Cocoa Rebounded But The Bearish Tone Continues

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Cocoa attempts to rally at the start of 2017.

Technicals still favor lower.

Supplies are abundant and politics have returned to stability.

Action in the British pound is bearish.

$1898 is the level to watch on the downside.

While many commodity prices saw dramatic rebounds in 2016, the price of cocoa stood out because of its lack of performance. In an asset class where many other raw materials posted double-digit gains on a percentage basis, cocoa was the worst performer dropping 33.79% on the year and closing just five bucks off the lows of the year at $2126 per ton. Cocoa closed 2016 at its lowest level since 2013.

The price of cocoa suffered from a triad of problems since turning south six months into last year. The Brexit referendum caused the price of the tropical commodity to fall as London is the hub for many physical cocoa transactions and the weak pound sterling led to a lower price. The bull market in cocoa that began in December 2011 took prices from $1898 per ton to $3422 in December 2015. Throughout that bull market period, the price of cocoa made higher highs and higher lows. However, since late 2015, the opposite has prevailed. Cocoa began making lower highs in the first half of last year but it was the crash of the pound that caused the technically bearish trading pattern. Finally, an increase in production from the two West African nations responsible for over 60% of the world's output of cocoa beans caused a cascade of selling leading to a close on December 30 at the lowest price in over three years.

Many commodities have posted gains in early 2017, the dollar came off early highs and precious metals, base metals and even some agricultural prices are higher than they were at the close of business on December 30, 2016. Cocoa has followed these commodities higher over recent sessions but the rally has been less than awe inspiring.

Cocoa attempts to rally at the start of 2017

After a brief dip to $2119 on the first trading day of the year, March ICE cocoa futures rallied to highs of $2291 on January 6. Source: CQG

As the daily chart highlights, cocoa has been making lower highs and lower lows since May 2016. To break that pattern, the price would now have to rise above the $2337 level on March futures but alas the price action over recent sessions could only manage a rally to $46 below that critical price. Open interest has been rising over recent sessions and is now at over 278,000 contracts, the highest level in history. Unfortunately for the bulls, rising open interest and falling price is a sign of technical validation for the current bear market in the main ingredient for chocolate. Meanwhile, on the daily chart the recent rally lifted momentum and strength indicators to neutral territory. Historically, a commodity in such a bear trend has had a better chance of appreciating when these metrics display an oversold condition.

Therefore, the brief rally that came at the very beginning of 2017 turned into a continuation of the bear market trading pattern of lower highs that has been in place for more than half a year.

Technicals still favor lower

While the short-term chart of cocoa futures looks like it has run out of an attempt at a head of steam, the longer term chart continues to look even more bearish. Source: CQG

On the first trading day of 2017, cocoa traded to lows of $2119 which was the lowest price since April 2013. On the monthly chart there are now three support levels for cocoa that stand between the tropical commodity and the bearish abyss. On Wednesday, January 11 cocoa traded to new lows of $2106 per ton on the March futures contract.

The first level is the March 2013 lows at $2046 per ton. Under there, the January 2012 low of $2003 is not only a price of critical support but is also only three dollars above the significant $2000 psychological benchmark. Under there, the December 2011 lows at $1898 sticks out on the monthly chart like a sore thumb. The monthly chart for cocoa now looks like the price is nothing less than a falling knife. While relative strength is in oversold territory, the slow stochastic continues to display an oversold condition that indicates continuation of a downtrend since it has yet to cross higher. Technically there is little to provoke a toe in the water on the long side in the cocoa futures market, and fundamentally the situation is even worse.

Supplies are abundant and politics have returned to stability

The world's largest producers of cocoa beans are the West African nations of Ghana and the Ivory Coast. One of the reasons for the bear market in cocoa has been an increase in output from these two nations that produce over 60% of world supplies. In December, so much cocoa was arriving at ports in the Ivory Coast that logistics became overwhelmed. At the same time, a two-day mutiny by the Army in the Ivory Coast paralyzed several cities in the nation during the first week of the year. The price of cocoa increased at the same time given the political risk associated with the insurrection. However, last weekend President Ouattara said that he reached a deal with the soldiers to avoid further problems. Gunfire in those cities stopped and business returned to normal. At the same time, the price of cocoa turned around and moved lower. One of the most bearish things weighing on the cocoa market right now is the massive crop and oversupply that faces the market.

Action in the British pound is bearish

London is the international hub of physical cocoa trading. Many transactions for cocoa flowing from producers in West Africa to consumers in Europe and around the world use the British pound as a pricing mechanism.

In the wake of the Brexit referendum in late June 2016 after the citizenry of the United Kingdom voted to exit the European Union, the pound slumped falling from $1.50 to the $1.20 level against the U.S. dollar. Source: CQG

The monthly chart of the pound versus the U.S. dollar relationship shows the significant downtrend in the British currency. As the pound declined in value, the price of cocoa in pound terms got stronger contributing to the weakness in the commodity. Another problem facing the cocoa market is that although the Brexit vote shocked the market and caused the pound to tank, the business of Britain's divorce from Europe has not yet commenced. Those negotiations have the potential to cause further declines in the pound dollar relationship which would present another problem for the future price of cocoa beans given the current state of supplies. The technical state of the currency continues to be in free fall and if the pound begins to make new lows, we could see cocoa go along for the ride on the downside.

$1898 is the level to watch on the downside

It is becoming more likely that cocoa will test that critical long-term resistance at the $1898 level in the weeks and months ahead. If that level does not hold, the price action could become ugly, for a time. Bear markets in commodities die hard, and they tend to extend way past the price levels that seem rational and reasonable.

Therefore, I continue to believe that the optimal course of action when it comes to trading in the cocoa futures market is to sell rallies and cover those risk positions on new lows and price weakness. Initiating positions from the short side in a bear market works best when opportunities arise during price recoveries that remain below previous highs. Right now, those highs are at $2291 and $2337. Any rally above those levels threatens to negate the trading pattern that has been in place since May.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.