Why Cocoa Futures Are In For A Real Bull Market

Includes: NIB
by: Burt Rothberg

Cocoa futures have moved up by 12% in the last two weeks, and are challenging the top of the range they have been in since last December.

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Cocoa is not a heavily followed commodity, and most people who follow it are technicians. I do follow the fundamentals, and I believe that this may be the start of a true bull market. Here's why:

About 60% of the world's cocoa is grown in the west African cocoa belt of Ghana and the Ivory Coast. About another 15% is grown in nearby African countries. So the growing conditions in this area are key to the market.

The most important weather feature in this area is called the InterTropical Convergence Zone (ITCZ). This is where the weather from the northern and southern hemispheres come together. As the earth swings from US winter to summer, this moves north toward the tropic of cancer. As this ITCZ moves over land, it creates unsettled weather and rainfall, just like the fronts on the 11pm news. This causes the rainy season(s) and is vital to the cocoa crop.

Although things generally follow this pattern, there are variations from year to year. This year the ITCZ moved north early and stayed about two degrees north of its usual position for much of the season ...

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What this has meant is that the spring rains came and went early, and the key areas have been in a moisture deficit for the last 1 - 2 months. This is not immediately disastrous for the crop, since the spring rains were adequate. However, the rains will normally return in September. If these are delayed (the ITCZ does not move south on a normal time frame), there will be a serious problem. At that point the crop will have been without substantial rain for at least three months. The cocoa trees will try to hoard their carbohydrate supplies for survival and will not use them to flower or grow new pods.

All this is in the future of course, and I do not believe that much real damage has been done yet. However, if the scenario occurs, there is reason to believe that the upmove could be quite substantial. This is due to the technical position of the market. (Note: by "technical" I mean the positions of buyers and sellers, not moving average type stuff.) Cocoa is one of the few markets in which speculators have not recently taken a significant long position. In fact, the CFTC commitments of traders showed them net short until recently.

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What this means is that managed money (mostly CTA trend followers) are only about 12,000 lots long. This means that the chocolate manufactures and trade have not been able to extend their coverage much beyond the normal forward-selling of the producing nations. These participants follow the crop's progress very closely. If it looks like there will be a problem, they will be forced into buying along alongside the trend-followers. This could lead to an price explosion. Moreover, the possibility of this scenario will keep prices supported until September. It seems unlikely that the major consuming and trade players will want to raid the downside without a large speculative long position to dislodge.

I am playing this by being long Dec 2012 call options. I doubt that implied volatility will come down much before Sep., and time decay will be small. Should I get the scenario I describe above, this could be a home run. If you do not have a commodity account, note that there is an ETF, symbol NIB, that tracks cocoa prices. It's liquidity is OK for retail traders, but probably not for funds.

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