Chocolate Lovers Keep Nervous Watch on Volatile Cocoa Prices

| About: iPath Dow (NIB)

World cocoa prices have been on a long upward trend, with a lot of volatility along the way. Prices have fallen a bit in the last few months, but chocolate lovers are watching nervously. What is going on? Will chocolate soon become a luxury good?

One of the factors driving chocolate prices has been strong income elasticity of demand.

In the United States, a 10% increase in income has been estimated to increase per capita chocolate consumption by 9.2%. Income elasticity is a little less or a little more in other countries, but everywhere chocolate is a normal good. Global income growth thus explains much of the long-term price trend.

As for volatility within the trend, supply conditions play the bigger role. Cocoa supply, like that of any farm product, is subject to fast-developing changes in growing conditions. For example, earlier this year market-watchers were worried about a virus called stunted shoot disease that threatened the crop in the Ivory Coast, the world's biggest producer. Later the virus threat proved to be overstated. Good weather, especially in neighboring Ghana, the second biggest producer, boosted supply and prices fell.

Volatility of prices is increased by the fact that chocolate demand is very inelastic. In the US, short-term elasticity of demand has been estimated at about -0.2, and is even lower in some big European consumer countries. When demand is inelastic, even a small shift in the supply curve can produce a big change in the market price.

An interesting episode earlier this year illustrates how volatile cocoa prices can be. In July, Armajaro, a London-based commodity trader and hedge fund, took an exceptionally large physical delivery of cocoa when July futures contracts expired. The price spiked in response to fears of an attempted squeeze on the market, and competitors cried foul. Armajaro vigorously denied any wrongdoing. It insisted that it was not trying to hold the delivered cocoa off the market, but needed it only to meet contractual commitments of its own. If Armajaro really had been holding the cocoa off the market, it would have lost big, since prices have fallen sharply since July.

The bottom line? You may have to get ready to pay more for your chocolate--or you may not. But look at the bright side--if the thought of rising chocolate prices depresses you, just remember that chocolate itself is a reliable cure for depression!

Click here to view or download a free set of slides that uses the concepts of supply, demand, and elasticity to tell the story of chocolate prices.