The price of cocoa continued to slide over recent sessions when the primary ingredient in chocolate reached $2322 per ton on Tuesday, December 6. Cocoa traded to the lowest price since August 2013.
While most other commodity prices made lower highs and lower lows from 2011 through 2015, cocoa did just the opposite. Increasing demand for chocolate confectionery products from China caused the price of the agricultural commodity to move higher, defying the price action in most other raw material markets and even rallying in the face of a rising dollar.
Cocoa's move was reflective of an important fundamental factor that underpins all agricultural commodities. Population in the world continues to grow at an exponential rate and that means each day there are more mouths to feed. With the popularity of chocolate rising in China and across Asia, it has brought an entirely new addressable market for cocoa demand.
A growing chocolate addiction in China was enough to cause cocoa beans to ignore the price action in many other commodity markets and move higher over recent years. However, in 2016, the bull market came to an end and the price of cocoa is now over $800 per ton, or 27% lower on the ICE March futures contract than it was during the week of May 3, just seven months ago.
The bull market ends
The bull market that started in December 2011 at lows of $1898 per ton and reached a high of $3422 in December 2015 seems to have come to an end.
As the monthly chart illustrates, the trend shifted to bear mode in early 2016 and the price has followed through to the downside. Additionally, as the price fell, both open interest and volume increased which provides technical validation for the move lower.
Cocoa initially fell to $2731 in January but it recovered back to $3237 in June. Then the Brexit vote hit the cocoa market like a ton of bearish bricks.
Now cocoa is not responding to the recovering pound
The hub of international cocoa trading is in London. London is the business center located closest to the world's largest West African producers. London is also the home of an active cocoa futures contract that trades on ICE in pounds sterling. Moreover, the world's most influential cocoa trader, Anthony Ward who runs Amajaro, a hedge fund and physical cocoa trader with infrastructure and production investments in Africa, is based in London.
Many physical cocoa traders use pounds as the pricing mechanism for the commodity. The Brexit vote in late June caused the pound to drop from $1.50 to $1.25 against the dollar. The lower pound made the price of cocoa rally in pound terms and the price in dollars fell like a stone.
In June, cocoa traded to a high of $3237 per ton and the commodity declined precipitously since. As of last Tuesday, cocoa futures were trading just above the $2300 per ton level. The pound likely contributed to the fall of the price of the commodity but it is the increasing output that has caused selling to continue.
The fundamentals look worse as West African output will climb
The Ivory Coast and Ghana are the world's largest cocoa producing nations; together they supply the world with over 60% of annual output. 2016 was a difficult year for production but signs are that the cocoa crop in 2017 will increase in the two West African nations.
While there have been some reports of black pod disease in the Ivory Coast, farmers are optimistic that output will recover as weather conditions have been favorable. Additionally, cocoa output in Peru and Indonesia are both rising. The bottom line is that cocoa producers around the world expect a bountiful 2017 crop of the beans that are the primary ingredient in chocolate confectionery products.
Cocoa approaches support at $2046
The monthly chart indicates that support for cocoa futures now is at the $2046 per ton level, which was the March 2013 low. Meanwhile, the daily chart of the commodity continues to look bearish.
The daily chart of ICE cocoa futures continues to make lower highs and lower lows and the trend is clearly lower. With cocoa sitting at the lowest level in three years, the prospects continue to look bleak.
While the pound has recovered from $1.20 to $1.27 against the dollar, Brexit has not yet taken shape and the chances are that the ultimate negotiations with the European Union could put more pressure on the pound. A combination of a weak pound and an abundant cocoa harvest in 2017 is likely to cause a test of critical support. Below the $2046 level, things could get even uglier.
Is cocoa going below $2000?
Cocoa traded to a low of $1898 in December 2011 when the price fell from all-time highs of $3826 in March of that same year. Cocoa fell by over 50% over a nine-month period.
As the quarterly chart shows, cocoa has traded in a range from the 2011 all-time highs of over $3800 per ton to lows of $674 in 2000. While a breach of the $2046 support could cause cocoa to fall below $2000, it is likely that the price will find support as demand in Asia continues to grow. The most important things to watch in cocoa now are the action in the pound-dollar relationship and the crop from West Africa and other marginal producers around the world.
In cocoa, there is always a chance that weather issues or crop diseases like frosty pod rot, witches' broom disease or other fungal diseases can cause massive yield losses. Additionally, in West Africa, the potential for logistical issues that prevent the transport of beans to port in a timely fashion could cause price spikes.
If 2017 turns out to be a year of smooth sailing with higher crop yields, it is likely that the price of the commodity will fall below the $2000 per ton level. Right now, the path of least resistance for cocoa is lower. However, this is a very volatile commodity and the one thing that is certain is that demand for chocolate will continue to rise for as far as the eye can see into the future. I continue to favor selling cocoa short on rallies and covering on price weakness and new lows.
For those trading in the futures market, a long call option as a price insurance policy against a sudden and unexpected price recovery could be worth the premium. Daily historical volatility in ICE cocoa futures is around the 15% level making options reasonable. Premiums depend on the future perception of variance in the cocoa market.
Enjoy your chocolate treats and while the price may get cheaper over the months ahead, it is only a matter of time until cocoa finds a bottom and its descent into the abyss comes to a sudden end.
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