The bulls are starting to tout their case in the coffee market as of late. Smaller production from Brazil, a 2007/08 production deficit and increased world consumption are all factors cited by bullish traders and the media as to why coffee prices should have a banner year in 2007.
But before you bet the house on coffee prices, it might be prudent to look at the current supply and pricing in coffee. While we believe coffee prices could see a slight increase in 2007, we feel rallies will be limited. The public’s belief that a bull market is imminent, however, could create some excellent profit opportunities for astute call sellers.
Coffee is one market that is very favorable to fundamental trading. A few producers make up the majority of production. Crop figures and demand estimates are available six to 12 months out and can be projected somewhat accurately. If you can focus on these big picture numbers and tune out the daily “noise,” you can compare them to supply and demand of past years and their corresponding price levels. This may not tell us exactly where the market is going to go, but it can give you an idea of where the market likely will not go. And as option sellers, that is all we need.
While coffee is grown in many countries across the globe, Brazil is the worlds largest producer and exporter of coffee by far, responsible for approximately 1/3 of the world's total coffee production and accounts for the majority of the higher quality Arabica coffee traded at the New York Board of Trade. Thus, developments in the Brazilian crop have a substantial impact on coffee futures prices at the Nybot.
The bulls are pointing to 2007’s expected 31.5 million bag Brazilian crop as reason enough to buy coffee now. After all, it is a substantial decrease from 2006’s massive 43 million bag harvest and some analysts expect Brazilian coffee exports to drop as much as 10% in 2007 as a result.
While this may be true, this viewpoint does not take into account the massive supplies in storage left over from the 2006 harvest. The South American coffee harvest typically wraps up in October. Most of this coffee is still sitting in Brazilian warehouses looking for a home. But Brazil is becoming much more active in exporting at current price levels. In December, coffee exports from Brazil were up 26.4% over last year at the same time. The bulk of these supplies will be hitting the world market over the next two to three months, which should keep a lid on runaway coffee prices in the near term.
This also assumes that 31.5 million bags of coffee is an accurate estimate. The Brazilian government is infamous for understating coffee production, as lower expected supply can help support price. Some private forecasts have the crop yielding as much as 36 million bags this year.
Bulls also point to an expected production deficit in 2007– as though the word itself implies “running out” of coffee. Nothing could be further from the truth. The world production/consumption figure merely measures that year’s total world production vs. total consumption for the year. In 2007, the world should produce 117 million (60 kg) bags of coffee while consuming 121 million bags. True, this is a deficit of 4 million bags. However, this figure does not take into account all the coffee in storage across the globe. In addition, the bulls may not consider that 2006 saw a production surplus of nearly 6 million bags.
In addition to last year’s burdensome supplies, the market has already at least partially priced the expected production decline in 2007. Coffee prices started climbing in late 2006 around the time the first private estimates for the 2007 crop were made public. Indeed, coffee prices have climbed nearly 30% since September of 2006. This is the primary reason that exporters have become so active as of late. Prices have reached a level that producers deem attractive enough to begin unloading product in earnest. In short, it is what they consider a fair price. Producers and roasters of coffee beans across the globe are well aware of expected supply figures for next year.
We are not necessarily bearish coffee prices over the next three to four months. However, in selling options, one does not have to decide where prices will necessarily go – only where prices will not go. And while it is possible that coffee prices could rise 10¢ to 15¢ from current levels by mid-2007, it is unlikely prices can climb much higher than that. The mild production deficit of 2005 produced only moderate price increases (prices topped out at $1.37 per pound) and coffee has not traded above $1.40 since the freeze scares of the late 90’s (it is currently early summer in Brazil).
It is our contention that rallies in coffee will meet with strong producer selling in the coming months and that call sellers are now presented with an opportunity to sell call premium at 50¢ to 60¢ even 80¢ above current price levels. Coffee closed on Friday at $1.20 per pound at the New York Board of Trade.
James Cordier and Michael Gross
Liberty Trading Group
401 East Jackson Street
Tampa, FL 33602
If you would like more information about selling options in the Coffee market or building a portfolio based on the option selling approach, please feel free to call or request one of our investor information packs at www.optionsellers.com.
Be sure to watch CNBC’s Dec. 28 interview with James Cordier on his outlook for 2007 commodity prices, now available at www.libertytradinggroup.com/news.html
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.