March 28, 2004

Cocaine Economics

Product Overview

Production costs are minimal. Low-paid farmers grow a common plant on inexpensive land. After harvesting, an extract is removed by a simple laboratory technique in much the same way instant coffee is produced from the coffee plant. The result is a highly compact product, with an excellent shelf life, sold at profit margins up to 2.6 Million percent (excluding distribution costs). Cocaine is a dream product: compact, addictive, expensive and cool.

Welcome to the high-finance world of Cocaine!

Legal Framework

Before diving into this mature, sophisticated, and expanding global market, legal issues should be considered.

In many countries coca products are prohibited or illegal. Governments cite health risks as the main reason for product prohibition though auxiliary trade issues such as funding for terrorism have been cited in extreme cases.

For decades various national governments have recognized the negative health impact of cocaine product abuse. Unlike similar products they have chosen not to adopt a ‘sin tax’ instead opting for prohibition. The result is that negative advertisement, policing, incarceration and health costs cannot be levied on producer and distributors as is the case in the tobacco industry; so costs are subsumed by local taxpayers. But there is more! All product sales remain tax and duty-free which results in anomalous retail pricing effects. For example, sin taxes in New York City have pushed cigarette pricing to the $7 mark in 2003; this effectively means that crack can undercut a pack of cigarettes and without taxation the retail margins still remain high.

Accusations of links between the coca market and terrorism have seldom been proven; in general terrorism is considered bad for business. However when certain industries are forced to conduct their business in covert or non-conventional ways this can result in queer bedfellows.

One recent example illustrates that terrorism can indeed be a factor in the drug trade and vice versa. Take the Iran-Contra affair. In 1986, the international court in The Hague censured the US government for crimes of international terrorism against the sovereign people of Nicaragua. Though the incident cited was the mining of a commercial harbor, this incident was but a small part of a concerted campaign orchestrated from Washington, D.C. to destabilize the socialist leaning government of Daniel Ortega’s FMLN. Without such covert US funding, and training and support of the Contra terrorists these anti-democratic insurgents exiled in Honduras would have been entirely ineffective and the war of counterinsurgency would likely have never happened.

To be effective against the Nicaraguan army the Contra terrorists needed funding, arms and training. Colonel Oliver J. North orchestrated various funding channels in direct contravention of the wishes of the US Congress for which he was convicted but never served time. The CIA and US Special Forces provided military training on site in the remote jungles of the Honduran Mosquito region focusing on terrorist skills. The Honduran government provided military cover, their troops isolating the region from the rest of Honduras. For their help in the “war on drugs” the US government has since provided the Honduran armed forces with two Black Hawk helicopters free of charge. At a retail purchase price of USD$40Mn. this generosity in US taxpayer monies seems strangely ironic and has proven largely ineffective but I digress.

To fund their terrorist attacks in the mid 1980s the Contra’s primary income was cocaine distribution. The Contras provided distribution services for coca products moving their markets mainly in North America. The US military ensured the profitability of this venture by providing protection services to Contra distribution. Indeed, many believe that this international economic lever is the real reason for the US war on drugs.

The US Congress banned direct investment in state terrorism in Nicaragua. The CIA & the president’s men resorted to providing “alternate aid”. The protection for Contra shipping services enabled them to corner the lucrative distribution contracts and fund their war with proceeds from coca distribution. Distribution protection was not always entirely covert. Tactics included the provision of US military bases as safe landing sites and use of US military hangars as warehousing facilities. Though Contra military successes were less than convincing the secured funding stream resulted in a prolonged military campaign and a flood of cocaine into the US. Protracted war costs, in conjunction with US trade sanctions, eventually had the desired effect; economic collapse brought down the Sandinista Government in the 1980’s.

Nicaragua and the Sandinistas are still struggling to recover. Their 2004 political campaign is being fought under the banners of “With Love all is possible” and “Return power to the electorate.”

Market Essentials

Let us take a closer look at this extraordinary product examining: branding, presentation, product varietals, target markets and distribution.

The coca plant is cultivated in the mountains surrounding the Amazon region. Coca consumption predates Incan times. It was primarily used as a stimulant in much the same way as caffeine is used. Historically, distribution and consumption was local and in the natural leaf form. Few negative health problems resulted from leaf consumption. On the contrary, the number of coca derivatives on the list of FDA-approved of legal and effective drugs is proof of the intrinsic health benefits of the plant.

Modern sophisticated production techniques mean that exploitation of the coca plant has become a global industry par excellence. Because of difficulties in bulk leaf transportation two product intermediates are shipped long distance. Both products are formed from processed coca: fully processed raw powder or the intermediate bulk deliverable coca paste. The common chemical ether is used to isolate active ingredients in the coca plant producing derivative pastes and powders. False shortages of ether have resulted from proscription of this chemical in various Latin American countries. Producers have resorted to the use of bulk diesel with unfortunate consequences of additional consumer health risk.

Retail products are divided into two broad market segments: ‘crack’ and ‘coke’. Naming is by no means standardized. Coke, the white powder retail product is marketed under as many underground brand names as other caché goods like surf boards or sports shoes. The term ‘coke’ is synonymous with many other English terms including, “Charley”, “Columbian marching powder”, "White", "Blow", "Snow", "Powder" and "Rails" or "Lines". Once referred to as "Freebase" Crack cocaine also has many street names.

Legal issues render retail branding impractical but paradoxically sales are strong. Marketing bans have not always been in place. The Coca plant still lends its name to one of the World’s most successful soft-drink brands: “Coca Cola”. Before coca was removed as an ingredient of ‘Coke’ it was an essential product differentiator in the ‘refreshing’ soda market. One reason coke enjoys such market penetration, absent retail advertising, is highly successful film placement and popular music exposure. This media coverage is provided free of charge.

Market segmentation, Pricing strategy and Targeting

The crack segment is a low entry, high volume, low margin product segment targeted at persons with low disposable incomes. Crack is more bang for your buck! Manufacture is extremely simple: small quantities of coke are mixed with bicarbonate of soda and water. This results in increased volume and greater product effectiveness. Paradoxically, the greater effectiveness results in a lower pricing segmentation principally to improve market penetration (see competition below). While addictive reactions to this form are stronger and health issues can result, they have yet to reach levels encountered in tobacco product lines. The crack segment demonstrates a counter-culture ghetto cool. Cross-selling opportunities include other drug products, malt Liquor, menthol cigarettes, and, of course, follow-on sales of more crack cocaine. Product placement is particularly prevalent in the Hip Hop films/music genre.

Coke, the high end product, is targeted to a different, mainly urban market, though the target market is spreading. Historically a slightly older market, with higher disposable income rates is targeted. Data shows that targeting is effective especially in the maximum earning, maximum disposable income ranges. Recently, growth in cocaine sales has been largely due to price reduction and targeting of middle income earners.

Coke product quality and effectiveness can have extreme quality variance but pricing remains at a premium. Geographical factors apply to pricing and quality variants. In the larger markets of the Northern Hemisphere, cocaine customers have been weaned onto lower quality product variants which could be compared with light beer or low-tar cigarettes. Two post-production techniques are used to produce these inferior but higher margin derivatives. Since the product is sold by weight it is often ‘cut’ with inert or alternate active compounds. In some cases where short-term profit outweighs customer-loyalty, dealers add replacement (cheaper) products such as amphetamines substituting for active cocaine. Additions of both inert and replacement ingredients are frowned upon by the marketplace. To alleviate the sales risk associated with marketing inferior product, obfuscation techniques such as misrepresentation of product quality are commonplace. Lack of government regulations have resulted in labeling deficiencies and consumer confusion.

Customer surveys in educated, more local markets such as Peru, Honduras or Belize often reveal higher expectations of product quality. Product pricing and production quality management have risen to meet these expectations. Parallels may be found in successful malt whisky marketing in Scotland or cheese or confectionary sales in France; the bar is raised so production quality rises to meet or exceed expectations. Though pricing is lower, margins remain high as a result of lower distribution cost and easier access to regional markets.

Competition and Distribution

Cocaine distribution presents its own challenges but these are not insurmountable as testified by market growth. Major markets are typically in those countries where legal issues are most draconian. This leads to complications not only in distribution but the resultant gains may present their own difficulties.

A high cost of international distribution principally as a result of US military channel influences is an issue absent for locally produced drug competitors which do not need to cross international borders to access their local markets. This has meant that locally produced synthetic products are eating into the low-end of the market, especially in key markets such as California. The crack segment is currently experiencing severe competition from amphetamine derivatives, speed in particular.

Speed has some innate competitive advantages; principally the fact that it does not need to cross borders to enter its markets and some clear negative differentiators including more extreme health risks. The two products are clearly battling for the same market segment leading to serious downward pricing pressure for both products. Because both speed and crack have minimal production costs the battle is being fought in the retail distribution markets. Ceiling pricing is clearly established by the simple economics of the purchasing power of the target market however, in price wars it is the price floor that is the differentiator.

The low cost of entry into the speed market is a constant threat to the dominance of the crack product. Speed production is often done in small rented apartments or remote rural farms in the United States and Europe. With little or no expertise and minimal production costs the business encourages small entrepreneurial startups. International biker gangs provide cheap distribution networks and effective channel protection; this contrasts dramatically with the higher entry costs and sophisticated international channels required for cocaine distribution.

The jury is out on whether the speed market can continue to make advances into the crack market segment but this is unlikely to affect the high end product sales of cocaine.

In the cocaine market there are new established entries competing for this recreational market. The largest competitor is a relatively recent entry into the market reaching maximum penetration levels especially in the lucrative European entertainment market in the late 1980’s. Marketed under the sexy moniker of ‘ecstasy’ production was largely based in Holland. Ecstasy and cocaine have reached a stable relationship both with mature market shares. This is not expected to change in the short term however, the entry of other ‘designer drugs’ into the market may alter this stability at any time and research is ongoing.

Marketing Case Study

Consider the example of a successful distribution network in urban New York. Such an operation might demonstrate a lucrative income stream in the form of cash or cash equivalents; say USD$100,000,000 per annum of which 50% might be profit. As the business is primarily conducted in cash the repatriation of profits presents some considerable challenges. Southern-bound bulky hard currency costs can sometimes be higher than Northern-bound product shipment to market. This encourages local investment of profits in local currency.

Unfortunately, few investment opportunities offer the capabilities to ‘launder’ the gains into a form declarable to the American Internal Revenue Service for further re-investment. This has led to anomalies in pricing for goods that can be purchased for cash such as property, cash businesses such as restaurants, hotels and cafes, land prices, luxury goods and most importantly, company stock. This effect has been further exacerbated with the introduction of new currencies such as the Euro and new currency notes introduced to combat forgery such as the new US dollar notes.

There are few items that can be purchased for large quantities of cash but stock is one of them. This may seem like a strange loophole indeed but not if one considers the advantages of such a tax law to national exchanges. The incentive to invest is obvious. Even if subsequent share sales result in considerable losses the remaining gain is clean money.

One may speculate that this incentive can account for at least some of the persistently high US Price to Earnings (P/E) ratios for traded stocks. This is of particular importance in privately traded stocks. Current US stock overvaluation as compared to other comparable stock markets is becoming even more difficult to explain as the US balance of payments precipitates the collapse of the dollar.

Post script

Many thanks to the good people of Roatán, Honduras for their expert help in the research for this article.

For further reading on this extraordinary industry consider purchasing a copy of James Mill’s excellent book: The Underground Empire.

Posted by Tony Phillips at 03:49 PM | Comments (2)

March 01, 2004

Honduras: Omoa to La Ceiba

We began our trip that day in the quaint little resort town of Omoa on the coast about 10 miles WSW from Puerto Cortes. Omoa is a backpacker destination which usually means cheap places to stay. For six of seven days of the week backpacker numbers are significant but not on Sunday. When we arrived the tourists were overwhelmed by drunken day-visitors from San Pedro Sula. Cheap beer and seafood, loud music, and the cool coastal breeze draw the Sunday pick-up crowd. They can be found parked on the beach and staggering along the beachfront till the wee hours trying to pick fights or make ‘friends’.

After Omoa our destination for the first full day in Honduras was the port city of La Ceiba. She is the main port town for the Bay Islands, and our eventual destination was the largest of these Islands: Roatán. The trip was a little circuitous avoiding the marshlands at the coasts and the Cortes and Yoro mountain ranges, keeping to the relatively fast paved main roads, south via San Pedro Sula, NNW toward Tula and on Westwards to La Ceiba.

There were a couple of toll stretches but rates were reasonable compared to Mexico (around 15 Lempira in all). The trip took about seven hours by road. First stop was Puerto Cortes, a major port and a busy centre of commerce. Like most commercial port cities it is rather ugly. However we were happy to find banking facilities, ATM’s that did work, fast cheap Internet and of all things a supermarket! We stocked up on goods that do not spoil in a hot vehicle and headed south toward the capital Tegucigalpa till we reached San Pedro Sula.

San Pedro Sula is Honduras’ second city. It is a major center of trade. It is also a city surrounded by Dengue infested poverty. In the year 2003 San Pedro proudly announced a major control program for the Dengue. Dengue Fever comes in two forms and is the result of infection by mosquito bite, a variety that bites during the day, unlike those that carry Malaria. The symptoms are difficult to treat and there is no cure or vaccine, nor preventative measure like anti-malarials. The most common form is relatively innocuous causing a minor fever but the other more serious hemorrhagic dengue is often fatal especially in children. So-called because of the symptoms of bleeding in internal organs this form is a major cause of death in Central and South America. Dengue is endemic from tropical Central Mexico to the Amazon region. The authorities in San Pedro Sula decided to alleviate the problem by spraying certain still water areas, a city canal in particular, thought to be the gestation site of Mosquito larvae. The result was rather underwhelming, this season there were ten times the number of incidences of Dengue in 2003 than in 2002 in San Pedro, despite their campaign.

After five months in Mexico and Guatemala it was shocking to see the influence of US commerce on Western Honduras, San Pedro Sula in particular. Esso gasoline stations sported full-functioning air-conditioned, fast food restaurants; their super-sized customers, staff and vehicles parked outside. The sickly lighting inside reflected the chilled cans of US-made beers in the freezers on the walls.

Though gasoline is more expensive in Honduras than Guatemala people were driving some ridiculously oversized 4-WD vehicles for such an urban area. As one might expect to find in London or San Francisco these behemoths were scrupulously waxed and scrubbed. I suspected that few were ever used off road except maybe for an afternoon run with a few Kilos of Cocaine from the Mosquito Coast. Such a weekend trip can supplement the income nicely paying for the luxuries in life: the mistress, the Gasoline and the new super-sized truck each year.

Even in larger Honduran cities white skinned visitors encounter little or no intimidation from Government/Security officials in the daytime anyway. In the words of a fellow traveler from San Francisco, Hugh Diamond: “They’re thugs all right, [the Honduran security services] but they’re our thugs!” I was driving with California plates so they naturally thought me a Gringo. You don’t meet too many Europeans in San Pedro Sula. I couldn’t get out of there quickly enough.

Outside of San Pedro the road heads west to the industrial new town of El Progreso. This rather ugly new town should be best twinned with Milton Keynes in the UK or maybe Ciudad Juarez in Mexico. One had the feeling that it’s industries like the maquiladoras of Ciudad Juarez could also find it difficult to compete with China if CAFTA or PPP is signed. Economic reviews published early 2004 of the first ten years of NAFTA’s effects on Mexican industries have not proven positive for the weaker trading partner. A maquiladora is an industrial complex fuelled by young, mostly single, cheaper and union-free labor. In Mexico these are conveniently located just south of the US border. These plants compete for low skilled contracts to assemble car-parts, clothing etc. for eventual consumption in the US.

Though labor costs are kept very low in Mexico the maquiladoras have tried hard but failed to compete with Chinese labor laws and pricing. NAFTA has had interpretation problems with sourcing of imported goods. US corporations insist that goods manufactured abroad benefit from NAFTA’s streamlined exportation into Canada and Mexico even if the goods are manufactured outside North America, in China in particular. Mexican contractors vying for low wage assembly contracts want this law to be interpreted in a different way, sourcing should apply only to US made goods. Such is not the case and many maquiladoras are closing up shop simply unable to compete.

The US corporate accountants have spoken. Current transport, manufacturing and tariffs costs mean short-term gains are to be made from outsourced Chinese manufacturing not manufacturing within NAFTA and that’s all there is to it! Short-term gain leads to short-term shareholder value — the one true God of the market. So long as the market accepts “Made in China” and the media downplays Chinese labor violations China can maintain US ‘permanent’ MFN (Most Favored Nation) status. With NAFTA expanding the markets of US-based marketing corporations the toxic combination of NAFTA and ‘permanent’ MFN for China can even undercut the cheap labor supply of Mexico. So why not Honduras? Mr. Clinton pushed through both Chinese MFN and NAFTA at about the same time ten years back, one wonders if the Mexican trade negotiators weighed in the China effect?

It is difficult to predict what might happen to these small plants in El Progreso if CAFTA mirrors NAFTA? Could they too find problems competing? How will US and Honduran trade representatives write the definition of ‘sourcing’ into their agreements? Will these small plants be competing with the industries of the north or will their true competition be in Asia, their tariff barriers breached by irrevocable treaties with the US?

From El Progreso it was relatively smooth sailing to Tula and on to La Ceiba through vast fields of tropical monoculture, mainly pineapples, the signs warning of agricultural vehicles were in Spanish but with Dole logos.

Arriving in La Ceiba in the early evening we drove straight to the port; I wanted to ship the vehicle to the Island rather than leave it at paid parking on the mainland for a Month. Prices were high and bargaining difficult but many boats left for Roatan at midnight. It eventually cost me six hours and just over $100.00 US to get two persons (smuggled) and the car to Roatan on a boat loaded with live cows, pigs and Honduran Chiquita Bananas. We arrived exhausted in the port of Coxen Hole our ugly gateway to paradise.

The mainly European dive master clique of the pretty West End village refers to Coxen Hole as “Toxic Hole”. They only go there to renew their work visas, buy cheap food, drugs and cigarettes. Open sewers are the norm in ‘Toxic’ as prostitutes skirt the heavy police presence and chronic traffic congestion.

It was such a relief to get to Half Moon Bay though the prices had suddenly doubled. Welcome to the traveller dive resort of the West End!

Posted by Tony Phillips at 12:38 PM | Comments (0)