Wake Up to This Bull-Top Coffee Trade

12/24/2010 12:01 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Coffee may be topping out here, and I believe a trade is about to present itself in this market. First, here’s a two-year chart:



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And here’s why I believe coffee may be near a top.

Traditional agricultural commodity markets have always been subject to supply disruptions. Think about the midwest flooding of the mid 90’s, mad cow disease, Florida orange crop freezes, as well as labor strikes and political coups. Almost two months ago, we talked about trading the coffee market. We noted that the two major growing regions both had weather-related problems and that’s what was driving up the price. There’s one other primary reason for commodity market supply shocks and that is the lack of substitute goods.

All commodity markets have very specific contract specifications that must be met in order for a producer to deliver their product to the exchange’s warehouses. The coffee market in the US, which is the by far the most dominant, accepts delivery on Arabica beans through 19 global warehouses. Arabica beans only make up about one third of the coffee crop and are the source for premium coffee blends. Robusta coffee is much more common. Robusta coffee is used in instant coffee and coffee blends because it grows quicker, is a hardier plant, and has high caffeine content.

The coffee market has seen supply shortages before. In 1996, total warehouse stocks declined to 321 bags. This meant the New York Board of Trade, now the Intercontinental Exchange, had just over 42,000 pounds of coffee on hand to meet global delivery demands. Consequently, prices shot up to more than $3 per pound at the exchange. By contrast, the current supply, which is down 44% for the year, puts the exchange’s coffee stocks at 1.7 million bags for December. Arabica coffee producers in Brazil and Central America ramped up production in the wake of the 1996 shortage. Those trees began to produce around 2000 and the coffee market bottomed in 2002 on the flood of their second harvest.

Much of this coffee has been sitting in storage for years and remained in the system through a loophole in which producers would take delivery of their own old stock and then resubmit it for certification. The bags then came in as new stock. Recently, this coffee has been making onto the market. Coffee roasters have taken delivery from the exchange only to find that the beans they bought were unusable. As a direct result of this, the Intercontinental Exchange has rewritten the delivery specification for their coffee contract to protect the integrity of the exchange, and in doing so, created an interesting setup for a commodity trade.

First of all, they are now penalizing warehouse stocks more than 720 days old. This closes up the delivery and re-tender loophole. Secondly, they are going to begin accepting robusta coffee beans at a discounted value as deliverable against the Arabica contract. This will open up the delivery ports of the ICE’s 19 worldwide warehouses to a global supply of fresh, deliverable coffee. Furthermore, this develops multiple production centers and weakens Brazil and Central America’s ability to monopolize the prices by controlling more than 50% of global Arabica bean production.

Commodity traders will see these changes manifest themselves in increased exchange liquidity, which translates into lower volatility with fewer and milder price spikes. Volatility will also be eased as Brazil continues pour money into the development of its own infrastructure with more than one billion dollars currently earmarked specifically for coffee production.

When I last talked about coffee, I noted that commercial consumers had been buyers of the market to lock in their production costs of items containing coffee (think ice cream, candy, etc.). Trend-following commodity index traders as well as small speculative traders have climbed aboard coffee’s upward trend as it has marched to 13-year highs. However, general coffee market sources have priced in a balance of trade ceiling around $2.70 per pound, which is about 15% higher than the current market price.

The bearish combination of: 1) the exchange’s rewriting of the contract specifications, and 2) the market nearing its pre-forecasted top, leads me to believe that commercial producers will begin selling this market in earnest in order to lock in their forward production at these attractive prices. We will watch this development closely. It has the makings of a bull market climax.

By Andy Waldock of CommodityAndDerivativeAdv.com

Andy Waldock is a trader, analyst, broker, and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

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