Venti-Sized Gains for Coffee

By Brad Zigler

There have been few comforts for long-only commodity investors lately. With the Continuous Commodity Index down more than 40% since July, it seems buyers have been on a four-month coffee break from most every futures pit and trading ring.

Now may be the time, however, to think about trading coffee rather than drinking it. We mentioned this before ("Coffee Time?"), but it's worth a closer look.

Chartists can argue the technical merits on either side of the current coffee market. You can see the points of contention in the December contract. If you're a glass-half-empty kind of analyst, you'll readily note that a new low was made in October, that prices remain below their 20-day moving average and that the down trend line dating from late February has yet to broken. Optimists, on the other hand, will see a month long base building and a trading range that could be the launchpad for higher prices if the fundamentals line up. The relative strength index indicator, too, is neutral; neither oversold nor overbought.

ICE/NYBOT Coffee (December 2008)

Fundamentals

So what about those fundamentals? Supplies were tight going in to the new marketing year because carryover stocks, at 12.4 million bags (a bag contains 60 kilos or 132 pounds of green coffee beans), were 35% lower than the previous year. In fact, the carryover was the lowest in over three decades. For the new crop year, the U.S. Department of Agriculture optimistically estimates production at 140.6 million bags.

World Coffee Production And Use (Millions Of Bags)

Crop Year	2004- 2005	2005- 2006	2006- 2007	2007- 2008	2008- 2009 (E)
Production	120.8	111.7	133.5	122.4	140.6
Total Use	118.3	115.8	132.3	129.2	135.8
Ending Stocks	22.0	18.0	19.2	12.4	17.2
Stocks-to-Use Ratio	.19	.16	.15	.10	.13

(E) = Estimated

Production is likely to be curtailed, however, if the tight credit market impinges on growers' financing of fertilizer and pesticide purchases or labor contracting. According to Juan Lucas Restrepo, commercial manager at the National Federation of Coffee Growers of Colombia, "The credit crunch limits the availability to exporters and cooperatives of working capital. We might see problems in coffee supply if it persists." Colombia is the world's third-largest coffee producer.

Worse still is the USDA's gloomy assessment of Brazil's ending stocks for the 2007-2008 marketing year. Agency attachés report that inventories are "the lowest in the past 50 years and theoretically not sufficient to guarantee the proper flow of product among the different players of the industry." Brazil is the world's leading coffee grower, accounting for more than 30% of global production.

Globally, in fact, we're heading into 2009 with the lowest stocks-to-use ratio in more than 30 years. A bad production year would raise a distinct possibility of shortage.

Demand

Coffee demand is unlikely to abate in our nascent recession, if history is any guide. There's no correlation between economic dislocations and diminution in coffee demand. In fact, total coffee usage actually increased by an average of 2.2% in each recent recession year over the past two decades.

Total Coffee Usage

Commercial Interest

The most bullish indicator in the coffee market is the flip in commercial interests from net short to net long. Commercial traders represent hedgers who use the futures market to lay off the price associated with buying or selling wholesale coffee. Producers would be likely to sell coffee futures to hedge against an anticipated decline in the value of their crops while coffee roasters, food companies and coffee retailers would buy futures when they fear future cost increases.

Commercial traders were net short coffee futures in the first three quarters of 2008 as prices ratcheted downward. Hedgers' net short interest, however, lightened as coffee prices swooned. By October, when coffee slid below $1.20, hedge interest shifted to the long side on burgeoning open interest, indicating aggressive commercial buying.

Weekly Coffee Futures Vs. Commercial Net Interest

Net long hedge positions are generally fleeting, but very reliable, indicators of higher prices ahead. Since 2003, there have been eight instances of long hedge predominance, and in each instance, coffee prices moved substantially higher in the ensuing six months. On average, the six-month price appreciation was 21.6%, which translates into a potential gain of $6,124 per contract for a futures buyer.

Long Hedge Interest In Coffee Futures

Date	% OI Net Long	Coffee Price	Coffee Price + 6 Mos.	Price Gain
01-Apr-03	8.0%	48.71¢	53.51¢	9.9%
24-Jun-03	15.2%	47.11¢	56.92¢	20.8%
25-Nov-03	15.3%	54.15¢	65.31¢	18.8%
17-Aug-04	8.1%	59.39¢	94.00¢	58.3%
27-Sep-05	2.3%	87.02¢	103.52¢	19.0%
13-Dec-05	2.4%	96.23¢	105.89¢	10.0%
27-Jun-06	7.7%	91.26¢	115.60¢	16.7%
15-May-07	4.4%	99.66¢	118.99¢	19.4%

"OI" = Open Interest

 

Target Price

Given current fundamentals, Colombia's Juan Lucas Restrepo says traders might look at the $1.20 to $1.50 level as a logical six-month target for coffee. From today's spot price, that's a 7% to 29% increase, well within the operating range of the coffee markets we've reviewed.

Over the longer term, though, coffee bulls are eyeing $2.50.

For investors disinclined to use futures and willing to take on credit risk, there's the iPath Dow Jones-AIG Coffee ETN (NYSE Arca: JO). Restrepo's targets translate to a price level of $39 to $46 for securities investors. Eighty-one dollars would be the objective for aggressive traders.

Comments

[Elaine:]

Very interesting analysis. Looking at a six month target, I think that coffee consumption thus demand increases by the summer. Just a thought.......

2008 Nov 12 09:25 AM