Cocoa Hits Its Sweet Spot

With Valentine's Day still in our memory, cocoa's back in a big way, hitting the sweet spot with investors. Last week, cocoa prices hit 24-year highs, with few signs of slowdown apparent in the short term. Is this sugar high too good to be true?

Boning Up on Beans

Our love affair with cocoa stretches back thousands of years to when the Olmecs first cultivated cacao trees along the Mexican Gulf Coast. Mayan nobles chugged frothy pitchers of the stuff, laced with chili and spices, and the Aztecs even traded cocoa beans as currency. When the Spanish brought cocoa back with them to Europe, the obsession quickly spread - to Africa, the West Indies, Philippines and beyond.

Today, the cocoa industry tops $1.4 billion worldwide. Over 3.6 million metric tons of cocoa beans were harvested globally in 2004, and the International Cocoa Organization [ICCO] predicts yields for the 2007-08 year could be as high as 3.78 million metric tons.

Almost 70% of the world's cocoa comes from West Africa. By far, Côte d'Ivoire is the largest producer, harvesting 40% of the world's crop, followed by Ghana, Indonesia and Nigeria. (The Americas, where cocoa once reigned supreme, only represent 20% of global production.)

Three-quarters of all cocoa beans are collected between October and February (a secondary harvest, or "midcrop," takes place from May to August). But cocoa's a finicky crop. Cacao trees need consistently hot and humid climates - like the lower story of a rainforest - and are especially vulnerable to drought. They're also particularly susceptible to insects and fungal diseases; some experts estimate that each year, farmers worldwide lose as much as 30-40% of their crop just from disease and pests.

Despite thousands of years of cocoa industry, bean harvesting is still a labor-intensive task. Ripened pods, which look like pale green footballs, are knocked from cacao trees with a pole or knife. Using a machete, workers slice them open and scoop out the pulp and "beans," or seeds, and pile them in heaps. This goopy mixture is left alone for several days, during which the pulp ferments and "sweats" out, leaving the beans to be collected and dried in the sun.

From Cocoa Bean to Chocolate

It takes anywhere from 300 to 600 beans to produce just one kilogram (2.2 lbs) of chocolate - but unlike bean harvesting, cocoa processing is highly mechanized.

In a processing plant (usually located in the Netherlands or the U.S.), beans are washed, roasted and de-hulled. The resultant broken pieces - or "nibs" - are ground down into a creamy paste known as "chocolate liquor."

After that, chocolate liquor can take two routes. Using a hydraulic press, liquor can be expressed into cocoa powder and cocoa butter. Or it can be molded into chocolate by adding sugar, vanilla, emulsifiers and extra cocoa butter.

Supply, Demand And Chocoholism

Back in the 1970s, cocoa prices skyrocketed due to worldwide drought, hitting $4,000, even $5,000/ton. The high prices fueled increased production in countries like Malaysia and Indonesia, but as more cocoa plantations started up, prices fell through the 1980s. Despite a slight recovery midway through the 1990s, cocoa has yet to recapture its astronomical 1970s levels.

But these days, demand's on the rise. Some of that's from developing countries, like China and India, hungry for goods and commodities of all varieties.

However, mostly the increased demand is fueled by Westerners - especially Americans - entranced by dark chocolate's health benefits. Every day, scientists find yet another plus side to chocolate consumption, from antioxidants that lower blood pressure and cholesterol levels, to lowered incidence rates of cancer and heart disease. Doctors say we should eat more chocolate? You don't have to tell us twice.

At the same time, the supply side of cocoa has been tightening. Although the civil war in Côte d'Ivoire (which spanned from 2002 to 2007) has ceased, the country's cocoa industry still runs well below peak capacity. In addition, strikes by West African cocoa exporters in late 2007 bottlenecked bean shipments; work stoppages at Côte d'Ivoire's Coffee and Cocoa Bourse left 380,000 tons of raw beans sitting in the port cities of Abidjan and San Pedro in January. That's not even accounting for the dry weather and pod fungus decimating crop yields throughout West Africa.

Sounds like a sweet time to get into the cocoa game.

Cuckoo for Cocoa

Investors looking to get into cocoa have several options. You could, of course, funnel your money into confectionary stocks:

Company	Total Sales in 2005 (in US$ millions)
Mars, Inc.	9,546
Cadbury Schweppes PLC (CSW)	8,126
Nestlé SA	7,973
Ferrero SpA	5,580
Hershey Foods Corp. (HSY)	4,881
Kraft Foods Inc. (KFT)	2,250
Meiji Seika Kaisha Ltd.	1,693
Lindt & Sprüngli	1,673
Barry Callebaut AG	1,427
Ezaki Glico Co.	1,239

Table 1: Top Ten Confectionaries Worldwide, ranked by 2005 sales

Source: Candy Industry, January 2006-via ICCO

But these companies aren't direct access points to the cocoa market, and they hedge their purchases to counter cocoa's natural volatility. In fact, high cocoa prices have mostly been bad news for chocolate makers, who must contend with climbing dairy prices, too.

Another option: commodity-specific ETFs, which sometimes feature cocoa among their listings. Then again, cocoa's usually not very prominent in the weighting.

A chocoholic's best plan, then, is cocoa futures and options, which conveniently enough, can also offset the risk of falling prices - in a market as volatile as this one, that's a good idea.

Cocoa futures are traded on two world exchanges: the London International Financial Futures Exchange (LIFFE) and the New York Board of Trade (NYBOT), now a subsidiary of the IntercontinentalExchange (ICE). On both, futures are traded electronically. In fact, the ICE switches entirely to electronic trading in March, which has led to higher volumes across all commodities, including cocoa.

Cocoa futures are traded in dollars per metric ton, with one contract worth 10 metric tons. Months for contracts delivery are March, May, July, September and December.

Easy enough - but what does tomorrow hold for cocoa futures?

Current Conditions: Rainy But Sweet

Simple: Cocoa futures are looking pretty good these days. "Cocoa has benefited from a strong bullish stance in commodities," Dan Vaught, futures analyst at A.G. Edwards, told MarketWatch Wednesday. "We've seen quite a bit of speculative buying."

Plus, according to analysts polled by Reuters in January, cocoa prices will keep going up in 2008. "There will be strong demand for cocoa and chocolate," Judy Ganes of J. Ganes Consulting told Reuters (via FlexNews). "There will be a continued struggle to have good quality crops with production highly concentrated between a few suppliers," like Côte d'Ivoire, Ghana and Indonesia.

Lately, cocoa's been in a three-week rally, pushing prices to their highest point in 24 years. Last Tuesday, ICE's May futures rose $45 to hit $2,463/ton, after skimming $2,499/ton - its highest level since 1984. London cocoa's doing well, too: LIFFE's May futures rose £13 to £1,284/ton - a 4½-year high.

At the same time, those highs may be dampened by increased rainfall in Côte d'Ivoire. After two months of drought, which had traders suspecting the West African midcrop might do poorly, rain has returned, soaking the southwest Soubré region, where 25% of the country's cocoa plantations lie.

"This rain received last week is the start of a pattern," with precipitation levels "that are actually quite good," Michael Ferrari, vice president of Weather Trends International, Inc., in Pennsylvania told Bloomberg on Wednesday. "There should continue to be a downward pressure placed on cocoa from the weather outlook."

What's more, despite pod rot, insect infestations and dry weather, the Ghana main-season cocoa crop is still predicted to hit target expectations. (Ghana's the second-largest producer, after Côte d'Ivoire.)

Cocoa Controversy

The cocoa market's not without its controversies. Although 40-50 million people worldwide depend on cocoa for their livelihood, many farmers still receive low compensation for their beans, even though prices are quickly rising. Plus, cocoa plantations - especially in West Africa - have sometimes relied on child labor to lower profit margins. A growing Fair Trade movement is aiming to pay farmers more for production, but so far, it represents just a tiny fraction of the market.

A Sweet Trade

Investing in cocoa isn't for the faint of heart. The market is subject to violent mood swings, and prices vary wildly by season. Plus, getting information on world cocoa production statistics is like pulling teeth - even producers have trouble getting access to much more than basic weather reports.

But if you're patient and meticulous, you can ride the cocoa rally to great heights. Which, by my estimation, is a pretty sweet deal.