Are Coffee Prices About To Perk Up?

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Includes: CAFE, JO
by: Daryl Montgomery

Summary

Coffee prices peaked in 2011, along with other commodities.

Except for a rally in 2014, they have been selling off since then.

There is a serious drought in Brazil, the largest producer, and a danger of frost this year.

The frost in Brazil in 1975 caused coffee prices to skyrocket more than sixfold.

Unlike metals and energy, weather can be the predominant determinant of prices and investing profits for agricultural commodities (disease and insects are the other major factors that can affect market behavior). Even then, this is not the situation across the board. One country or region must grow a disproportionate amount of the food or fiber, and that area must be prone to damaging weather patterns. Welcome to the coffee market and Brazil.

Coffee is a finicky plant that can only grow in the mountainous regions of countries with tropical or semi-tropical climates. Too much heat, and it doesn't do well. Too much cold, and the plants die. Plant death is a far more serious problem for coffee than other agricultural commodities, since coffee grows on bushes (sometimes referred to as small trees) that take around five years before they can begin producing a crop. Optimal production takes place in plants aged between seven and twenty years, although a coffee bush can live as long as one hundred years. Coffee plants also have an odd pattern of producing larger amounts of beans on alternate years and smaller amounts in the years in between.

Brazil has been the largest coffee producer for at least 150 years and can account for as much as 30% of global production these days. Vietnam, Colombia, and Indonesia are the next largest producers, but none of them come close to Brazil in output. Brazil's dominance in the market means that something that seriously impacts the coffee crop in Brazil also seriously impacts the global coffee market as a whole and can send prices skyrocketing.

Coffee, like most commodities last peaked in 2011. A confluence of events including insect and plant disease issues, along with weather problems in a number of countries restricted supply. At the same time, global demand was rising substantially because middle class Chinese and Indians were taking up coffee drinking. Increased supply then dramatically brought down the price until the end of 2013. A price spike followed afterwards because Brazil began experiencing its worst drought in 80 years - and that drought was centered in the coffee growing region in the southeast of the country. Since then, prices have come back down and gone to lower lows.

Coffee Prices (NYSEARCA:JO) 10 Years Monthly

The drought is still not over even though there were heavy rains leading to flooding in some places in the most of Brazil's coffee growing region this February. This bodes well for a better crop than in the previous two years once harvesting is over this May. Even before the recent rains, estimates in January for the final crop production were highly optimistic despite all the drought-induced stress to the plants. The Brazilian Conab agricultural bureau estimated that harvest would come in between 49.1-51.9 million bags, which could be better than the record 50.8 million bag harvest in 2012 (a bag is 60 kilograms).

Continued drought for another year would certainly take its toll on future coffee production. Heavy rains are also risky and can lead to mold infestations. There is, however, a far bigger risk, - frost. Most other country's coffee growing areas are not subject to frosts because they are too close to the equator and not at high enough an elevation. Brazil's coffee growing regions are an exception, being close to the Tropic of Capricorn. They have killer frosts that can destroy the plants and wipe out all production for five years (even borderline frosts that don't kill the plants can lower production for years). These frosts tend to come in approximately twenty year cycles, with the previous ones in the 1994 (with a secondary incident in 1999), 1975 (with a secondary incident in 1981), and the triple frosts of 1953/55/57. The next severe frost is due…soon.

The frost in July 1975 was particularly devastating. Prior to it, coffee was selling for as little as 50 cents per pound. By April 1977, the price had reached $3.25 per pound or more than six times as much. There Internet wasn't available back then and information about the damage to the coffee crop traveled slowly. It should be assumed that price would adjust much faster now-a-days.

Some think that the coffee crop in Brazil may not be as susceptible to frost today as it was in the past. Production has moved further north into warmer areas (which are more prone to drought) and the weather itself might have gotten warmer. This might be too optimistic a view, though, since in July 2013, there was a serious frost in the southern state of Paraná that caused significant damage to agricultural crops. This covered a much smaller area than the killer coffee frosts, but many of these smaller frosts are not uncommon.

Below is a 45-year chart showing the volatility of coffee prices over time:

Coffee, like other agricultural commodities, isn't mostly influenced by inflationary forces. Weather, plant disease and insects are more important in determining its price in the short term, and that price can be highly volatile. In the long term, its price of course moves with broad trends in supply and demand, but the real money is made based on the short-term moves. Currently, the price in on the low side, and it could go even lower, if production manages to continue to increase. However,If you hear about a cold front moving toward southern Brazil this July, you just might want to consider buying a coffee ETN such as JO.

Disclosure: I/we 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.