Be a little more patient, as it will likely be soon before the market tells us if it wants to bottom...
The Case for Trading Coffee
11/08/2010 11:50 am EST
Is the price of that morning cup of coffee doing more to wake you up than the coffee itself? Lost among the commodity headlines of gold, silver, and oil prices, the price of coffee has risen to a 13-year high over the last three months. Starbucks, Millstone, Caribou, and others have all been forced to raise their prices to account for the increased price of their raw materials, and the rise in prices has not been confined to high-end purveyors. Both J.M. Smucker’s and Kraft Foods have been forced to raise prices on their Folgers and Maxwell House brands, respectively. Currently, McDonald’s is the only outlet able to hold their prices steady.
Coffee prices have risen 45% since the beginning of June due to serious production issues in multiple geographic locations. The extended length of the Asian monsoon season has affected the harvests of India, Vietnam, and Thailand. These countries are responsible for nearly 30% of global coffee production. While an extended rainy season has delayed the Asian crop, Brazil’s has been hampered by lack of rain. Brazil is the world’s largest producer, and according to the Brazilian Coffee Council, the drought they’ve suffered could cut production levels to the lowest output in four years.
The fact that retailers have been able to keep their prices reasonable, raising their prices around 11%, on average, is a testament to the necessity of the futures markets and their role in the economy. The futures markets were originally designed to allow producers and end-line users of commodities to create binding contracts that specified the delivery date, price, and quantity of the given commodity. Coffee retailers have been able to stay ahead of the rising prices by hedging their price risk in the coffee futures market. Contracts that were purchased prior to June have the benefit of the stable prices that coffee had been trading at for nearly two years.
Trading agricultural commodities entails an understanding of the price risk associated with each individual market. Broadly speaking, supply and demand are the two types of risks that need to be accounted for. Agricultural commodities have a supply risk factor factored into rising prices. This protects against any setbacks created during the growing season by the weather, as well as accounting for any labor unrest during the harvest season. This is exactly the opposite of the risks associated with investing in the stock market. The fear is on the downside and there is a built-in risk premium to the downside. The stock market deals with demand-based risk.
Commercial traders are made up of two groups, the commodity producers, who control the supply of a commodity, and the end-line consumers, who create demand for the given commodity. These two groups are responsible for the battle to create value. When a market gets overvalued, commodity producers come into the market and sell the crop they expect to produce within a given time frame. Conversely, when the price of a commodity falls below a perceived fair value, end-line consumers like Kraft Foods and J.M. Smuckers will come into the market and stockpile the commodity to meet their future production needs.
This is the battle that’s currently unfolding in the coffee market. Coffee retailers are being forced to pay higher prices to ensure their raw materials for future production, while coffee producers are taking advantage of the higher prices to make up for their lack of output. Tracking the movement of commercial trader positions shows that end-line consumers were large purchasers of coffee futures beginning at the end of June. We can also see that their buying appears to have peaked in early September. This cycle ensured delivery of the necessary raw materials through the end of the year.
Right now, the producers still have control of the market, and we will continue to look for opportunities to buy selloffs in the coffee market. This allows us to put the purchasing power of major retailers behind us, as well as the seasonal strength that tends to accompany the coffee market harvest period and into January. Our opinion will change when we begin to see the coffee producers rush to get their future crops sold. Whether the rush comes at higher prices or lower prices isn’t as relevant as the fact that farmers believe they won’t be able to sell their crops at these prices in the near future.
By Andy Waldock of CommodityandDerivativeAdv.com
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