Rayden's  Instablog

In the past two weeks, the Brazilian government sold at auction to farmers put options for 3 million bags of coffee (roughly 10000 NYBOT coffee "C" contracts) with a strike of $1.18/lb, and it is expected to sell another 3 million in upcoming auctions.  This is fully 20% of this year's projected Brazilian arabica coffee crop.  All puts offered were sold; the bidding was very heavy in the first auction and somewhat lighter in the second.  Based on previous experience with similar interventions (last seen in 2002), the government will not keep this coffee off the market, if the puts are exercised against them they will simply turn around and sell into the cash market, so this does not affect supply directly.

While at first this may appear bullish ("putting a floor under the market"), this development is actually intensely bearish.  Remember, the government is not trying to make money here, they are deliberately giving money away.  So instead of being a mildly bullish trade, this implies the government is concerned that coffee can/will go a lot lower, and that they feel farmers are under sufficient pressure to require an intervention.  What do the farmers know that we don't that makes them jump at the chance to lock in that price, even at the cost of paying substantial cash up front?  Why does the government feel the need to do this now, and why do they call it a "coffee crisis"?

The answer is simple: the cash price for current crop coffee in Brazil has imploded, from $1.35/lb earlier this year to recent prices as low as $0.95/lb.  While Brazilian arabica coffee is not deliverable on NYBOT, it is often interchangeable with that grade as far as end users are concerned.  Typical differentials are stable at around 10 cents.  Thus, the implied NYBOT coffee "C" cash price based on current Brazilian cash prices is around $1.05.  Ouch.  The main drivers behind this are (a) the largest off-year crop ever at 39 million bags, and (b) no buyers!  There are lots of players (commodity funds, etc) who want to buy coffee futures, but really not many people who want physical coffee at the moment.  That is not a sustainable situation, and it will be resolved with the futures price converging towards the cash price.

Bear in mind also that world stocks are relatively quite high, and that next year's Brazilian crop is likely to be a mega record-breaker at over 50 million bags, possibly as high as 60 million with good weather, as the trend of increased production accelerates.  Brazilian coffee alternates high and low yield years, and on top of that there is a lot of trees planted years ago which are now maturing so there is a trend to larger crops, corresponding to an increase of around 4 million bags per year.  The sequence of crops in millions of bags from 2003 to 2008 has been 28, 39, 32, 42, 36, 46, with the current year predicted at 39 and next at 50+.  As everyone is anticipating this, players in the market will be drawing down stocks substantially this year.

In addition, there are a few other, somewhat harder to quantify trends that are bearish for coffee.  First, the trend for people to drink instant coffee or drink at home instead of at Starbucks, and increased price sensitivity, will lead to roasters using more of the cheap robusta and less of the expensive arabica in blends, thus narrowing the arabica premium.  Second, according to NCA-USA data, there has been a sharp drop in the number of regular coffee drinkers in the 18-24 age group last year (other age groups are relatively flat).  This suggests coffee is no longer "cool".  Per capita consumption in the USA and Europe is down slightly in the last few years, confirming this.  Third and last, there is a rough correlation between business activity and coffee consumption, given coffee's status as the "office drug" of choice.  Therefore, if you do not entirely believe the "green shoots" theory, you might also expect US demand for coffee to drop noticeably, by up to 10% or so (similar to what happened after the dot-com bust).  While these trends and observations are admittedly imprecise, they nonetheless point to demand which is at best flat, versus a continuing explosive increase in supply.

In light of all this, the crash in coffee from the May highs of over $1.40 to this month's lows of $1.12 was no surprise, and neither is the overall downtrend since last year's $1.66 high.  The current move up off the lows is simply short covering of speculative positions (possibly triggered by the slight drop in the dollar) and it is close to done, offering a good entry point to short coffee again if you didn't catch it at the previous high.

The NYBOT coffee "C" target is $0.85/lb or lower by the end of the year.  Short coffee now.

Disclosure: short coffee.