The rise of the ETF industry has made commodity investing readily available to millions of investors whose options for exposure to this “fourth asset class” were previously limited. Most of the money in commodity exchange-traded products is in diversified funds offering exposure to more than a dozen natural resources through a single security (see a detailed breakdown of the sectors included in these products here). Among commodity-specific funds, those focusing on precious metals, agriculture, and oil and gas tend to be the most popular – GLD ($42.6 billion in assets), DBA ($2.4 billion), and UNG ($4.0 billion) are among the largest ETFs across all asset classes.
But the scope of commodity exchange-traded products go far beyond these “superstar” tickers. Coffee ETPs have become a popular option among certain investors looking to gain exposure to an often volatile commodity that has the ability to deliver big returns over short periods of time (for complete coverage of the ETF industry, sign up for our free ETF newsletter).
Most investors don’t view it as such, but coffee is a globally-traded commodity just like oil. Futures for Grade 3 washed arabicas trade on the NYMEX Exchange, with contract deliveries occurring each year in March, May, July, September, and December. A significant portion of coffee, however, is bought and sold in off-exchange transactions. Starbucks, for example, purchases all of its coffee through private, multi-year contracts.
Coffee is big business around the world, with ingestion in North America and Europe approximately one-third that of tap water. Worldwide, some 25 million small producers rely on coffee for a living, including significant portions of the population in certain South American and Asian countries.
Brazil has long been the world’s leading producer of coffee, but in recent years Vietnam has become an increasingly important player in the industry. Indonesia is the world’s third largest producer and the largest producer of washed arabica coffee. Finland is the world’s leading consumer of coffee, at an astounding 12 kg per year (by comparison, the U.S. comes in at 4.2 kg). Most of the world’s biggest coffee drinkers are located in Europe, with Norway, Iceland, Denmark, and the Netherlands rounding out the top five on the per capital consumption list.
Drivers of Price
Supply and demand for coffee beans are impacted by a number of different factors, resulting in a price for this commodity that has been known to show considerable volatility historically (see a good explanation of some of these price drivers here).
- Weather Conditions: Expectations for extreme weather conditions – such as a drought in Brazil or freezing in Vietnam – can send coffee futures soaring, as expectations for supply shortages translate into higher prices.
- Geopolitical Tensions: Because the major coffee-producing nations are emerging economies, the supply of java can be disrupted by the combustible political situations that often characterize these countries. Moreover, trade relations between countries can have a big impact on the cost of coffee. When the U.S. lifted a trade embargo against Vietnam in 1994, demand for beans from South American nations dropped, as did prices.
- Production Levels And Supplier Agreements: In the 1970s and 1980s, the International Coffee Agreement set a floor on prices at around $1.20 per pound. When this agreement collapsed, prices plummeted, falling as low as $0.42 per pound in 2001. While coordination between the world’s coffee producers is minimal (certainly not near the scale of OPEC), there are several organizations that seek to ensure stable prices and act on behalf of producers.
Transportation Expenses: Because of the considerable distance between major coffee producers (South America, Asia) and consumers (Europe and North America), prices can be influenced by costs of transporting coffee. When oil prices rise, the costs of getting coffee to consumers increases, generally sending prices upward.
Coffee ETF Options
Coffee is given a moderate allocation is several diversified commodity ETFs, but these funds generally have significantly larger allocations to energy and metals. The iPath Dow Jones-UBS Coffee Subindex Total Return ETN (NYSEARCA:JO) is the best “pure play” option for ETF investors looking to gain exposure to coffee prices. JO is a senior, unsubordinated, unsecured debt security that delivers returns available through an unleveraged investment in futures contracts as well as the rate of interest earned on cash collateral.
For investors considering a purchase of JO, there are two important details to note. First, JO is an exchange-traded note (NYSE:ETN), a debt instrument issued by a financial institution that exposes investors to some degree of credit risk (although the risk of default from Barclays, the issuing bank in this case, is minimal). Second, the index to which JO is linked utilizes a futures-based strategy to determine payouts. While the spot price of the underlying commodity (i.e., coffee) generally has a meaningful impact on the returns generated by such a strategy, it isn’t the only factor. Interest earned on collateral and the shape of the futures curve also play a part. The “roll yield” generated by a futures-based strategy can have a significant impact on prices (see our feature What’s Wrong With UNG? for a closer look at this phenomenon).
Since its inception in mid-2008, JO has been rather volatile, often rising or falling by 1% or more in a single trading session. While this inherent volatility would seemingly make this ideal for use by speculators and short-term traders, the implied turnover is rather low (only about 3% of the shares outstanding change hands in an average day). JO has shown low correlations with other major asset classes, and has a correlation of less than 0.50 with broad-based commodity funds.
Disclosure: No positions at time of writing.