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By Tony D'Altorio

Coffee companies like J. M. Smucker (SJM), Kraft Foods (KFT) and Nestle ADR (OTCPK:NSRGY) used to talk prices with retailers once a year.

But not anymore.

As coffee joins other commodities with prices spiraling upwards, those annual discussions have turned into monthly meetings. They had to, considering price movement in high-quality Arabica coffee beans.

In New York, the benchmark May futures contract hit $2.784 a pound, their highest level since $3.40 in 1977, an all-time record. During the past 12 months alone, those prices rose by 145%. That has led to a string of retail price increases that has yet to dent consumption growth. Smuckers, the company behind the trendsetting Folgers coffee brand, raised retail prices three times during the past year; last week, it said it might have to do so again, due to the rising cost of coffee beans.

Java lovers had best get used to hearing similar stories, because these prices aren’t going anywhere (but up).

It’s Not Just Frost Causing Coffee Prices to Percolate This Time Around

The previous four big rallies in the coffee market – 1975-77, 1985-86, 1994 and 1997 – were triggered solely by frost, which hit Brazil’s key coffee-growing belt. But no such luck this time.

Numerous nations are struggling to sustain their coffee crops while demand keeps rising. As a result, inventories have fallen to their lowest levels since the International Coffee Organization (ICO) started tracking this data in the 1960s.

Jose Sette, executive director of the ICO, doesn’t see conditions improving anytime soon. “The fundamental situation,” he says, “is expected to remain unchanged – the tightness will continue at least until the end of this year.”

Over the past three years, Colombia largely drove the rally. It suffered from a string of bad crops, partly due to heavy rains and partly due to its program to replant coffee trees. Two years ago, its output plunged to a 33-year low of only 7.8 million 60-kilogram bags -- down by nearly a third from 11.1 million bags in 2008.

Output did recover to 9 million bags last year. And the market extrapolated that, betting on Colombian supplies rising by a million this year.

But as the crop advances, most traders are scaling back their forecast to about 8.5 million bags. Some even worry production could fall back to the poor levels of 2009.

Meanwhile, Mexico is suffering a bad crop as well, due to low temperatures. And Brazil, the world’s top coffee exporter, could also have a small harvest of low quality beans.

Traditionally, Arabica coffee futures in New York trade above the local market coffee price in Sao Paulo. But domestic Brazilian prices have beat them out for the first time since the 1990s … a definite sign that the country’s crop is not nearly as large as projected.

The Best Way to Play Java Price Increases

All of this strongly points to java prices heading higher. Most industry insiders say Arabica bean coffee prices are headed to at least $3 a pound.

But if, for some reason, prices drop over the short-term, it will present an excellent opportunity for watchful investors.

Any price drop opens opportunities to buy an exchange-traded note designed to track the coffee future prices: iPath Dow Jones-UBS Coffee Subindex Total Return (JO). Having inventory at its lowest levels in a half-century is reason enough to buy this ETN. But Mother Nature adds even more reason to do so.

Brazil’s coffee bean output will drop next year due to the biennial cycle of Arabica coffee bean production. This means that an “off” year follows an “on” year … and this was supposed to be the latter.

In other words, next year should further tighten the global coffee market, leading to gains for JO investors.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online -- or 72 hours after a direct mail publication is sent -- before acting on that recommendation.

Source: Coffee Prices Hit a 34-Year High