Craving Chocolate

By Julian Murdoch

Cocoa: We drink it, give it as gifts and - most importantly - eat it. And in little over a month, our streets will fill with small, costumed humans begging for the stuff.

But lately, despite a drop in demand, cocoa has risen to levels not seen in months, with prices propped up by falling production worldwide. Especially as food giant Kraft (NYSE: KFT) preps for a second bid for U.K.-based Cadbury (NYSE: CBY), it's worth taking a second look at just how this commodity has performed lately:

CC, ICE [NYBOT] Daily, Dec. 2009

But that's just the short-term view; here's what the actual price of cocoa has averaged this year, according to the International Cocoa Organization (ICCO):

As you can see, cocoa futures have had quite a run, with prices increasing 20% just since July. We've had some volatility, but given the fundamentals, prices seem poised to continue upward.

Global Cocoa Production Down

Consider the supply coming from the world's top cocoa producers: Ivory Coast, Ghana, Indonesia, Nigeria and Cameroon. These five countries are responsible for roughly 70% of global cocoa production each year.

Ivory Coast, by far the largest producer, has had to contend with an overabundance of rain this year, which has allowed diseases such as black pod disease to afflict crops. As the country's harvest season comes to a close - picking occurs from April through September - estimates are that Côte d'Ivoire will produce only 1.1 million metric tons for crop year 2008-09, down 20% from the last year's harvest of 1.38 million metric tons.

Considering that previous 2008-09 forecasts as recently as July estimated the yield would fall between 1.29 million and 1.37 million metric tons, this latest estimate lends support to cocoa prices, to say the very least.

Next year may be more of the same, especially if nothing is done to improve Ivory Coast's aging plantations. In an Aug. 24 interview with Bloomberg, Ali Lakiss, the director of cocoa exporter SAF-Cacao, said:

The crop year that ends in September will probably reach 1.1 million metric tons and the new crop "won't be any higher than that. Many beans will not be of a commercial standard" for the 2009-2010 season.

In a separate AP interview, Lakiss added, "The quality of the cocoa is falling year by year. And the production volume will only fall as the plantations are very old."

He even warned that production could dip below a million tons within three years if nothing is done. Not exactly positive news from the man who handles 80% of Ivory Coast's cocoa exports.

Ivory Coast isn't the only cocoa producer suffering falling yields; Indonesia too is seeing a slightly lower harvest this year, due to El Niño-driven dry weather patterns. The ICCO estimates that Indonesia will produce 490,000 tons - 5,000 tons less than the 2007-08 crop year.

That hasn't stopped the farmers from selling though. Indonesia's exports of the bean were up 60% from last August, as farmers took advantage of higher prices.

Slight Production Increases

But not all cocoa producers had a bad harvest. Ghana, the second-largest cocoa producer, will produce around 680,000 tons this year, 30,000 more than expected. That's good news, especially considering the country's current attempts to boost production levels to 1 million metric tons annually. (Production increases in the cocoa industry are long-range goals, since it can take 10 years for a newly planted cocoa tree to mature and produce cocoa berries.)

And then there is tiny Cameroon. Cameroon's production grew 9.4% for the season that just ended, which surprised even its own National Cocoa and Coffee Board, according to Bloomberg. Although at 205,000 metric tons, Cameroon is still a relatively small player compared to Ivory Coast, the country is currently improving both its farming methods and transportation lines, upgrades that could help boost its importance as a global supplier.

Initial forecasts for Cameroon's 2009-10 season were 210,000 tons, but that may need to be revised upward. In an interview with Bloomberg, the general manager of the National Cocoa and Coffee Board said, "We may even produce more than 225,000 tons." Giddy times, indeed.

Still, these production increases just aren't enough to overcome the supply deficit from Côte D'Ivoire and Indonesia, and the end result is that global production will fall 7% to 3.456 million tons for the current 2008-09 crop year, according to the ICCO's Quarterly Bulletin of Cocoa Statistics. That means a deficit of 73,000 tons of cocoa this year - even though demand for cocoa is also down, by approximately 6.7%.

Inventories aren't faring much better. The ICCO has forecasted end-of-season stocks to be down 4.7% for the year. A little more locally, the stockpiles that ICE Futures monitors in U.S. warehouses are sitting at a scant 2.78 million bags - a level not seen since February.

Investing In Cocoa

If you're interested in cocoa, but perhaps not in moving to western Africa and starting a plantation, one way to play the market is via iPath's Dow Jones-UBS Cocoa Subindex Total Return ETN (NYSEArca: NIB). You can also get exposure to the bean by investing in vehicles based on the Rogers International Commodities Index (RICI), but cocoa only makes up 1% of its holdings - any gains (or losses) are easily diluted by the rest of the commodity holdings. And of course, there's always futures, which trade on NYMEX in contract sizes of 10 metric tons.

One thing to remember: Cocoa is a relatively small market, which means it's susceptible to any single large trade that moves the market in either direction.

Lining Up For Cadbury

At the moment, food producers are far more concerned with dropping chocolate demand than cocoa price increases. But some candy companies are sitting pretty for other reasons.

If you happen to currently own shares of Cadbury, life is, pardon the pun - sweet. Kraft Foods' $16.84 billion offer for U.K.'s Cadbury pushed the confectionary maker's stock up a startling $14.42 on Sept. 8, to close at $51.88. That's a one day jump of 38%.

Cadbury told Kraft to suck an egg - preferably a creme one - by stating the offer was too low. But rumor has it that Kraft is not discouraged and is currently seeking financing for the deal.

Of course, it's not just Kraft that might be interested in Cadbury - Nestle (NSRGY.PK) or Hershey (HSY) may be tempted as well.

Will this turn into a candy-coated version of BHP/Rio Tinto?

Comments

[DVW:]

It's actually at the top of the trend line. I wouldnt do a thing with CCZ9 till it shows what it's going to do at that trend line. It's been bouncing consistently in a channel for months. It's been an easy play so far.

Sep 10 08:23 PM

[AndrewBaker:]

Cocoa is at the top of its trend at the present and is hitting resistance that's been there for a year. I'm waiting until it either drops back to give it room to rise again, or breaks through this resistance level.

Sep 11 12:41 PM

[Plant the s...:]

Cocoa farming could develop further with some of the Agriculture revolution in this country that has driven farm productivity as high as it has become. Access to finance is also an issue.

Sep 14 04:41 PM