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Many commodities have surged in recent weeks–especially base metals such as copper–on hopes of a continued economic recovery and increased demand from both emerging and developed markets. But not all resources have participated in the recent surge; many of the “soft” commodities, including sugar and cocoa, have slumped. After soaring to finish 2009, the iPath Dow Jones-AIG Cocoa Total Return Sub-Index ETN (NYSEARCA:NIB) has dropped nearly 14% since the beginning of the year. This weakness is due to a variety of factors, but three main issues responsible for the poor performance stand out:

1. Excess Supply

Many of the world’s largest cocoa producers added enormous amounts of capacity right before the global slowdown in late 2008. This had led to some plants to operate at one-third of their capacity in West Africa, one of the main growing regions of the crop. With plants operating at such low levels, increased prices are likely to be met with increased production, limiting the upside potential for prices in the short-term.

2. Discretionary Downturn

The global economic slowdown has decreased demand for discretionary items, including everything from luxury cars to chocolate bars. In fact, cocoa output will exceed demand by about 80,000 metric tons in the year that begins on October 1, according to the International Cocoa Organization. This lack of demand, especially to meet the high levels of capacity, has helped to push cocoa prices lower.

3. Hedge Funds Bailing

Hedge fund managers and large speculators have been exiting cocoa positions en masse in recent weeks, a reversal of trends that drove prices higher over the last year. “Cocoa prices may fall 13 percent in two months, extending this year’s slump, as traders shift money away from commodities to the dollar”, writes Yi Tian. Luis Rangel, a commodity trader and researcher acknowledges that the exodus of institutional investors is beginning to have an impact on prices. “This year, we’re starting to see a very different macro-economic picture than what we had been experiencing for the previous three years,” says Rangel. “Whereas commodities were riding this tidal wave of investment inflows, all of a sudden now we’re starting to see investment outflows.”

Despite the recent weakness, some are still optimistic about the long term prospects of the industry and are bullish on the commodity if the global economic recovery picks up steam soon. Although the fund is down double digits in 2010, it has produced a gain of about 15% over the past 52 weeks.

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NIB

Disclosure: No positions at time of writing.

Source: Three Reasons the Cocoa ETF Is Leaving Investors Bitter