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As a friend of mine says "You can't eliminate risks, you can only move around them." When it comes to the price of coffee beans per pound compared to the price of coffee per cup, the risk is on the side of being long the commodity through ETF/ETN instruments such as the iPath Down-Jones UBS Coffee ETN (NYSEARCA:JO) or (NYSEARCA:CAFE).

In what follows, I suggest some ways to move around that risk by utilizing differing trade set-ups involving JO and Starbucks (NASDAQ:SBUX) mentioned at the conclusion. These set-ups are built upon the thesis that due to the growing production of coffee globally, there will continue to be a global surplus of coffee, keeping coffee prices down.

A Sip of the Continuing Global Surplus of Coffee

Coffee is complex. The volatility of futures contracts can serve as indicators in the short-term, but if you know much about how coffee beans are harvested, you likewise know that coffee is a long-term game. There's typically only one harvest a year or possibly two depending on the country and type of beans (robusta, arabica, or green). This is important to note simply because any volatility in the futures market right now may only be due to traders buying (or companies hedging) as a result of how low coffee prices have been or because a seasonal shock has occurred and is being priced in. Furthermore, there's been talk in recent articles that the price of coffee will find a floor soon as its price is reaching the cost of production - see, WSJ - but when you review coffee production on a global scale, it makes arriving at this conclusion more difficult. I believe coffee prices may rise some in the near-term, albeit subtly, but for the long-term could move further south continuing their legendary lows.

And just how low have they been as of late? JO the ETN which derives its value from the commodity's futures contracts on a monthly rolling basis has fallen approximately 40% over the past year.

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The actual commodity itself, using a per pound metric, has fallen to approximately $1.12. Although futures contracts are traded in tonnes and pounds, I pay attention to the actual commodity price on a per dollar basis. This allows one to quickly estimate the margins for a given coffee company by looking at their unit's price point (excluding trade and import costs). For example, SBUX's lowest cost for a whole bean bag or ground bag of coffee is approximately $8. Dunkin Donuts' (NASDAQ:DNKN) lowest bag of coffee beans retails for roughly $7.50. And Green Mountain Coffee Roasters, Inc.'s (NASDAQ:GMCR) lowest cost for a package of their K-Cups is approximately $11. While all three of these companies have been benefiting from the price of coffee in recent quarters, GMCR and SBUX are the ones which are truly most affected and show the inverse correlation between coffee prices and how it affects their bottom line most clearly.

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When you read the differing articles on the falling price of coffee beans you mainly hear about Brazil, Columbia, and Vietnam. This is rightfully so as Brazil alone makes up about a little more than a third of all coffee exports globally due to their Arabica beans, whereas Vietnam is the largest supplier of robusta beans. What I believe is underfollowed and will continue pushing the price of coffee down is the harvesting and exporting of coffee elsewhere around the world and most importantly, the current growth and future growth prospects of coffee harvesting in China.

Not to understate the importance of Brazil when it comes to coffee production, it is true to say that Brazil's coffee harvest over the next year or two could largely affect where the price of coffee goes. The greatest risks Brazil's coffee production presents to the increase in coffee bean prices are fourfold:

  1. Coffee leaf rust (wind-born fungal disease)
  2. Frost (cold weather hurting the crops)
  3. Brazilian real strengthening
  4. Harvesters utilizing their land for another crop

A brief word on that last risk: A recent article from The Motley Fool, which in large part was quoting the WSJ, said that coffee prices would soon find a price floor because "prices are approaching the cost of production in Brazil. Many farmers are converting crop lands to cattle pasture, nixing tree planting, and rationing fertilizer use." Without knowing either of these authors from the WSJ and Motley Fool, I would tend to think neither have visited an emerging market context where the lead export is coffee. This is simply because in a third-world society, it is unbelievably difficult, if not impossible to simply convert your land for the utilization of another crop. This isn't merely because the soil quality may not be the same for other commodities, but also because the risks in doing so would not be appealing for any third-world farmer. For example, where I worked in Uganda I would regularly see coffee crops being harvested as seen in the pictures below.

These farmers typically had enough land to harvest two small to medium size crops (typically one to sell and one to partially live off of). If they even wanted to change their land to begin raising cattle, there is little they could do to do so. It would be quite difficult to find a line of credit for them to pursue to buy cattle with and they would have no operating capital in place (cattle is extremely expensive in an agricultural-based society). Uganda is not unlike other third-world countries wherein the average local farmer is going to be small in scale and have just enough of a harvest to sell to a local buyer.

What this means is that farmers already in the business of the coffee trade have too many accompanying risks to get out. For those larger operations in Brazil or even larger operations in other third-world settings, sure, it's true the risk/reward relationship for them is such that they could utilize some of their land for cattle. But if they're already vested in coffee, they won't want to miss out on any future climb in coffee prices, nor lose any of their current buyers. This would mean that any land they may use for cattle would be small in scale, not giving a healthy risk/reward relationship. Therefore, when you read in the aforementioned WSJ or Motley Fool articles that coffee beans will be finding a floor due to farmers using their land for cattle, I would not suggest you stop trading short coffee in favor of futures contracts on cattle.

What is important for the potential investor here to know is that while Brazil, Columbia, and Vietnam make up an abundance of the global coffee production they are not the only ones. This gives importers other options to chose from should one of these larger coffee producing countries have a bad harvest or utilize their land differently. This is to say, the global coffee surplus should continue.

Take a look at the interactive data of coffee production per given country provided by International Trade Centre and you'll see the growth in other country's coffee production will not help to form a price floor for coffee prices over the long-term. If there were any non-recurring seasonal events which could cause coffee prices to rise sharply in the near-term, it would only be temporarily due to the remaining countries producing the needed beans. At this, there's one country in particular which warrants further attention with regards to their coffee production - China.

China's Coffee

Although China is a massive country, they are currently a smaller player in the coffee industry. What makes them captivating to monitor is their recent acceleration in coffee production. An excellent and intriguing study published earlier this month by the International Coffee Organization (ICO) titled Coffee In China makes an ever convincing case that China is beginning to show vast amounts of growth in both their imports and exports of coffee. As you read through the study, the interesting point of comparison is made that Japan was once a country wherein coffee was nonexistent. Then, over the course of two decades Japan showed immense growth in their coffee consumption and production, becoming the world's fourth largest coffee industry. The study goes on to point out that China has surpassed Japan in terms of their economy and that China's rapid aggregate growth over recent years would lead one to conclude we could easily see the same growth in their coffee industry. This is made clear by reading in the study that between 1998 to 2012 China has shown a 15.1% y/y growth rate in their coffee production (production at 15.1% y/y; exports at 15.8% y/y).

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While China's imports are growing as well, it is interesting to note that they import mainly from Vietnam, Indonesia, the US, and Uganda. This would further strengthen the above mentioned point that while Brazil currently plays a massive role in global coffee production, they do not, however, play such an integral role that other exporting countries should be ignored. If China's growth continues, soon only a handful of other third-world countries' coffee exports could equal that of Brazil's.

The correlation is clear: China's coffee potential is beginning to take shape, making a dim outlook for coffee prices.

Does going long coffee prices make sense at all?

The futures market allows a trader to buy contracts, not just on coffee in general, but also on specific kinds of beans. I would suggest looking at going long robusta bean contracts. This is due to Uganda and other East African (EA) countries which are undergoing an attack from a twig borer, hurting their coffee production. This may present a profitable long trade for robusta beans, but I would research and monitor the situation more before making a trade. EA countries mainly produce robusta beans; Uganda's coffee production accounts for 93% of all of net exports, making them one of the top ten producers of robusta beans. Therefore, with a bad year of crops being discovered, it makes sense that we could see some volatility in futures market pertaining to robusta beans as the affect of the twig borer is unknown and may not be entirely priced in. To read more about robusta futures and options on robusta futures, see here: NYSE EuroNext/robustafutures and NYSE EuroNext/robustafutures/options.

Conclusion

The factors which would have to come to fruition for coffee prices to rise enough to present a profitable trade are many. At the same time, the factors which have currently led to their prices falling are also many and should continue.

Two trade ideas to consider:

  1. Pair trade-like concept: Consider shorting JO (the ETN JO which derives its value off coffee futures contracts on a month/month rolling basis). If you're not comfortable shorting JO at legendary lows despite my argument above, then consider going long in the money puts, while also buying some insurance through buying out of the money calls. At the same time of shorting JO, go long companies whose bottom line is largely contingent upon coffee prices. The two companies which come to mind would be Green Mountain Coffee Roasters and Starbucks. With GMCR and SBUX at their current levels, I would wait for a pullback before opening a position. GMCR's operating costs make SBUX a more attractive long opportunity. With SBUX having recently raised the price of some of their units and expanding into China, they have seemingly provided an immediate hedge against a rise in coffee prices. That is, if coffee prices were to rise in the near-term due to a seasonal, non-recurring incident, SBUX's bottom line will remain stronger than it otherwise would have prior to their price increase.
  2. Futures traders: Consider buying call contracts on robusta beans.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Coffee: Short The Commodity, Long The Companies - An International Insight