Commodities Roundup: Coffee
June 2, 2008
With commodities continuing to take the spotlight in the investment media, it is easy for fundamentally based investors to hone their focus on some of the headline markets such as crude oil, corn or gold. With all the talk of $200 oil, bubbles bursting, or a new use for ethanol, some of the “back page” commodities are getting less attention. And that is precisely why this is where some of the best opportunities could lie for astute investors.
Coffee is one such market. Unlike some of it’s spec-led brethren, coffee has remained true to it’s fundamentals. While it has been influenced by some external factors such as the falling dollar and increased shipping costs, it’s price has primarily reflected the balance between it’s supply and demand which, unlike oil or corn, have remained quite stable.
Exciting it is not.
But for option sellers looking to generate income, a nice, steady fundamentally driven market may be just what the doctor ordered. Trying to pick “the high” in gas prices may be more exciting but real investors are looking for returns –not fun.
Coffee is one market that is favorable to fundamental trading. Unlike the equities or bond trader that has to decipher countless government economic data, pour over daily and often contradictory reports, wonder what the Fed is going to do next month and worry about the subprime credit fallout, the coffee investor has to monitor two things – coffee supply and coffee demand.
Fortunately, worldwide coffee demand has remained relatively stable in recent years, increasing at a rate of less than 1%-2% annually. This leaves much of the number crunching to the supply side.
As we at Liberty Trading have stated in past articles, for most of the year, the coffee supply story is centered around Brazil. Brazil is the world’s largest producer and exporter of coffee and is responsible for approximately 1/3 of the world''s total coffee production in any given year. While prices ebb and flow, they general gravitate towards a general range based on the world supply/demand balance which is heavily dependent on the size of the Brazilian harvest.
Thus, while world production must also be considered, it could be said that one can get a rough gauge of where prices will gravitate towards simply by looking at estimates for the Brazilian crop.
The year 2007 was an "off" year for Brazilian coffee growers. Brazil produced approximately only 33.7 million bags of coffee down substantially from 2006’s 46.5 million bags. The steady trend of higher prices in 2007 and early 2008 was the market pricing in this lower production figure.
It appears that fair price for the 2007 crop ended up somewhere between $1.20 and $1.40 per pound. Chart readers may point out coffee’s surge in March of 2008, but this had little to do with Brazil and more to do with a Market aberration. Typically by March, the Brazilian supply is all but exhausted and the market turns to Vietnam for the majority of it’s coffee needs until the next Brazilian harvest begins in May. However, this year, Vietnam experienced a rash of heavy rains which caused delays in harvest and shipping. Exacerbating the problem was that Vietnamese farmers were getting virtually no competition from Brazil at all due to the low Brazilian harvest last year. Thus, the Vietnamese controlled the market for awhile and held coffee beans off the market, holding out for higher prices. They got them as coffee peaked at nearly $1.70 per pound. However, once the Vietnamese began releasing their beans on the market, prices adjusted lower again.
They probably won’t have the same luxury next year.
The 2008 Brazilian coffee harvest began this month and is expected to be the second largest on record at nearly 50 million bags. Because of moist conditions for much of 2007, coupled with an upcoming "on" year for harvest, independent analysts Safras e Mercado sees the 08 crop coming in between 47.6 – 49.9 million bags. Liberty Trading’s official estimate for the upcoming Reuters survey is 50 million bags.
An ''08 Brazilian crop of 50 million bags will have a substantial impact on the balance of world coffee production vs. consumption. In 2007, world production reached 121.8 million bags while world consumption was seen at 124.0 million bags. This resulted in a 2.2 million bag deficit for the year – which was widely reported in the press and is largely responsible for coffee’s current price range remaining north of $1.30 per pound.
With Brazil’s larger production this year, world coffee output is expected to reach 133.25 million bags while consumption is seen at 126.0 million. If these figures are realized, it will result in a 8.25 million bag surplus for the 2008 crop year. This is not a record surplus, but it should be enough to knock prices down into a new trading range for the second half of the year.
In short, higher supplies equal lower prices. Like many agricultural commodities, coffee prices tend to reach their lowest during and immediately after harvest when supplies are at their highest. And while past performance is not indicative of future results, we do expect prices to begin a slow descent as the new Brazilian supply begins to flow onto the world market. Coffee prices have a seasonal tendency to move lower once harvest begins.
We at Liberty Trading see prices gravitating back towards the ranges of 2006 when Brazil produced 46,500 bags of coffee ($1.00-$120 per pound) settling towards the lower end of this range by year’s end as fund interest wanes in response to the sizable new crop.
We expect any price shift to be gradual as Brazilian “frost” season and a slight shift higher in demand for 2008 should help cushion price declines. However, as we have stated in past coffee articles, the “frost” season phenomenon is becoming largely a psychological one now that the majority of coffee trees have been moved further north out of frost prone regions.
Our recommended strategy is selling calls far out of the money for Fall 2008 coffee contracts. Supply fundamentals are bearish and the market has not yet fully priced in the ‘08 surplus. More importantly for call sellers, we see little incentive for coffee prices to rally substantially in the coming months and thus, this should set an ideal stage for sellers of call premium. Remember, as an option seller, you don’t have to pick where the market is going to go. You only have to pick where it is not going to go. Considering that strikes are available well above the March price highs, we recommend traders taking advantage of the surprisingly high volatility still left in this market.
While aggressive traders may look to sell naked calls, we at Liberty Trading recommend selling covered calls (credit spreads) for lower margins and limited risk.
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Figure 1: Weekly Coffee
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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