Commodities Forecast: Coffee Reaching Tipping Point

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Coffee is being traded hotter than usual lately; corresponding ETF iPath DJ-UBS Coffee Subindex Total Return SM Index ETN (JO) is up 91.15% YTD.

The price of Brazil’s Arabica beans rose to its highest point in two years, at $2.07 per pound.

Coffee currently has the most bearish forecast of the 51 commodities the self-learning algorithm tracks and predicts.

If you're a coffee drinker, you can appreciate the effect that coffee has on your body. In fact, there is a good possibility that you enjoy this famous beverage since it is the second most popular drink in the world after water and the second most widely used product in the world after oil. Your cup of Joe this morning was one of 1,400 million cups of coffee consumed in an average day and of which Americans consumed 100 million cups. Coffee is traded like any other commodity and has recently been the #1 investment from our advanced commodity forecast by the I Know First self-learning algorithm returning an impressive 72.22% in 3 months.

Where Is The Value In Coffee?

Did you know that 54% of Americans, 18 years and older, drink coffee every day? Four billion dollars is spent every year just to import this caffeinated drink. Brazil is responsible for about 30% of the entire world's coffee output, making it the largest coffee producer followed by Vietnam, a distant second and Colombia as the third.

Some claim drinking coffee to be an addiction, as caffeine stimulates the central nervous system and regular use does cause mild physical dependence. While enjoying a fresh brew in the morning will not threaten your social, physical or economic health the way addictive drugs do, 54% of coffee drinkers say that coffee makes them feel more like themselves. Sixty-eight percent have their first cup within an hour of waking up and 60% claim they need it to start their day. While coffee is generally regarded as breakfast beverage, it is actually consumed at nearly all times throughout the day where 30% of the total amount of coffee consumed is between meals.

Drought In Brazil

Brazil, the world's largest coffee producer, had the worst drought in decades, leading to the biggest rise since 2000 in the price of Arabica coffee beans. This month, the price of Brazil's Arabica beans rose to its highest point in two years, at $2.07 per pound. The International Coffee Organization (comprising producers, importers and exporters) has warned that Brazil's coffee crop could possibly be affected for years to come. As this was one of Brazil's driest summers on record, fears are rising that supplies will be restricted in the coming months. The country produces around a third of the world's coffee. Arabica coffee futures, which track price expectations, have increased from $1.14 per pound to $1.70 in the last month, and are up 21% this week.

Thirty-five percent to forty-five percent of the coffee crop is anticipated to be lost in the South Minas region of Brazil due to its hot weather; however, the full extent of the damage is still not known. Minas Gerais is the fourth most extensive state of the country and the main producer of coffee, providing about half of Brazil's coffee. Chart 1 displays the location of Minas Gerais.

Fortunately, Brazil's coffee industry reports they have enough of a surplus to mitigate the impact on the market. However, worldwide consumption of coffee continues to increase. An initial estimate of total consumption in 2013 suggests a momentous 2.7% increase to 145.8 million bags, which is up from 142 million bags in 2012. The average annual growth rate over the past four years is 2.1%.

Traditional markets, particularly the United States, which have provisionally recorded strong increases in consumption compared to 2012, account for much of this growth in 2013. Prices have also escalated amidst mounting demand in China, the world's second largest economy, which is drinking less green tea and developing a taste for coffee. The International Coffee Organization's monthly coffee market report states, "It seems likely that the market is heading towards a supply deficit."

While this drought will not likely cause a supply shortage this year, analysts expect it will likely cause significant damage to beans intended to be harvested in 2015.

Coffee producers may have to raise prices due to the scale of the increase even though they buy beans many months in advance. Consumers that purchase instant coffee, beans and ground coffee are more likely to notice the difference than Starbucks customers, where bean prices make up a smaller proportion of the price.

Our Prediction

In a prediction made three months ago from the I Know First Top 10 Commodity's forecast, Coffee was one of the top 10 picks on January 19th 2014 for the 3-month time horizon. The corresponding ETF is the iPath DJ-UBS Coffee Subindex Total Return SM Index ETN (NYSEARCA:JO). In accordance with the algorithmic prediction, coffee produced the largest return from this forecast by increasing 72.22% in the 3-month time horizon.

The market prediction system (the algorithm) works by modeling and predicting the flow of money between markets. It separates the predictable part from stochastic (random) noise and then creates a model that projects the future trajectory of the given market in the multidimensional space of other markets. The self-learning algorithm outputs the predicted trend as a number, which in turn is used by traders to identify when to enter and exit the market. Chart 2 displays the Top 10 Commodity forecast with the corresponding returns.

The forecast is color-coded, where green indicates a bullish signal and red indicates a bearish signal. Deeper greens signify that the algorithm is very bullish as it does at the top of this forecast. Coffee had a signal of 6.78 and a predictability of 0.19 displaying confidence in the forecast. The signal is the number flush right in the middle of the box and the predicted direction (not a specific number or target price) for that asset while the predictability is the historical correlation between the prediction and the actual market movements. In other words, the signal represents the forecasted strength of the prediction while the predictability represents the level of confidence, however, further explanations are available here.

In the most recent forecast, Coffee has a bearish 1-month and 3-month prediction. Chart 3 displays today's algorithmic forecast for Coffee.

In the 1-month time horizon, coffee has a bearish forecast with a signal of -69.21 and a predictability of 0.46. The tech giant has a slightly stronger signal of -229.25 in the 3-month forecast and a more confident predictability of 0.49. In fact, coffee is the most bearish forecast of the 51 commodities tracked and has daily predictions for. This indicates that there will be a severe price correction for this commodity and now is the time to sell the corresponding ETF, the iPath DJ-UBS Coffee Subindex Total Return SM Index ETN.

Business disclosure: I Know First Research is the analytic branch of I Know First, a financial startup company that specializes in quantitatively predicting the stock market. Joshua Martin, one of our interns, wrote this article. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

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.