Our July 30 recommendation to establish a long position in cocoa (NYBOT:CCZ13) would have been a dandy – had we not suggested to patiently wait “...for setbacks.” Unfortunately, there were no setbacks. The market took off within days and has since rallied by more than $400 per tonne, or 18%.
There have not been any earthshattering changes in the fundamentals, but the developments on both the supply and demand sides continue to be bullish.
About 65% of global supply of cocoa beans is grown in the Ivory Coast and Ghana, and production levels have not increased over the past few years. While some minor producing nations have increased output, others have seen declines. Brazil, for example, had a bit of a renaissance in 2012-13 after years of falling off the cocoa map, but for 2013-14, arrivals are down 40%, year-over-year. Overall, global production is stagnant.
Aside from intermittent weather problems, crops in both the Ivory Coast and Ghana have suffered from insufficient application of fertilizer and from neglect of other crop enhancement activity.
The Ghanaian government successfully engineered a doubling of the country’s crop size over the past 10 years, by subsidizing 50% of fertilizer costs. Last month, however, the government announced that it will be phasing out the subsidies in the coming years. Fertilizer purchases have reportedly plunged. So it is highly unlikely to see any further output growth.
With the jump in world prices, the Ivorian cocoa ministry recently raised the minimum prices farmers will receive for their beans. But poor pesticide and fertilizer usage is widespread, and the increase in farmers’ income will not readily find its way to improved crop management.
Global demand, at the same time, has been quite strong. Third-quarter European grind figures, released on Oct. 10, show a 4.7% increase over last year. When compared with anemic production, it is not difficult to see why the market has tightened.
Butter stocks have dwindled, which has shown up in skyrocketing butter prices. The butter-to-beans ratio has spiked to 2.9 times the price of spot London beans. As seen in Chart 2, the ratio had fallen to1 in mid-2012. Powder prices have fallen, keeping the combined butter/powder ratio at bay (Chart 3), but butter drives the market.
On Oct. 7 the International Cocoa Organization (ICCO) revised its balance sheet for the recently concluded 2012-13 marketing year to reflect these developments. The estimate for the global production/consumption deficit jumped to 86,000 tonnes, a larger shortfall than its previous estimate for a deficit of 52,000 tonnes. It cited sluggish output and the fresh demand coming out of a growing Asian middle class.
The ICCO also forecast that the global balance sheet would remain in deficit over the next four years. This outlook may be a bit hasty, but based on current trends, ongoing deficits will persist.
If you did not follow our (exact) recommendation and were astute and aggressive enough to establish a long position, remain long and place sell stops at $2,500 per tonne, basis the nearest contract, close only. If you are sidelined, we continue to recommend discipline and close monitoring for the inevitable setback – shallow as it may be – to get long this market. We believe the market is poised for a return to the 2011 highs that reached beyond $3,700 per tonne.