This Is the Real Hot Commodity

01/22/2013 9:30 am EST


Not only is coffee sitting at lows, but a growing coffee culture in Asia means there is a lot of upside opportunity in this little green bean, notes Stephen Belmont in World Money Analyst.

Coffee was one of the commodity sector’s worst performers in 2012, shedding 36.6% of its value and cleaning even the most inveterate bulls out of the market.

Don’t look now, but this market could be setting itself up for a big wake-up call in 2013. Growing global demand—especially from the population-heavy nations of Asia—as well as the peculiarities of the two-year coffee growing cycle of the world’s largest coffee exporter, Brazil, could give this market an unexpected jolt this year.

Coffee is one of the most heavily traded global commodities, right behind crude oil. It is also notoriously volatile. Price swings of 20% to 40% are fairly common, making it perfectly suited for speculation.

Brazil and Vietnam are the globe’s biggest producers. Brazil grows “Arabica” coffee, a higher-end product used in specialty coffees and by chains like Starbucks (SBUX) and Caribou Coffee (CBOU). Vietnam produces mainly “Robusta” beans that are used in cheaper coffees and mixed with Arabica beans to create midrange blends.

Coffee Craze Is Catching in Asia
The world’s largest coffee consumers are Europe, the US, and Japan, in that order. Japan’s consumption is roughly 75% of America’s, and that is impressive considering that the Land of the Rising Sun was a tea-drinking nation not too long ago.

Japanese coffee consumption has risen nearly 300% since the mid-1990s. But other Asian nations are experiencing their own coffee crazes as well. In just four years, consumption is up 400% in Taiwan and 1,800% in South Korea.

Coffee consumption appears to be a byproduct of a Western lifestyle. As affluence spreads throughout the globe, coffee houses are popping up in places inconceivable just a few years ago. Starbucks expects China to be its biggest market outside the US and plans to increase the number of its stores in the country from 600 to 1,500 by 2015. With a potential 1.4 billion coffee drinkers, who can blame them?

Faster-paced societies seem to breed the need for more and more caffeine. The number of Americans who drink coffee has climbed from 71% to 76% over the past decade, and each drinks an average of three to 3.5 cups per day. This is more than the average Chinese consumer drinks in an entire year!

According to the International Coffee Organization (ICO), demand for the black, bitter stuff has risen 2.5% annually since 2000, mainly due to 4.7% annual growth in emerging markets. Get China into the coffee game, and that number could increase dramatically.

Supplies Sufficient for Now, But…
The ICO projects Brazilian harvests for the 2012-2013 crop year will come in at roughly 51 million bags total. Approximately 38.5 million of these will be premium Arabica beans. While this is sufficient to meet this year’s demand, the market could run into big trouble next crop season.

Brazilian coffee trees operate on a two-year cycle in which a year of plenty is followed by a year of sharply diminished output. This year will be a year of plenty, but not so in 2013-2014. Stockpiles could disappear completely at current levels of demand.

It’s not hard to identify the two-year Brazilian growing cycle. Years of plenty cause a stockpiling of coffee, while years of scarcity cause a drawdown in supplies. Stockpiles are generally sufficient after years of plenty to tide the market over during the down-cycle until they can be replenished again the following year, but next year’s surplus is expected to be the lowest on record. It won’t take much of a reduction in yield due to weather or other concerns to turn this minuscule surplus into a deficit.

Coffee prices also tend to reflect this two-year cycle by anticipating potential surpluses and deficits well in advance of actual conditions. Not only is this market very oversold, it is also resting on solid support, making it a prime candidate for a bullish speculation.

Wake Up and Smell the Opportunity
Given the severity of next year’s supply situation, it would not surprise us to see prices begin to anticipate a coming shortage. Our initial target is a Fibonacci retracement of 38% of last year’s down move that would bump prices back up to roughly $2 in the July futures contract.

Coffee options trade on the electronic Intercontinental Exchange (ICE). Each option contract covers 37,500 pounds of premium Arabica beans. Both the future and option contracts trade in dollars and cents, making each one-tenth of a cent “tick” or “point” worth $3.75.

An aggressive, fixed-risk way to play this market is to buy July $1.80 coffee calls while simultaneously selling an equal number of July $2 coffee calls for a net cost of 220 points ($825) or less. This is a professional trading strategy known as a “bull call spread.” Buying the $1.80 call gives us the right, but not the obligation, to be long 37,500 pounds of coffee at a price of $1.80 per pound. We pay money for this right.

Selling the $2 call puts money in our pocket in exchange for our obligation to sell coffee at $2 per pound. We use this money to help offset the cost of our long $1.80 call. We’ve now mated the right to be long at $1.80 with the obligation to be short at $2, and that means we can make the full 20 cents or 2,000 “points” between the two strike prices. 2,000 points times $3.75 per point equals $7,500. Using a bull call spread rather than buying a call outright lowers the cost of our bullish option play dramatically.

If filled at our suggested price of 220 points, our maximum risk is $825 plus transaction costs. We can gross as much as $7,500 should coffee wind up at or above our $2 price objective on or prior to option expiration on June 13.

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