Five Ways to Profit as Coffee Prices Soar

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 |  About: iPath Dow Jones-UBS Coffee ETN (JO)
by: Money Morning

By Jack Barnes

If you're anything like me, you can't resist stopping in for a "cup of Joe" every morning. If so, you're probably also like me in that you're experiencing a bit of pain in the wallet right now, given the steady increase in coffee prices we've see over the last year (and especially in the last few months). If you want physical proof that we're operating in a truly global economy these days, just look at how these three factors have creamed your coffee budget:

  • Lousy weather in Latin America is threatening a big chunk of the worldwide coffee crop.
  • U.S. coffee stockpiles are reportedly at a 10-year low.
  • And Vietnam and Brazil - two of the world's Top 3 exporters - are scheming to hoard their stockpiles.

Little wonder coffee prices are at 13-year highs, and coffee futures have zoomed 44% since June.
Expect the trend to continue. This may be bad news for your pocketbook - but it's great news for your portfolio. Coffee prices are going to rocket another 30% from here. And with the strategy we're about to show you, this run-up in prices will be truly good 'til the last drop.

Food Price Inflation

In the soft agriculture commodities sector, inflation in food and staples is starting to really hit a lot of people's food budgets. Wheat has really run up in price, and now latecomer coffee is joining the price-increase party.The price of coffee has been brewing for years but now it's boiling over. Coffee has zoomed 54% in the last year, including a 41% move since June. Since hitting its market lows back in 2002, coffee has generated a compounded annual rate of return of about 20%.

It's forcing a reaction in the marketplace. The J.M. Smucker Co. (NYSE:SJM) - parent of the Folgers, Dunkin' Donuts and Millstone brands - has raised prices 10%. "The J.M. Smucker Company has been committed to transparent coffee pricing that reflects the fluctuations of the global green coffee market," a company spokesman said. The Maxwell and Green Mountain brands also are raising prices as their margins get squeezed.

Trust me, you're going to see many more such announcements come along: These are just the first of many trickle-down price increases for consumers, who can expect a flood of these events in the months to come as retailers pass on the increases to their customers.

For now, weather is the biggest catalyst. Three countries combine to provide about 65% of the world's coffee supply, according to International Coffee Organization. Those three countries, and their respective shares of the global market, consist of Brazil (38%), Vietnam (14.5%) and Colombia (12.3%).

Because the supply of coffee beans is so concentrated, weather plays a huge role in market prices. The weather in Brazil last year and Vietnam this year have played havoc with crops. And in Colombia, high levels of rainfall have caused a major outbreak of fungus.

There are concerns in Congress - specifically in the Senate, that coffee hoarding could break out at the exporter level. As noted, there are already concerns that Vietnam and/or Brazil will start to stockpile coffee, driving up prices even more. "Stockpiling by the two largest producer countries would have adverse economic consequences for importing countries, as well as for consumers around the world," U.S. Sen. Charles E. "Chuck" Schumer, D-NY, said.

Arabica is the world's most-widely grown coffee. Vietnam is the world's largest producer of robusta beans. "We've seen some international companies ask for more robusta than they used to," Bui Hung Manh, head of the business department at Tay Nguyen Coffee Investment, Import and Export Co., Buon Ma Thuot, Vietnam, told Bloomberg News. Tay Nguyen Coffee is Vietnam's single-biggest exporter.

Don't Forget Demand

Coffee demand has grown by 2.5% per year for the last decade. For context, demand has grown from 100 million bags in 2000, to 135 million bags today. Each bag consists of a 60-kilo sack of green, unroasted coffee beans.

This demand has continued during the recession, as people have switched from retail purchases, to home brews. So while the price of coffee has gone up, and retail stores are experiencing lower volumes, the overall demand for coffee has continued to rise as people drink more at home.

In 2002, when green-coffee-bean supplies were in surplus, a pound of coffee sold for 47 cents. Today that same coffee sells for close to $2 per pound. The price was around $1.03 per pound in December 2008 during the peak of the economic crisis.

Let's review how the price of coffee has managed to compound by 19.8% per year, every year for the last 8 years, without too much notice. The reality is that:

  • Demand has grown, regardless of economic conditions worldwide for the last decade.
  • Weather conditions for the last two years have impacted the major exporters.
  • About 65% of the world's supply comes from three nations.
  • And with demand high and supplies getting squeezed, exporters may be prompted to hoard supplies to further drive up prices.

Currently, the market has had a significant move up; technical charts show just the start of a pullback. While I am bullish on coffee in the intermediate and long terms, I believe there is a very real possibility that we'll see a pullback in the coming days or weeks.

Once that occurs, however, I would urge investors to take a really careful look at coffee as a top profit play, particularly given the demand, hoarding and weather-related catalysts - which are all bullish for coffee prices. The price of green coffee beans has a chance to break out to historic high prices in 2011.

While I am bullish on coffee in the intermediate and long terms, I believe there is a very real possibility that we'll see a pullback in the coming days or weeks. Once that occurs, however, I would urge investors to take a really careful look at coffee as a top profit play, particularly given the demand, hoarding and weather-related catalysts - all of which are bullish for coffee prices.

Here is how we can hedge our own personal exposure to the price of coffee, and make some profits at the same time. There are listed profit plays for coffee in both the European and U.S. markets.

If you live in the United States, you can purchase shares in the recently launched iPath Dow Jones-UBS Coffee Subindex Total Return Exchange Traded Note (NYSE: JO).

If you live in Europe, or you have trading exposure to the London stock market, you can buy an exchange-traded-fund equivalent, which gives you the ability to go "long" on coffee, "short" on coffee, or be 200% leveraged long on coffee.

These ETF-like vehicles also are based on the USB-DJ Coffee sub index. They are traded on the London stock exchange. They are, in order:

  • ETFS Coffee
  • ETFS Short Coffee
  • ETFS Leveraged Coffee

With this foundation of understanding now established, let's look at some specifics.

If you're a U.S. investor, wait for a pullback of between 5% and 10% in the next few weeks, and then buy an amount of the ETN equal to 3% to 5% of your portfolio. I would suggest using a 10% moving stop loss and look for a 30% gain in the next 12 months to 18 months. If you want to leverage this trade, look to purchase coffee futures. Specifically, the Dec. 11 coffee futures look interesting.

Once this move up has been fully digested by the market in 2011-2012, and the weather around the world has permitted growth of a bumper crop big enough to meet growing demand, I would consider switching out of the long side, and buying the short coffee ETN for a chance to "double down" on your profits.

Finally, in the near term, you can obviously hedge your own exposure to coffee by buying in bulk at your local Costco Warehouse Corp. (Nasdaq: COST) - type warehouse store. This will be the solution for my family, as my wife will not start her day without her pot of coffee.

Disclosure: None

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