The last six weeks have been good times for coffee bulls. While Arabica coffee prices at the new York Board of Trade (Nybot) have experienced a mild rally, Robusta coffee, traded in London at the London International Financial Futures Exchange (Liffe), has seen a substantial surge in prices. This is due primarily to tight supplies out of Vietnam, the world’s primary exporter of Robusta beans.
And while Robusta prices have dragged Arabica reluctantly higher, it is left to wonder what will become of Arabica prices at the New York exchange as London prices level off, or even correct. We feel there will be an opportunity for call sellers in the Arabica (New York) contract this month and so we will focus this article on New York coffee.
For those unfamiliar with the growing seasons of Arabica coffee, June 21 begins winter in Brazil and the time of year when speculators often buy coffee calls in hopes of a Brazilian freeze driving up coffee prices. And why not buy calls? After all, in addition to winter freeze fears, there are plenty of other reasons to be bullish coffee. The 2006/07 Brazilian crop is “officially” projected to be the smallest in seven years, with an expected yield of roughly 32.1 million bags of beans according to the latest government estimates. There are quality concerns affecting the market as well, as many traders feel heavy rains in growing regions earlier in 2007 will hurt bean quality. The International Coffee Organization is estimating a 6 million to 8 million bag world-coffee deficit this year. In addition, coffee prices have been in a relentless downtrend for much of 2007, bringing prices to levels that many feel are “cheap.
To some traders, buying calls in coffee may seem like a lucrative opportunity at this time, but we feel quite the opposite.
To understand the trading opportunities, we must first understand the fundamentals. In reviewing these key determinates of price, we can understand why coffee prices are at their current levels and why they are unlikely to push anywhere near the strikes currently available at which to sell call premium.
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 one a clear idea of where the market most likely will not go. And as option sellers, that is all we need.
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. It accounts for the majority of the higher quality Arabica coffee traded at the Nybot. Thus, developments in the Brazilian crop have a substantial impact on coffee futures prices at the Nybot. Brazil grows more than three times as much coffee as Vietnam, the world’s second largest producer. Vietnam, however, produces primarily the Robusta variety of coffee traded in London. Several smaller central and South American countries produce coffee such as Columbia and Guatemala. However, much of this is higher quality beans that are sold to specialty coffee retailers. Brazil meets the majority of global Arabica demand, and therefore developments in its crop have a major impact on prices at the Nybot. This is also why at times there appears to be a substantial difference in values between Nybot and Liffe coffee prices.
Brazil experiences an every other year “on/off” cycle in coffee production where higher production years are usually followed by lower production years. This is a natural cycle of coffee trees. 2006 was an “on” year for coffee production. Brazil produced nearly 42.5 million bags of coffee last year. This resulted in a small world coffee surplus for the 2006 crop year.
2007 is an “off year” for Brazilian coffee growers. But there is a wide discrepancy between estimates for the 07 harvest. Conab, the official estimate of the Brazilian Government, pegs 2007 production at 32.1 million bags, a substantial decline from last year. Many traders believe, however, that the Brazilian government often understates production in order to help boost futures prices. Safras e Mercado, an independent source, pegs ‘07 production at 36.5 million bags – an estimate many traders feel is more realistic. Yet, at the National Coffee Association convention in Arizona earlier this year, talk from Brazilian industry members was that the harvest could reach 38 million to 40 million bags by the time harvest is completed in October. If this figure were to be realized, it would account for a large percentage of the ICO’s projected deficit – a figure that, incidentally, does not account for coffee beans in storage from previous year’s harvests.
As the 2007 Brazilian coffee harvest hits full swing in June and July, market talk will turn to the subject of freeze season. Yet, while freeze season may get a lot of hype in the press, the chances of a freeze causing significant damage to the Brazilian Coffee crop have dropped significantly in the last 10 to 12 years. After crop damaging freezes in the early and mid 1990s, Brazilian producers began a trend of planting replacement trees further north towards the equator in regions such as Minas Gerais and Sao Paulo. This effectively transferred production to a more moderate winter climate and out of more frost prone zones. The last significant crop damaging frost was in 1994.
Even before this change in growing areas, a sustained summer price rally in coffee has extremely rare. Normal seasonal averages generally see coffee experience a rally in May and June as bullish speculators buy the market. This will often be followed by a sustained regression in prices as new Brazilian supply works its way to market just when the Northern Hemisphere heads into the lower consumption summer months.
This year’s lower crop figures should be given their due. After all, even if we assume the industry average estimate of 35 million bags, it is a considerable decrease from the 2006’s harvest.
Does this mean that prices will rally as the market prices the 2007 crop? Possibly. But we do not feel prices can rise substantially unless there is some kind of unforeseen, extreme weather event. Bulls who touted Conab’s initial 31.5 million-bag crop estimate earlier in the year are now coming to grips with the fact that Brazil will harvest substantially more coffee (Liberty Trading estimates 2007 Brazilian production closer to 37 million to 38 million bags.). Secondly, many roasters in the United States and Europe, anticipating tighter supplies in the fall, ramped up forward purchases in the first half of 2007. This means that they will have less coffee than usual to buy through the northern hemisphere summer, which should translate into lighter than normal commercial buying on the Nybot.
The big story, however, is the 2008 Brazilian crop. Back in January and February, coffee bulls were touting the extremely wet summer as a reason for concern for the ‘07 crop. Excess moisture can affect the quality of the coffee bean. While early indications are that quality has not been a concern, the above average rainfall this year in Brazilian growing areas will have a secondary effect on the market. Increased soil moisture in the southern hemisphere summer and fall produces lush, healthy trees the following spring. In October, South American coffee trees go to flower. These flowers turn into red buds called “cherries.” The cherries are actually immature coffee beans. The healthier the trees, the more flowers. The more flowers, the more coffee beans.
Because of these moist conditions coming ahead of an “on year,” many coffee analysts and industry panels are projecting 2008’s Brazilian harvest to be massive, possibly eclipsing 2003’s record 53 million-bag yield. While there are no official estimates as of yet, there is a growing buzz from Brazilian industry members that with favorable weather, the ‘08 crop could be as large as 58 million to 60 million bags.
While no official estimates will be available for months, the specter of this gigantic figure looming over the market should be enough to keep the bulls in check for the second half of 2007 – again barring any unforeseen weather events. These are the futures markets and it is common for coffee traders to begin pricing the next year’s crop before this year’s beans are even off the trees.
With the 2007 harvest well underway, a crop estimate that continues to grow, roasters already forward bought and the potential for a blockbuster 2008 crop, coffee’s ability to mount a substantial rally is limited. Expect rallies to be mostly spec led and short-term in nature. Weather reports will also play a role in the short term.
We see fair price for September ‘07 Coffee (Nybot) somewhere between $1.10 and $1.25 per pound, based largely on final harvest figures. As the year progresses, however, expect the market to begin focusing on the 2008 crop. Barring a freeze over the next 60 days, heavy commercial selling could drive coffee prices well below the $1.00 mark by year’s end.
Prices, however, can move quickly up and down in the short term and can make futures trading treacherous business in Coffee. This is why we recommend selling calls as an excellent strategy for taking advantage of this volatility. Selling calls allows traders to ride out short-term swings in the market without being forced out of position.
The seasonal interest of small speculators in buying cheap call options at absurdly high strike prices (when one considers the fundamentals), has driven demand, and therefore premiums on these options to attractively high levels. Speculator interest in calls makes it possible now for an astute option seller to collect substantial premiums for calls at strike prices nearly double the current price of coffee. This means that coffee prices would have to increase by nearly 100% over the next 16 to 20 weeks for these options ever to trade in the money.
As a call seller, prices do not necessarily have to move lower for one to profit. They only have to stay anywhere below the seller’s strike price.
If there is anything I have learned in my 23 years of trading, it is to bet against the small speculator and side with the commercial trader. This approach has proven most effective in the flexible strategy of option writing. Speculators can move the market temporarily on momentum and media hype, but the commercials bet on the long-term fundamentals. As an option seller, you should too.
Nonetheless, we do expect to see some seasonal spec buying coming into the futures through June and possibly even July. We would view limited rallies in coffee prices as call selling opportunities, as commercial growers should be eager to hedge their crops before the market starts eying the prospects for 2008 production.
James Cordier and Michael Gross
Liberty Trading Group
(800) 346-1949
www.optionsellers.com
James Cordier is head trader and president of Liberty Trading Group, the first futures firm in the US to specialize exclusively in selling options. James’ market comments are featured by several international financial publications and worldwide news services, including the Wall Street Journal, Yahoo Finance, CNBC and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier 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.
