Is it time to buy coffee?

Coffee has not offered many opportunities on the long side since the huge 2010 rally, where coffee prices more than doubled. There have been signs of strong emerging fundamental underpinnings for this market throughout the first half of 2012 and now the market appears ready to take-off. Here’s why.

Historical prices would suggest $2.50 per lb. coffee over the next 12 months and $4 per lb. coffee two years out are possible based on price cycles, commercial net positions, micro-fundamentals and relative value to the Continuous Commodity Index.

Fundamental case

The very wet Brazilian summer that created premature blooming/flowering for the next off-season crop had the effect of straining the coffee tree from its normal resting period leaving it with less energy and resources to produce a maximal large flowering period. In this scenario, buds and flowering are less frequent, smaller with less quality. Also, the new buds are very susceptible to being damaged by the ongoing harvest of the current crop thereby reducing potential yields. Additionally, the current crop harvest suffered from very heavy rains by having cherries fall off the trees. The falling cherries hit the ground and begin to ferment on the wet ground thereby lowering quality and some spoiling altogether.

All of this likely will continue to have a very long tail to it as the heart of the flowering /blooming phase occurs in the September/October timeframe. My homework strongly suggests that this likely will have the effect of lowering the production potential for the offseason Brazilian coffee crop from normal trendline expectations. Trendline expectations for this coming offseason crop would have been about 51 million bags but given what already has happened over the wet summer and what still might happen for the September/October timeframe, the potential exists for a crop no better than 45 million bags. This would be a 10 million bag reduction in supply from this year’s crop. Should such an outcome begin to gain traction in the global coffee trade then coffee prices will need to price violently higher to ration demand and begin the long road of encouraging long term Arabica production growth. Also Central America had a very poor flowering season this year and the harvest that is about to begin likely will fall well short of current expectations. Also, the likelihood of El Nino reduced Robusta crops in Vietnam and Indonesia next year will further exacerbate this impending supply squeeze.

While the market has been hyper focused in the lost demand of Arabica in favor of Robusta given last year’s near record premiums for Arabica prices in relation to Robusta prices, lost in the shuffle is that this relationship has been flipped to where Arabica is now historically cheap in relation to Robusta. This fact as well as the fact that the coffee/tea price ratio is also in a similar relative cheapness of Arabica suggest that demand growth should reaccelerate over the next year at a time where production could be off by as much as 10 million bags depending on Mother Nature. Remember, the typical surge in the stocks to usage ratio during the on-season Brazilian crop and record Vietnamese crop was mainly in the Robusta grade and not in the Arabica grade. Nonetheless, next year should break new multi-decade lows and necessitate further demand rationing.

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