The Coffee Cash Cow

Advanced Technique

With Brazilian “Flowering” season wrapping up, the coffee market braces for record production. 

Seasonal tendencies create opportunities for increased volatility in commodity markets. Increased volatility in price tends to create increased value in options premium. 

In late 2017,  the Brazilian coffee “flowering” season appeared to come off without a hitch. With a potential record Brazilian crop now growing on trees, and with Vietnam, the second largest global producer of coffee, beginning the harvest of its near-record crop at the end of 2017, coffee options traders could have a cash-generating asset well into 2018. 

Timely rains during the Brazilian flowering season could help spur on a record 2018 coffee crop. As coffee prices now face both seasonal and fundamental pressures, substantial upside breakouts seem less likely. 

Pressure after Flowering

Flowering season is the time in the Brazilian Spring when coffee trees well, flower. These flowers then drop off leaving behind a cherry. The cherry is simply the bud of a coffee bean. Thus, the more flowers, the more cherries. The more cherries, the more coffee. Flowering is the most vulnerable time for the upcoming coffee crop and its successful conclusion brings a sigh of relief to producers.

In late 2017, when flowering occurred, there were the usual scattered rumblings of dry weather in Brazilian growing regions. The market mostly discounted the talk – not because it wasn’t dry but because September is often a dry month in Brazil. But wetter weather in October, especially in heavy coffee producing regions such as Minas Gerais and Espirito Santo, has mitigated those concerns. Rainfall in these regions totaled 76% above average for the second week in October. These two regions account for nearly 75% of all Brazilian coffee production. 

While there was a great deal of dry weather in central Brazil, the major growing regions saw plenty of rain. What does all of this mean for price? Historically, the coffee market has tended to build a weather premium into prices during flowering season. This typically occurs as trader anxiety over flowering keeps the market supported, although this effect was somewhat muted in 2017 – perhaps over talk of record production.

Once flowering is complete and the upcoming crop can begin to be measured, this anxiety tends to come out of the market. This has historically pressured coffee prices as is evidenced in the seasonal chart (see “Seasonal slide,” below). 

Bumper Crops in Brazil and Vietnam

As the world’s top producer of coffee by far, Brazil must be the focus of any serious coffee trader. Thus, the size of upcoming coffee crops can have an outsized impact on price.

With projected mammoth harvests in both Vietnam and Brazil and a strong seasonal tendency for lower prices into northern hemisphere spring, we feel the least likely scenario is a sustained rally higher (see “A lot of joe,” below). 

September dryness kept official estimates for the 2017/18 Brazilian Coffee crop at 53 million bags. However, timely rains during October flowering will almost surely increase that estimate. Newer estimates peg the upcoming crop as high as 65 million bags of coffee, which would shatter the current production record. 

While growing season weather will play a role, it now seems likely that 2017/18 Brazilian coffee production will set a record. 

On the other side of the world, Vietnam began its annual coffee harvest in November. Harvest pressure from this country has historically played a role in price, helping to accelerate the previously mentioned seasonal tendency, as new Vietnamese inventory floods supply channels in Q4 2017 and Q1 2018. 

The 2017/18 Vietnamese crop is no slouch either. At 28 million bags, Vietnamese production will be the third highest on record. 


Outlook and Strategy

We are not in the business of predicting what commodities prices will do. You don’t have to either. As an option seller, you only have to get a rough idea of what prices are not going to do. 

With projected mammoth harvests in both Vietnam and Brazil and a strong seasonal tendency for lower prices into northern hemisphere spring, we feel the least likely scenario is a sustained rally higher. 

Prices are technically oversold so a bounce in early 2018 is not out of the question. However, those rallies should be limited. Fundamentally based investors should consider any such rally an opportunity for writing deep out of the money calls above the market. 

Aggressive self-directed traders can consider selling the May 1.80 calls for premiums of $400 to $500 each. The margin requirement per option is approximately $1,250. Thus, a worthless expiration would result in a rate-of-return of 32% to 40% in about four months (see “No stress trade,” above). 

More conservative investors can look for limited rallies in January as opportunities for selling higher strikes, above the all-time contract highs. 

With both freeze and flowering season now behind the 2017/18 coffee crop, the primary threats to yield are out of the way. The market now sets its sights on pricing the crop. If Brazilian production comes in anywhere near private estimates, selling calls could be a cash cow for investors well into 2018.  

 

About the Author

James Cordier is the founder of www.OptionsSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. He is the author of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).