why: With its tree-lined driveway, stately villa, and swimming pool, the lavish Brazilian farm bore little resemblance to the modest coffee plots of Buon Ma Thuot.

The mayor of Monte Carmelo was in attendance, but the luncheon's guest of honor was Andrea Illy, chief executive of the Italian coffee roaster that bears his family's name--and that many Brazilian coffee farmers who produce gourmet quality coffee hold responsible for their good fortune. During the past 12 years the Illy family may have had more impact than anyone on the creation of a high-quality coffee sector in Brazil. The family-owned company's standards are among the most stringent in the industry, and Illy pays handsomely for the beans that meet them. At a time when arabica prices are well below the cost of production, Illy pays growers as much as twice the going rate for their finest coffee. "One day people may pay very high prices for quality coffee as they do for wine," says Illy, "instead of buying it all as a commodity."

Yet the indirect benefits Illy has brought to Brazil may be even more valuable than the millions of dollars a year the company puts in the pockets of the country's coffee farmers. Illy taught Brazilian growers how to produce high-quality coffee, in the process helping Brazil shake its bad reputation among the gourmet coffee crowd. As a result, the Brazilian growers who supply Illy--and those who don't--get more for their coffee today, relative to the market price, than a decade ago. "The Illys were pioneers," says Joao Carlos de Souza Meirelles, the secretary of agriculture for Sao Paulo State, a large coffee-producing province. "They helped us learn to produce high-quality coffee, first for them and then for everybody else. Today we don't think anymore in terms of quantity of production. We think in terms of quality of production."

There have always been discerning coffee buyers willing to pay a premium for the best beans. But led by the efforts of Starbucks, Illy, and others, the specialty-coffee sector has grown enormously in the past decade and now constitutes about 19% of the coffee market in the U.S. and 10% of exports worldwide. That has provided growers blessed with the right conditions--and willing to devote the time and investment--with the chance to grow gourmet coffee. Traditionally those coffees have come from Colombia, Central America, and Africa, although the disastrous impact of the coffee crisis on all of those areas has given Brazil an opportunity as well.

When Illy first bought coffee directly from Brazilian farmers in 1991, the country's reputation as a cheap, low-quality producer was so ingrained that Starbucks and others wouldn't even look at Brazilian beans. Under the cartel, growers received roughly the same price for their coffee regardless of quality, leaving them little incentive to improve. But the cartel's collapse forced Brazil to open its market to foreign exporters for the first time in decades.

That coincided with a change in Illy's purchasing strategy. Since it was founded in 1933 by Andrea's grandfather Francesco Illy in the Italian port of Trieste, Illy has differentiated itself by building the company around a single product: the finest espresso coffee. Illy's espresso is a blend of coffees from around the world. And sun-dried Brazilian arabica is a crucial ingredient. It gives espresso body and helps develop the rich, creamy layer of emulsified coffee oils, called crema, on the drink's surface. Until the late 1980s, Illy bought its coffee from exporters in Brazil, like everybody else. But as the company expanded outside Italy, it had an increasingly difficult time finding the beans it needed.

Illy's solution was to give the commissions it had once paid middlemen directly to farmers. The company pays enough to ensure that suppliers can sustain their farms. To find the best growers, Illy started a competition in 1991. Growers submit samples, and the winners become Illy suppliers. The process has made Illy's purchasing more efficient. "We used to have to analyze 45 samples to find one good one," says Aldir Teixeira, the white-haired agronomist who runs Illy's quality-control lab in Sao Paulo. "Now we buy one out of every three or four."

The scientific rigor Illy brings to selecting and producing its coffee is unusual. Andrea and his father, Ernesto, Illy's chairman, both trained as chemists and can speak at length about the science of coffee; Ernesto recently published an article on the subject in Scientific American. And then there are the gadgets. Patriarch Francesco Illy patented the first automatic espresso machine in 1935. In the years since, Illy has been responsible for numerous innovations, including an electromagnetic sorting machine for coffee beans, a canning process that keeps coffee fresh for two years, and an idiot-proof pouch that eliminates human error from the espresso-making process. The Illy laboratories in Sao Paulo and Trieste are outfitted with scientific instruments, from mass spectrometers to gas chromatographs, all employed in the service of perfecting espresso.

But the Illys are neither mad scientists nor bleeding-heart philanthropists. Their direct-buying model was created in the service of the company's expansion. Proponents point to Illy's financial success as the reason its model may offer a viable solution to the global coffee crisis. "If we are ever going to have a better situation," says Pablo Dubois, head of operations for the International Coffee Organization, "the efforts of companies like Illy need to be reproduced and enlarged."

In recent years other companies have begun to follow Illy's lead. They tend to be socially conscious and include smaller specialty roasters such as Green Mountain Coffee and Seattle's Best. An association of wholesalers, retailers, and producers called Fairtrade, affiliated with the relief organization Oxfam, has also become a large direct buyer of coffee. But because Fairtrade pays the same minimum price regardless of quality--currently $1.26 per pound--some have criticized its members for having an inconsistent product.

The question that remains is whether the Illy model is viable on a larger scale. So far the answer appears to be no. Nestle says that only 13% of the estimated 13 million bags of coffee it buys each year comes directly from the farm; Sara Lee claims 10%; P&G and Kraft don't buy directly at all. But regardless of their individual commitments, none of the Big Four believe it is a long-term solution for ailing growers. "For us it would be impractical and less financially feasible to manage commercial relationships and bean quality at the farm level," says P&G spokeswoman Tonia Hyatt. "We would have to work with one million growers to buy directly."

Even Starbucks, which sells Fairtrade coffee and has made a big effort to publicize its support for so-called sustainable coffee, buys less than 10% of its beans directly. The rest come from the same giant traders that supply the Big Four. "We would love to know where all our coffee comes from," says Mary Williams, a Starbucks senior vice president. "But it is very difficult to purchase directly from such small farmers."

The ICO's solution to the crisis is to eliminate the bottom 5% of the market--the lowest-quality producers. The organization recently began implementing higher minimum standards for exported coffee, which the ICO estimates will eliminate 300,000 to 400,000 tons a year from the market, about half the current surplus. It wants the industry to compensate farmers hurt by the policy and to help them grow other crops. Some in the industry say the U.S., as the world's largest consumer of coffee, could further reduce the global glut if it brought its import standards in line with the ICO's. Although a lot of really bad coffee is pouring into the U.S. every year, no one will admit to buying it. Big Four executives insist they do not buy coffee below the new ICO standard, which allows half as many defects, yet they all oppose the idea of raising the U.S. bar.

Recently the U.S. has taken a more active role in resolving the crisis. In mid-November, citing concerns about Colombian coffee farmers growing cocaine and opium bound for U.S. shores, the House of Representatives passed a resolution calling on the Bush administration to "adopt a global strategy to respond to the coffee crisis." Meanwhile, the Agency for International Development has been helping coffee farmers in Latin America with crop replacement.

Robert Nelson, president of the National Coffee Association, a U.S. lobbying group, says the quality debate is off base. "Some in the industry would like people to think that if we only grew cause-related, organic, shade-grown coffee, the crisis would be over," Nelson says. "There just isn't a huge market out there for this kind of coffee, and to encourage people to grow it would be doing them a disservice." The only way to resolve the crisis, the Big Four argue, is to increase consumption, especially in the Third World. "There are various stages in the development of a coffee culture," says Nestle's Gillett. "It's no good offering an Asian consumer a very high-priced coffee to draw him to coffee as a beverage. You have to offer him something he can afford and appreciate, and then as that coffee culture develops you start to introduce more-sophisticated products."

But the past few years have been a missed opportunity for the Big Four, which lost market share to the gourmet sector during the 1990s. With coffee prices at historic lows, the Big Four could have improved the quality of their products while preserving profit margins. Instead, they chose to fill their cups with short-term profits. In the long run that may prove to be an empty strategy.