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A Premium Coffee Trade
08/31/2012 10:00 am EST
One type of coffee beans is undervalued and ready to rise, says Andy Waldock, but rather than simply buy the commodity, smart investors can hedge their risks by playing one type of coffee against another.
The uncertainty that has kept retail investors out of the equity markets, out of the interest rate markets, and out of the commodity markets still remains as all eyes focus on this weekend’s Jackson Hole meeting of central bankers, minus Mario Draghi, President of the European Central Bank.
Investors are unsure what to do, as the decisions made at the meeting will have a bigger impact on the markets than any earnings story in the stock market or supply and demand story in the commodity futures markets. Cash is still king. However, a spread trade is one type of discretionary trade that is relatively immune to the central bankers’ decisions.
Spread trades are relative value plays. The actual profit or loss is determined by the movement of the markets relative to each other, as opposed to what each market does on its own.
The coffee spread trade that will be outlined trades two types of coffee against each other. The advantage to this in news event-driven markets is that the “risk on” and “risk off” announcements will affect both markets similarly. Therefore, what is lost on the contract that is owned will be made up for by the contract that has been sold. Only the movement of the two markets against each other will affect the account’s cash balance.
There are two types of coffee traded in the futures markets, Arabica and Robusta. Arabica coffee is the premium coffee used by Starbucks to make their specialty coffees, while Robusta is the cheaper of the two and used to make instant coffee and espressos.
The economic weakness in the Eurozone has boosted demand for Robusta while reducing demand for Arabica, as European tastes move downmarket along with their economies. Europe imports more than half of the world’s coffee production, and imports by Spain have fallen by 6.6% over the last year. This makes sense considering Spain’s 25% unemployment rate.
The move towards cheaper coffee drinks has shifted the normal balance of supply and demand by closing the gap between Robusta and Arabica coffee beans. Coffee blenders have been using more Robusta in their blends to try and hold consumer prices down. This shift picked up steam after last summer’s Arabica prices soared due to the weak Columbian Arabica harvest.
This shift has caused Arabica’s premium over Robusta to decline from $1.45 per pound at the end of last year to around 70 cents currently. Much of the recent gains came from a weak Vietnamese Robusta harvest.
The timing of this spread has more to do with Brazil’s Arabica crop. Brazil is the No. 1 producer of Arabica beans, and their harvest is quickly drawing to a close. Their crop received substantial summer rains that forced the trees to bloom early and beans to develop ahead of schedule.
However, the early formations of the bean pods led to unsustainable weights on the trees. Many pods fell early and the expectations are for this year’s Brazilian crop to be of good weight but poor quality. Poor-quality Arabica beans will be blended with Robusta beans and used for inferior coffee products. This will leave fewer high-quality beans available for the premium coffee drinks Western cultures have grown accustomed to.
It’s already been noted that slowing economies have forced consumers towards cheaper products. Therefore, if this weekend’s Jackson Hole meetings reveal further economic weakness, premium blend demand would be expected to decline. Conversely, an uptick in economic expectations should begin to fuel ownership in all commodities. A rising economic tide floats all ships.
Given the relative value of Arabica beans on the open market, they could be considered an outright buy on their own. However, due to the economic uncertainties, it would be prudent to trade with a reduced risk profile rather than betting the farm on a single outright trade.
Buying Arabica beans while selling Robusta beans will limit losses on an overall decline in the economic outlook, while maximizing the return based on the fundamental scarcity of Arabica beans over Robusta. Any upside economic surprises should add fuel to the fire in this spread, causing it to widen toward its historical average around $1.45 per pound.
Andy Waldock can be found at Commodity and Derivative Advisors.
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