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By Tony Daltorio

The average coffee drinker probably doesn’t realize what a huge global business coffee is. As one of the so-called breakfast commodities (along with orange juice, sugar and cocoa), coffee is the world’s most widely-traded tropical agricultural commodity. It is also the world’s second-highest traded commodity, trailing only crude oil.

Worldwide, more than 26 million small coffee producers in more than 52 coffee producing countries rely on the beans as their principal means of earning a living. In North America and Europe, people consume a third as much coffee as they do water. In the United States alone, Americans consume 400 million cups of coffee per day, making it the world’s biggest consumer of the beverage.

Coffee Basics

In the past 12 years, global consumption has increased at an average of 2.5% annually. In 2011, there were nearly 131 million bags of coffee exported, weighing over 132 pounds each. However, demand outpaced supply with consumption of coffee at nearly 138 million bags.

Investors looking to make savvy trades must pay very close attention to what is going on (such as weather and politics) in the two largest producers of coffee in the world – Brazil and Vietnam. For instance, a major frost during the growing season in Brazil can send prices skyward. The four biggest upward spikes in coffee prices – 1975-1977, 1985-1986, 1994 and 1997 – were all due to such an event.

Geopolitics and economics can also come into play. In early 2012, farmers in Vietnam decided to hold back their crop due to low prices, which in turn, sent robusta prices higher. Or, as also happened in 2012, a fall in the Brazilian currency (the real) forced Brazilian farmers to dump their product on the market, forcing down arabica prices.

The factors that affect the price of coffee fall into four general categories: weather conditions, geopolitical conditions (particularly in Brazil and Vietnam), transportation costs, and consumer discretionary income. Higher oil prices, for example, can lead directly to higher shipping costs, putting upward pressure on coffee prices.

Consumer discretionary incomes are also another major factor, since coffee drinking is not a necessity (at least to most). The financial and debt crisis in Europe, for example, may adversely affect coffee consumption in those regions, as individuals will be more concerned with saving money than spending it on a cup of Joe. However, rising discretionary incomes in the emerging countries offer the potential for rising coffee demand overall. Take Brazil, for example; coffee consumption there is rising quite rapidly. Forecasts are for demand to exceed 21 million bags annually, up 50% in the past decade. The arrival of the coffee culture in Asian countries such as China (with 20% coffee demand growth in 2011) is another demand driver [see also How to Trade Coffee Futures].

Coffee 101

There are several ways to invest in this commodity, including futures contracts on coffee beans and exchange-traded notes designed to track the performance of futures contracts.

Coffee drinkers today have a vast array of flavors to choose from. But there are only two types of coffee beans traded on global financial markets. The first type of coffee bean is the robusta, which is considered to be of lower quality and usually ends up as instant coffee. Most of this variety of coffee is grown in Southeast Asian countries such as Vietnam and Indonesia and parts of Africa. It is a hardier bean, and can be grown at altitudes up to 2,000 feet [see also Four Little Known Factors Driving the Price of Coffee].

The futures contracts for robusta coffee beans are traded on either the London International Financial Futures and Options Exchange (LIFFE) or through the Euronext Exchange (symbol RC). The contract size for robusta is 10 tons and the minimum price movement is $1 per ton or $10. The delivery months for the contracts are January, March, May, July, September and November such that ten delivery months are available for trading. The trading hours are 9:00 a.m.to 5:30 p.m. London time, and the last trading day is the last business day of the delivery month at 12:30 p.m. London time.

The second type of coffee bean is the arabica, which makes up over 60% of global coffee production. This bean produces the better tasting coffees, such as espressos, that can be found at coffee shops. It is grown in high elevations, usually above 3,000 feet, where the coffee develops more slowly and is subject to frosts. It is mainly grown in tropical countries such as Brazil and Columbia.

Investors can find the futures contracts (symbol KT) on arabica coffee beans traded on either the New York Mercantile Exchange (NYMEX) or the IntercontinentalExchange (NYSE:ICE). The contract size for arabica is 37,500 pounds and the minimum price movement is $0.05 per pound or $18.75 per contract. The delivery months for the contract are March, May, July, September and December. The main trading hours in New York are 3:30 a.m. to 2:00 p.m., and the last trading day is eight business days prior to the last business day of the delivery month.

Coffee ETNs

Investors can also participate in the up and downs of the global coffee market through the use of two exchange traded notes (ETNs) from iPath. The first pure play choice is the iPath Dow Jones-UBS Coffee Subindex Total Return ETN (NYSEARCA:JO) and is designed to track the movement of coffee futures. However, there are other risk factors; ETNs expose the investor to credit risk from the issuer of the note, in this case Barclays Bank. Another possible risk factor is the shape of the coffee futures curve.

A second similar ETN from iPath is the Pure Beta Coffee ETN (NYSEARCA:CAFE). The only difference here is that there is no pre-set rollover schedule for the futures contracts. The fund manager may roll over into one of a number of futures contracts with varying expiration dates, as selected using a methodology designed by Barclays [see also The Best (and Worst) Commodity Investments of H1 2012].

Both of these ETNs are traded on the NYSE Arca, making it very easy for the average investor to access exposure to one of the world’s most interesting commodity markets.

Original Post

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: The 5 Minute Guide To Coffee ETFs