The price of cocoa reached all-time highs of $3,826 per ton in March 2011, but like many other commodities, the price fell dramatically from that peak. Unlike many other raw material markets, cocoa fell quickly and furiously, and by December 2011, the price halved and was at $1,898. While other commodities continued to decline from 2012-2015 and into early 2016, cocoa made higher highs as increasing demand from Asia provided support for the agricultural commodity.
It turns out that China developed a taste for chocolate confectionery products and each time selling hit the market, Asian buying stemmed the drop. Cocoa made a series of higher highs and higher lows from 2013 until December 2015.
Over 60% of the world's annual cocoa crop comes from the West African nations of the Ivory Coast and Ghana. Cocoa beans only grow in tropical, equatorial climates. Therefore, each year the price is susceptible to massive volatility as the production comes from nations that are not the most stable in the world. However, demand rather than supply issues fostered the bull market in the beans that are the critical ingredient in delicious chocolate that has addicted people all over the world. A new addressable market with almost 1.4 billion consumers was enough to fuel the cocoa bull while other commodities fell, but over recent months when the sector seems to have found a bottom, cocoa has faltered.
Cocoa's bull market falters
On Tuesday, October 11, 2016, cocoa fell to the lowest price since November 2013 when it traded to lows of $2,625 per ton. Click to enlargeAs the monthly chart of ICE cocoa futures highlights, the commodity traded at a significant level on Tuesday and the momentum of its price trend has turned lower after not holding support at $2,669 per ton. Click to enlargeThe daily chart of cocoa futures shows that the beans have been making lower highs and lower lows since May 3 when the commodity was at $3,216 per ton. Cocoa has dropped around 18.4% from those highs and open interest, or the number of open long and short positions on ICE cocoa futures has increased during the price swoon. Rising open interest during a period of falling prices tends to provide technical support for a trend, in this case, a bearish trend. The reason for the plight of cocoa may have little to do with the commodity, but everything to do with the move in currencies.
The pound weighs on the price of chocolate
The U.K. shocked markets in late June when the citizens of the nation voted to exit the European Union. In the wake of the referendum surprise, the value of the British currency, the pound, plunged. Click to enlargeAs the daily chart of the pound versus the dollar highlights, when it initially looked like Britain would remain in the EU during the hours leading up to the vote, the pound rallied to $1.50 versus the greenback. However, after the results of the referendum and since, the British currency dropped to the $1.21 level as of Tuesday, a decline of over 19%. Meanwhile, the price of cocoa has moved into a bearish trend, but when it comes to the price of the beans in pound terms, the trend of higher lows and higher highs since the December 2011 lows remains intact. Click to enlargeThe weekly chart of cocoa in pounds illustrates that the bull market in cocoa continues, and the price has done nothing to negate the pattern of higher lows and higher highs. In dollars, cocoa is a dog these days, but in pounds, it is still a strong bull.
While currency volatility is a significant factor for all commodity prices, in the case of cocoa, the pound holds special significance.
A London-based market
Commodity prices are like a pyramid in many senses. We all watch the futures prices on a daily basis, but futures are a derivative of what occurs in the world of physical cocoa trading as the futures attempt to replicate buying and selling for the raw beans.
London has been the international hub for cocoa trading for decades. The Ivory Coast and Ghana are geographically close to the European hub of international cocoa trading, which is located in London. Moreover, the world's largest cocoa trader lives and works in the British capital.
Anthony Ward operates a fund, Armajaro, which is his vehicle for trading cocoa and other soft commodities. To say that Ward has an influence over world cocoa prices would be an understatement. He is the largest physical cocoa trader in the world and at times takes strategic positions in the beans that represent a huge percentage of annual production. Moreover, Ward has investments in West African production. Ward's office is in the heart of London. I had the pleasure of working with Mr. Ward at Phibro in the 1990s and his tentacles in the global cocoa market have resulted in his nickname, Choco-finger. Charles W. Engelhard who controlled the international mining and metals conglomerate in his name was the inspiration for Auric Goldfinger, the notorious character from Ian Fleming's James Bond. Engelhard was a friend of the author. In the cocoa market, Tony Ward's influence has appropriately earned him his reputation and nickname.
The chances are that Anthony Ward prepared for the potential of Brexit by hedging exposures in the international cocoa market. It is also possible that he has been responsible for selling cocoa in dollar terms over recent months. Whatever the case, Ward has his finger on the pulse of the cocoa market and the fact that it is a London-based market has caused the dollar price of cocoa to defy all other pressures from the demand side, and that is likely to continue in the months to come.
The time for buying dips has come to an end
Since the end of 2011, each and every dip in the cocoa futures market had been a buying opportunity. Cocoa had never made a lower low during the period from December 2011 until this week. However, with the break of the February 2015 lows on Tuesday, all bets may be off for long positions in cocoa for a while as the price action has broken the technical back of the market in dollar-based cocoa.
I had been a scale-down buyer of cocoa futures on each price correction over the past three years, and the trading results were positive. However, now I will stand aside as trading cocoa amounts to trading the British currency. With a new prime minister facing the effects of Brexit and the divorce negotiations with the E.U. that are likely to take years, the pound looks set to continue its slide. The pound is trading at the lowest level since 1985, and it could be heading for a nice round number, parity against the U.S. dollar. If that happens, cocoa will skyrocket in pound terms and tank in dollars.
Demand continues to provide some supply - the only hope is a supply issue
The Asian demand that caused a bull market in cocoa from 2011 through 2016 will continue to underpin the price and provide support. Chinese consumption of chocolate confectionery products continues to rise, and the addictive nature of the delicacy is likely to accelerate that trend in the years to come. However, at this point, the only thing that could cause the dollar price of cocoa to rise dramatically and move back into a bullish trend given the action in the pound would be a supply shock to the market. With the lion's share of cocoa beans coming from two West African nations and Nigerian supplies falling this year, a supply deficit is certainly not out of the question. However, the future price direction of dollar-based cocoa may depend on supply problems at this time to stem the inevitable bearish trend created by Brexit.
Cocoa has moved from a futures market where buying dips to initiate trades and selling on rallies was optimal to just the opposite. As the daily chart highlights, anyone who sold rallies to start a short position since early May has profited as the market has done nothing but make lower highs and lower lows since. My bet is that Anthony Ward has been a seller of cocoa futures rallies in dollar terms over recent months and when the time is right, he will once again buy the lion's share of annual production and squeeze the market higher in pound and dollar terms. However, that time will probably not come until the pound can find a low and at the very least consolidate at a new level. For now, I will be scale-up selling rallies in dollar cocoa using levels slightly above recent highs at $2,934 on the December futures contract as a buy stop.
Cocoa has been getting pounded by the British currency, which is likely to continue to be a giant weight around the neck of the commodity.
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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.