Cocoa Analysis Completes Our Tropical Trifecta

By Brad Zigler

Who would have thought our web site devoted to, and named for, hard assets would devote so much space to soft commodities?

Last week, we ran features on sugar and coffee, which prompted some readers to wonder about other soft commodities. We rather briefly dealt with the prospects for orange juice in a Desktop piece ("Orange Juice Set To Shine?"), but that's wasn't enough, according to lovers of tropicals. "What about cocoa?" they ask.

Indeed, what about cocoa? Are cocoa futures building a price base? You might be tempted to think so by looking at the chart for the March 2009 delivery.

ICE/NYBOT Cocoa (March 2009)

Technical Picture

Prices have held above $1,900 a tonne (a metric ton of 1,000 kilograms or 2,200 pounds), and now seem to have formed a rounded bottom together with a break above the contract's moving average price. That's a pretty bullish formation.

Some of the buoyancy in March prices, however, may be due to speculative longs rolling their positions forward ahead of the first notice day for the soon-to-expire December contract; in other words, no real expectations of higher prices, just a supply-and-demand effect for the futures themselves. The fact that volume and open interest didn't expand on the upside breakout makes cocoa's upside case less convincing.

Fundamentals

Add in the fundamental picture now. Cocoa, unlike coffee (see "Venti-Sized Gains For Coffee"), is a luxury item. Economic uncertainty in the United States and Europe, the world's largest consumers, weakens demand for beverage cocoa and chocolate.

The Ivory Coast and Ghana account for more than half of the world's cocoa production. Ivory Coast's production - more than a third of the global supply - is double that of Ghana. Indonesia is the third-largest producer, generating 15% of world stocks.

Cocoa is particularly sensitive to weather damage and to disease, particularly the swollen shoot virus, and black pod disease.

The International Cocoa Organization [ICCO)]estimates that world production of cocoa will fall short of consumption by 88,000 tonnes for the 2007-2008 marketing year. However, the cartel says ending stocks will total 1.5 million tonnes, or 40% of annual use. A 40% stocks-to-use ratio seems to bespeak abundant supplies, but still, there are questions about the quality of those stocks. Disease has been taking a growing toll on cocoa. Ivory Coast producers are forecasting the 2008-2009 cocoa harvest will come in 7% lighter than the previous year due to black pod disease and No. 3-producer Indonesia's crop being beset by fungal disease.

World Cocoa Production And Use (Millions Of Tonnes)

Marketing Year	2003- 2004	2004- 2005	2005- 2006	2006- 2007	2007- 2008 (E)
Production	3.5	3.4	3.7	3.4	3.6
Grindings	3.2	3.4	3.5	3.6	3.7
Ending Stocks	1.7	1.7	1.9	1.6	1.5
Stocks-to-Use Ratio	.52	.50	.54	.44	.40

(E) = Estimated

 

The potential for civil unrest in the Ivory Coast, too, could impact production. Long-standing internal rifts looked like they were going to be reconciled through a national election slated for November 2008, but the referendum has now been pushed back to 2009 because of continuing conflict between government and rebel elements.

All and all, the fundamental picture's a bit of a muddle. That leaves us to gauge trader sentiment for clues about future price trends.

Net Interest Of Cocoa Futures Traders

Trader Commitments

Commercial traders have been lightening their selling hedges apace with the decline in futures prices this year. The smart money is thus telling us of its growing comfort with price levels. In other words, producers don't believe prices are headed much lower.

Meantime, small speculators have been growing less bullish and, in fact, recently turned bearish. There's typically no better contrarian indicator than small speculator interest. More often than not, it's the opposite of smart money.

Total open interest, however, has been drying up, a symptom of a liquidating market. That's left the market in equilibrium and increasingly susceptible to the next economic or supply shock. There seems little immediate concern about the cocoa supply imbalance, which leaves us to guess when the next economic upheaval will drive buyers back into the market.

We've speculated about the timing of a reflation in a previous article (see "Golden Opportunities"). The likelihood of an upturn in inflation increases in the second quarter of 2009, and with it, the potential for a sustainable rally in cocoa prices.