Trying to pick the low in the stock market may be more exciting than examining supply/demand fundamentals in coffee, but real investors are looking for returns – not fun. For those willing to tune out the media for a moment, there are markets not heavily swayed by credit market fears, interest rate headlines or the latest drama out of Iran. If you’re seeking such a market, consider coffee. Unlike the equities or bond trader, the coffee trader has to monitor two things: supply and demand.
Fortunately, worldwide coffee demand has remained relatively stable in recent years, increasing at a rate of less than 1% annually. This leaves the number crunching to the supply side.
Crop figures and demand estimates are available six to 12 months out and can be projected somewhat accurately. This may not tell us exactly where the market is headed, but it can give you an idea of where tit most likely will not go. Brazil is the world’s largest producer and exporter of coffee and is responsible for approximately one third of the world’s total coffee production. It accounts for the majority of the higher quality Arabica coffee traded at ICE Futures U.S. (formerly the New York Board of Trade).
Brazil experiences an “on/off” cycle in coffee production where higher production years are usually followed by lower production years and 2006 was an “on” year for coffee production. Brazil produced nearly 42.5 million bags of coffee. This resulted in a small world coffee surplus for the 2006 crop year. The 2007 “off” year for Brazilian coffee growers produced approximately 33.7 million bags. Prices adjusted accordingly in 2007 and now trade approximately 15% higher than last April’s pre-harvest lows.
Because of moist conditions in 2007, along with an upcoming “on” year for harvest, many coffee analysts are projecting 2008’s Brazilian harvest to be substantially larger than 2007. Official Brazilian government estimates peg the upcoming 2008 coffee crop between 41.3 and 44.2 million bags. These official estimates, however, historically have been roughly 10% lower than the actual figure. Respected independent analysis firm Safras e Mercado sees the 2008 crop coming in between 47.6 and 49.9 million bags. The Liberty Trading/OptionSellers.com official estimate is 49 million bags.
A Brazilian crop of 48 million bags would be the second largest on record and 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 million bags. That 2.2 million bag deficit is largely responsible for coffee’s current price range remaining north of $1.30 per pound. That could change soon.
With Brazil’s larger production, world coffee output is expected to reach 133.25 million bags in 2008 while global consumption is seen at 126.0 million bags. This would result in a 7.25 million bag surplus for the 2008 crop year.
In addition to pricing in larger supply, the coffee market also is entering what is typically a quiet time of year. The bulk of the weather risk occurs June through August, the Brazilian winter, and in the October flowering season. The 2008 crop has emerged in good shape from these tests and the next several months are typically mild in Brazil. That should mean steady to lower prices. Supply fundamentals are bearish and the market has not yet fully priced in the 2008 surplus.
While a trader could simply short a back month futures contract, our recommended strategy is selling far out-of-the- money calls. Though fundamentals almost always will dictate longer- term direction, short-term fluctuations can happen in any market. Fund buying, technical signals or even commercial short covering all could conspire to produce limited rallies of up to 10¢. This would likely stop out a short futures position. However, for an option seller short strikes 40¢ to 50¢ above the futures price, the detrimental effects of such a rally would more than likely be minimal on a position. Selling options gives a trader more staying power and allows for such short-term fluctuations. Also, if the trader shorts coffee futures, he needs prices to go down to profit. A seller of calls profits if prices move lower, remain stagnant or even if they move moderately higher.
Now we see strikes available in mid 2008 coffee contracts that should meet this criterion. Based on end of January volatility levels, you could collect $500 in premium for one July 180 call, which would require approximately $970 in margin. It makes a lot more sense than putting the value of our investment portfolio in the hands of Ben Bernanke.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com. Michael Gross is an analyst with Liberty. Cordier and Gross wrote The Complete Guide to Option Selling (McGraw-Hill 2005).