It was only this spring that coffee prices touched a 14-year high from a combination of lower supplies and an optimistic economic outlook. These prices were responding to a marked shortage of high quality, washed arabica beans. These are the beans primarily used in higher-end, gourmet coffees such as Starbucks. The beans often command a premium in the market and generally are produced by smaller "boutique" growing nations, such as Colombia, Peru and Central American producers.
While Brazilian farmers may object to the oversimplification, think of Brazil as Folgers — coffee for the masses — and Colombia as Starbucks — gourmet specialty for the few.
Weather problems in 2010 for several of these smaller producers brought about smaller crops, which meant lower supplies. Economics 101 dictates lower supply means higher prices. Yet as the 2011 summer approached, most Central American producers were in recovery mode. Total production from these key regions is expected to be up by 2% in 2011. In addition, Brazil, the world’s largest producer and exporter, began harvesting its 45-million-bag crop in June. The influx of supply brought harvest pressure to coffee prices through much of the North American summer.
We had expected coffee prices to continue a slow consolidation into the fourth quarter, when the market likely would turn its focus to the 2011-2012 crop. Brazil, the world’s largest producer of coffee beans, is expected to yield a record crop of more than 55 million bags in 2012.
However, there was a wrinkle. In early August, a frost occurred in Brazil’s southeastern coffee growing belt. While frost will have little effect on this year’s harvest, traders worried that next year’s yields could be hurt. At the same time, heavy rains during harvest forced Colombia to reduce its crop estimate for 2011. Coffee prices spent the remainder of August rallying by more than 25%.
The Brazilian frost will have no impact on this year’s harvest and, by most accounts, will not affect 2012 either (see "Future looks bright").
Brazilian co-ops in the affected regions have acknowledged widely that crops were spared in the recent frost, calling damage "light" in only a few of the areas believed to be affected. Later in the month, Reuters reported on frost damage in the heavy producing South Minas Gerais state by confirming "few of its members’ plantations were affected by the freeze."
More will be known when the much anticipated "flowering season" begins for Brazilian coffee trees in October. However, as it stands now, a record crop is being forecast still.
In the meantime, Colombia reduced 2011 harvest projections from 9.5 million bags to 9.0 million. It sounds insignificant and probably is. Production still will be an improvement from 2009’s and 2010’s subpar yields. However, after the recent shortages of gourmet grade beans, traders have been sensitive to any reduction in the higher quality Arabica varieties produced in Colombia.
These two events, along with equity market volatility, were enough to fuel a late summer rally in coffee. But should investors really be betting on coffee prices eclipsing those of 1997 — the year of the "Great Brazilian Freeze?"
With the window for additional freezes closed and South and Central American harvests reaching their climax in September, prices appeared fundamentally overvalued and began to fall sharply.
In October, the market already began pricing the 2012 crop. If Brazil comes anywhere close to a record crop in 2012, it will be a bearish force on prices for much of the year. Flowering season in October will be the first and largest hurdle for this crop. A successful flowering season goes a long way toward ensuring a crop’s full potential.
Outside forces such as general economic outlooks also can play a role. While the Fed, White House and U.S. Congress will try desperately to jump start the U.S. economy this fall, we wouldn’t expect any rabbits coming out of hats and continued U.S. and EU weakness will not help coffee prices
Coffee prices most likely have set the high for the year, yet premium levels remain inflated. The fall sell-off took out support and suggests a test of further support below $2. Call options sold above the $3.00 strike basis the March or May contract still are offering value and are a safe way to execute a bearish outlook.
While the fall sell-off took out the August low, price has consolidated in the near term as the market is digesting the newly harvested beans. Assuming a successful flowering season, look for increasing price weakness as the year draws to a close.
James Cordier is founder of investment firm Liberty Trading Group/OptionSellers.com. Michael Gross is an analyst with Liberty Trading Group. They wrote "The Complete Guide to Option Selling," 2nd Edition (McGraw-Hill, 2009). Visit them at www.OptionSellers.com.