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.
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.
Back to technicals
Price cycles are bullish-coffee price cycles have tended to see a low point in the middle of the 8 year cycle and then see another big run back up higher in prices. The current DNA of time and price are perfect for a secondary price cycle bottom and surge back up. Also two long term trendlines reside near $1.50 further suggesting that the current retest of such lows likely will hold and launch the next bull market in coffee. The eight-year price cycle for coffee predicts another large run back up in coffee prices.
The 8-year price cycle for Coffee predicts another large run back up in coffee prices
Looking at the December 2012 futures price chart a likely higher low is developing that should breakout to the upside no later than October 2012. This would be consistent with typical seasonal price lows in the fall and a seasonal pick up in coffee demand.
Also, relative value levels remains very bullish and cheap. Despite the impressive bull market in coffee during the 2010/2011 timeframe, the relative price chart barely budged and fell way short of reaching the typical .70-1.00 relative value level. A true coffee bull market will go it alone. This strongly suggests that the bull market in coffee has a long way to go.
The current level for commercial interest is one of the most bullish net commercial positions in history only seen two times since 1986: Nov. 28, 2003 and Dec. 12, 2008. Both set off massive bull market moves.
Commercials have loaded up on coffee and the latest surge has taken them to historic bullish high ground. This has only been seen two other times before in 2003 and 2008. Both times preceded fantastic multi-year bull market moves. If history is a guide, all-time highs could be achieved over the next few years.
Despite all the bearish factors that have been the basis for the bear market in coffee prices over the last year that included Europe falling into the abyss (reduced coffee demand), large demand switch from Arabica to Robusta, a crashing Brazilian real, slowing coffee demand in Brazil, record Robusta production in Vietnam and record Brazilian crop, the commercial interests are long and see great long term value. As always, in order to make money in a commodity you have to see the bullish fundamental picture coming before everyone else does and before such bullish underpinnings begin to get priced in the market with higher prices.
It is very hard to buy when everything seems bearish but that is the nature of the beast. If it was easy everyone would be trading commodities. All my homework indicates that a new bull market is about to begin. The same contrarian streak that allowed me to buy the last bull market in coffee despite widespread bearishness in 2010 is at work here and now.
The prudent play is to go long December 2012 coffee and place an option collar around it to reduce downside risk. With uncertainty around U.S. elections, global central bank money printing or lack thereof, possible Chinese fiscal stimulus or lack thereof, possible war with Iran, possible Europe implosion, banking system crisis and possible worsening global recession, the macro picture offers huge risks to any long position.
Of course these risk factors have been in place for many years and will remain in place for years to come. With a contract as large as coffee and with the higher volatility typically seen in coffee one should remain focused on risk control. An option collar is a perfect vehicle to do this. Here is the trade: Buy 1 Dec. ‘12 coffee futures at $1.6310 closing Friday price, buy 1 Dec. ‘12 150 put at 3.03 closing price, sell 1 Dec. ‘12 180 coffee call at 3.10 closing price. What this does is essentially give you a $1.50 floor under your straight long position at no cost as the buy and sell for the options are essentially the same premium.
Should the coffee market collapse because of a macro event then the puts will appreciate dramatically minimizing your loss to at most the difference between the executed futures price and the put strike. One would then have the flexibility to take the put option off at a large profit and ride the coffee futures market back up. If the coffee market takes off as the bullish fundamentals take hold in a money printing environment, then profit can be made up to the short call strike. Once prices move over $1.80 the profit potential is capped. Of course the flexibility exists that if one felt the bull market in coffee was getting underway you could take the short call off and let the futures run higher to capture further gains.
What is great here is that a substantial profit would already be in place that would dramatically reduce the risk of being naked long as one can apply a trailing stop strategy to manage risk. One could also apply a different collar at a higher strike price level to bracket it once again. The whole point of using an option collar strategy is that it allows for a calculated loss that is quantified and allows for flexibility.