Cocoa was trading above $3200 per ton before the Brexit vote on June 28, 2016. The shock result of the referendum caused the pound to sink against all world currencies, and since London is the international hub of global cocoa trading, the massive move in the British currency weighed on the price of the primary ingredient in chocolate and cocoa fall. At the same time, the output from the Ivory Coast and Ghana increased. The two West African nations produce more than 60% of the world's cocoa beans each year, and a bumper crop added additional bearish fuel to the price action in the futures market.
Moreover, as cocoa grindings fell during the final three months of 2016, weaker demand on a year-on-year basis made the price tumble to the lowest level since October 2008. May futures hit lows of $1869 per ton on March 2, over 42% below the pre-Brexit high at $3237 and only $2 above the lowest level in over seven years. Cocoa had been a falling knife during the second half of 2016 and the first two months of 2017, and as if looked like the price was about to take out critical support at those 2008 lows, the market realized that all the bad news was in the price of the active month futures contract.
All the bad news was in the price
Commodities tend to be the most volatile asset class because production is a local affair and consumption is ubiquitous. Shortages and gluts are commonplace over the course of a commodity cycle and weather, political, and macroeconomic events can cause wide price swings and dislocations. The price of any commodity transcends the production cost and available supplies as the cost of transportation, storage, handling, and logistical problems often influence prices dramatically.
If all that is not enough, the major platform for commodities trading are the futures markets which operate on a high degree of margin meaning that for a small good faith deposit of 5-10% a speculative long or short can control a whole lot of volume for a small percentage of the total value for a time. Considering that the total market cap of some commodities markets is low when compared with other financial instruments that trade, volatility is the norm rather than the exception. Therefore, when commodities prices move to highs or lows, they tend to overshoot and rise or fall to levels that are uneconomic or rise to levels that boggle the mind.
Cotton rose to $2.27 per pound in 2011, a price that was so high that it put many market participants out of business because of the irrationality of the price. Sugar fell to under 2.3 cents per pound in 1985, a price that was not only uneconomic it created a disaster for many countries. Onions, a commodity that once traded on the futures exchange as an agricultural product fell to zero years ago. There are so many examples of irrational prices in the raw material markets, but the lesson is that these assets tend to rise and fall to absurd levels before they eventually return to economic prices because of the forces of supply and demand.
During the second half of 2016, the price of cocoa fell like a stone. An abundant West African crop and a plunging pound sterling sent the primary ingredient in chocolate lower after a bull market that lasted from 2011-2015. Oddly enough, cocoa rallied during years when many other commodity products were moving to the downside.
Cocoa got to cheap
As the weekly chart highlights, the price of the soft commodity plunged from $3237 per ton in June 2016 to lows of $1881 on the continuous contract ($1869 on the May futures contract) by the beginning of March 2017. Cocoa moved lower for fundamental reasons, but as the chart highlights, open interest rose to the highest level in history at just under 300,000 contracts or 3 million tons in March. Open interest is the total number of open long and short positions on ICE cocoa futures contracts, and it was likely that there were many trend following and fundamental shorts who hopped on the downtrend fueling the downside pressure in the market. At $2500 per ton, the entire ICE cocoa open interest had a gross value of $7.5 billion.
As a comparison, the Intercontinental Exchange, the platform for cocoa trading, has a total market cap of $35.6 billion, almost 4.75 times the value of its cocoa futures market. Now that is certainly food for thought and the downside extension recently seen in a commodity produced in West Africa, South America, and Asia in nations that are close to the equator is because of the lack of liquidity during market repricing periods. All of the bad news was in the price of cocoa, and that price got too cheap. However, as the price of cocoa was falling, the potential for a bottomless pit seemed a reality. Stocks can drop to zero when companies go bankrupt, and bonds can become worthless when issuers default. Commodities, on the other hand, are necessary requirements for consumers around the world and unlike Enron or Lehman Brothers, chocolate is never going bankrupt.
It took a brave soul to stand up and buy cocoa futures or ETN products over recent weeks as the price had fallen off the edge of a cliff. In hindsight, the logical reaction to the plunge in cocoa was to remember why it was in a bull market while other raw material prices were moving to multiyear lows.
Demand from Asia continues to support the market
Asia, and most specifically China, had only discovered the wonders of chocolate confectionery products over the past ten to twenty years. While chocolate was probably always available to the privileged in the nation the growth of the middle class created a new generation of hundreds of millions of chocoholics boosting global demand and prices to record highs. Source: CQG
As the monthly chart illustrates, in March 2011 cocoa futures traded to the highest level in history at $3826 per ton and then fell to $1898 just nine months later in December of the same year. However, a demand-based rally took the price back to over $3400 in late 2015 when copper, oil, gold, grains, iron ore, coal, and almost all other commodities were on their ways to multiyear lows.
Asian demand kept a big bid under the cocoa market until last June, but with the hub of physical trading in London and contracts often trading in pounds, the Brexit and a big crop lit a bearish fuse that seems to have finally found a low over recent weeks. Source: CQG
The momentum indicator on the monthly chart that had been falling since December 2015 appears to have finally found a low in oversold territory and has crossed to the upside indicating a shift in momentum. All the while, I am quite sure that the Chinese have continued to enjoy chocolate and that the lower price of cocoa has served to increase demand for the world's newest chocoholics.
A myriad of bearish factors caused the price of cocoa futures to plunge. Now it is possible that a total shift in market sentiment will take the price right back up. It took cocoa ten months to rally from $1898 in December 2011 to $2735 in September 2012. The move from $3237 in June 2016 to lows of $1869 in March has a midpoint of$2553, and the move from the December 2015 highs of $3422 to the March lows has a 50% retracement level of $2645 per ton.
A rebound in the pound sterling
Demand remains high for cocoa in Asia and around the world. While this year's crop is sufficient to meet demand when you trade cocoa never forget that West African production is the key to the path of prices and the stability of the region is not exactly a sure thing. Additionally, last week the British confirmed their intention to declare the exit from the European Union and negotiate the terms of the divorce. The pound sterling rallied on the news. Source: CQG
As the daily chart displays, the pound has rallied from $1.2138 against the dollar on March 14 to over $1.2550 even after a horrible terrorist attack struck London last Wednesday. Just like weakness in the pound sparked the selloff in the cocoa market, a rising pound could ignite a significant rally.
Important technical levels to watch
Cocoa has begun to recover as it rallied to a high of $2187 last week, $318 off the lows in just three short weeks. The next level of technical resistance is around the $2250-$2275 level which is less than $100 above last week's highs. The price action in cocoa has broken the pattern of lower highs, and a myriad of factors could now cause an explosive move on the upside.
Cocoa recently did what commodities tend to do when they rise or fall dramatically in futures markets. It dropped to a price that disregarded fundamentals and rationality. However, a seasoned commodities trader knows that when those types of moves are under way, it is best to get out of the way of a speeding freight train. Cocoa now looks like the bottom is in and rather than selling rallies, buying dips is likely to yield optimal results. NIB, the cocoa ETF, offers those who choose not to dip a toe in the leveraged and shark infested hedonistic world of futures, the opportunity to participate in a market that seems to be returning to a balanced representation of supply and demand fundamentals.
When it comes to commodities, what goes up tends to come down and what comes down tends to rebound. Cocoa is already around $300 per ton off the lows but it is still more than $1000 per ton below where it was in June 2016 so risk-reward favors the long side now that the carnage appears to be over. Stick to buying dips in the cocoa market as commodities rarely move in a straight line. We have seen a reversal of fortune in cocoa over recent weeks and perhaps better stated a return of rationality to the price of the primary ingredient in chocolate.
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Disclosure: I am/we are long NIB.
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.