Soft Commodities Third Quarter 2018 Review And The Outlook For Q4 2018

by: Andrew Hecht


The soft commodities sector posts an 11.51% loss in Q3, making it the worst-performing sector.

Decade lows in sugar.

The lowest price since 2005 in coffee.

A double-digit percentage decline in cocoa and cotton.

The best-performing soft commodity is FCOJ, but it posts a significant loss.

Demographics point to ever-increasing demand for food. Each quarter the world adds 19-20 million people to the global population, and with wealth growing, more people with more money around the world are competing for finite natural resources each day. While demand continues to expand, each year is a new adventure when it comes to supplies of the soft or luxury commodities. Despite the compelling nature of the demand side of the fundamental equation for food, soft commodities prices plunged in the third quarter of 2018. All members of the sector lost value, and three of the five saw their prices register double-digit losses.

The composite of five soft commodities sugar, coffee, cocoa, cotton, and frozen concentrated orange posted two straight years of gains in 2015 and 2016. At the end of 2017, soft commodities were down just 2.25% on the year. In Q3, the sector dropped by 11.51% and was 7.04% lower in 2018 as of the close of business on September 28, 2018. Gluts in markets, trade issues when it comes to tariffs and subsidies that distort supply and demand fundamentals, and currency movements all lined up to create an almost perfect bearish cocktail for soft commodities prices.

The dollar index moved 0.41% higher in Q3 and was 3.17% higher at the end of the first nine months of 2019. The dollar moved considerably higher against the Brazilian real in 2018. Brazil is the world's leading producer of three of the five commodities in the sector including sugar, coffee, and oranges. The inverse historical relationship between raw material prices and the U.S. currency weighed on the sector. The dollar is the reserve currency of the world and the benchmark pricing mechanism for most commodities, including those of the soft or tropical variety.

The price of sugar dropped almost 15% during the three-month period, while coffee lost over 8% of its value. Cocoa was just under 17% lower. Cotton fell 10% while FCOJ a loss of 7.5%. The price action was ugly, and for the majority of the past three months, it was a case of today's lows are tomorrow's highs in the five agricultural products.

The demand side of the fundamental equation tells us that lower prices create incredible buying opportunities, but the price action has said the opposite. While some of the markets experienced a bit of two-way price variances, for most of the time any sale at any time turned out to be profitable. Meanwhile, the demand side has become even more attractive at the prices at the end of the quarter, but the markets have scared away buyers who have had their fill of trying to catch falling knives in the hope of a price reversal to reflect demand characteristics.

Like all agricultural commodities, demographics continue to provide an ever-increasing base of support for these food products. In Q3, the world added over nineteen million people to the global population. With wealth rising in the world's most populous county, China, competition for food continues to increase which puts a strain on supplies. Soft commodities can be one of the most volatile sectors of the raw materials market. It is not unusual for these products to double, triple, or halve in value in short periods when supply issues impact prices on the ICE futures exchange. However, in Q3, the common theme in the sector was slow and steady price deterioration. While prices plunged on a quarter-to-quarter basis, none of the agricultural products experienced sharp drops over a short period; they deteriorated like out of the money options prices with expiration day on the horizon. For those who chose to roll positions from one contract to the next to hold onto long positions, or those long ETF or ETN products in the sector, the glut in markets caused contango conditions. Longs had to sell a discount item and buy a premium one to roll their risk to hold onto risk positions adding to the pain of the downward trajectory of the market.

Sugar Review

Sugar was 28.02% higher in 2016 and gained 4.96% in 2015. In 2017, the price of sugar lost a total of 22.3% of its value. Sugar traded in a range of 9.88 to 15.37 cents over the first nine months of 2018 with the low coming at the end of Q3. Ample supplies of sugar had caused the commodity to make a series of lower highs and lower lows from 2011 through August 2015 when the sweet commodity traded down to 10.13 cents per pound. Sugar then proceeded to rally making a series of higher lows and higher highs culminating with the highs in late September 2016 at 23.90 cents per pound. From late 2016 through the end of September the sweet commodity moved lower making a series of lower lows reaching a bottom at 9.88 cents per pound on the nearby ICE world sugar futures contract during the final week of September as the nearby Ice futures contract was expiring. Nearby sugar futures that trade on the ICE settled on September 28, at 10.42 cents per pound. Sugar declined 14.94% in Q3 and was 31.27% lower through the first nine months of 2018 compared to the closing price at the end of 2017. Sugar traded to the lowest level since Q2 in 2008 when it found a bottom at 9.44 cents per pound. The low in Q3 was at 9.83 cents per pound.

Sugar prices traded as high as 36 cents per pound in February 2011. In countries like the US and the EU, the price of sugar is subsidized by the government. However, the major sugarcane producers, Brazil, Thailand, and India sell their crops at world market prices. Even in these countries, the government occasionally adopts policies to support sugar producers. At the end of Q3, news that India that is heading into a general election in April 2019 was providing subsidies in violation of World Trade Organization rules has caused objections from Brazil and Argentina. In India, more than 50 million people are farming sugarcane or working in mills, and generous incentives have caused the national output to leap from 20 to 35 million tons this year creating a massive glut of the sweet commodity. Similar subsidies in Pakistan have exacerbated the situation. The bottom line is that the world is awash in sugar. The current environment of oversupply and deteriorating prices has pushed sugar to the bottom end of its pricing cycle and production that is only possible because of government assistance will eventually lead to a decline in output, falling inventories and a significant upside reaction in the sugar futures market.

In Brazil, the weakness of their currency, the real, throughout 2015 contributed to a lower sugar price. Brazilian producers were dumping sugar into a falling market in dollar terms, but as the real moved lower, the price of sugar in Brazilian currency had done much better. At the same time, lower energy prices decreased demand for biofuels, and in Brazil, ethanol production comes from sugar cane. The price of the real began to recover, and sugar caught a bid. At the same time, crude oil recovered from lows of $26.05 per barrel on February 11, 2016, and that raised the prospects for domestic demand for the sweet commodity when it came to ethanol production in Brazil. After five straight years of surplus conditions, the sugar market went into a small deficit in 2015/2016, and that imbalance had increased in the 2016/2017 crop year. The price of sugar rose to 23.90 cents per pound in October 2016 which was the peak.

The higher price caused an increase in production, and the deficit turned into a surplus in the sugar market which weighed on the price throughout 2017 and into the second quarter of 2018. At the same time, the Brazilian real declined against the U.S. dollar in 2018 falling from 0.32 to under the 0.24 level recently putting additional pressure on the sugar price.

Brazil was able to sell sugar into the market regardless of the low price for the soft commodity which added pressure to the price and sent sugar to a low of 9.83 cents in late September. The real is weak these days for two reasons. First, after years of corrupt leadership, Brazilian will elect a new government in October, and the potential for a socialist wave in the election has weighed on the value of the currency. Second, neighboring Argentina is in the midst of another financial crisis which has decimated the value of the Argentine peso.

Sugar production from India and Brazil, a falling Brazilian real, and increased output from other producing nations have created a perfect bearish storm for the sweet commodity. However, prices are now at a level where future production, and even current subsidies, could become unsustainable for governments and producers over the coming weeks, months, and years.

Source: CQG

The quarterly chart of ICE sugar futures shows that since sugar fell to a low of 2.29 cents per pound back in 1985, the price had made higher lows during periods of oversupply. In 1985, there were 4.85 billion people on the earth, and at the end of Q3 2018, that number stands at over 7.50 billion, an increase of over 54.6% over the past thirty-three years. The number of people on our planet has increased exponentially over the past three decades which has increased demand for all agricultural commodities, and sugar is no exception. While the quarterly chart remains in a downward sloping trend when it comes to price momentum heading for oversold territory, the monthly, weekly, and daily charts display oversold conditions suggesting that the price of sugar is close to the bottom end of its pricing cycle.

The price of crude oil has been rallying with NYMEX crude at over $73 per barrel at the end of Q3, and Brent crude over the $80 level. Higher crude oil prices mean more demand for biofuels like ethanol. Brazil is not only the world's leading producer and exporter of sugar, but it is also the leading exporter of ethanol. When oil prices rise domestic demand for ethanol rises as does demand for exports from the commodity-rich South American nation. While ethanol in the U.S. comes from corn, in Brazil it is a product of sugar. Therefore, the higher price of oil increases the demand for sugar to process into the biofuel.

Weather conditions in primary growing regions around the world have created more than enough sugar to satisfy global demand which sent the price to the lowest level in more than a decade. However, the falling Brazilian currency and increased Indian subsidies helped sugar move lower in 2018. The rise in energy price has not provided much support for the price of the sweet commodity. Subsidies and tariffs tend to distort commodities prices as they interfere with supply and demand fundamentals. Economic theory teaches that commodities flow from those producers with the lowest output costs to consumers around the world. Those producers whose cost of output is above the price buyers are willing to pay do not survive. When prices fall to a level where production declines, inventories begin to fall in response to growing demand. Demand typically increases at lower prices which leads to a decline in inventories when output slows.

Meanwhile, production subsidies or tariffs interfere with the fundamentals of efficient markets. Therefore, supply and demand analysis become challenging in markets where governments support businesses that are losing money or where they restrict the flow of goods around the world. The Indian subsidies have created an environment where a government-sponsored glut of sugar is flooding the world market and weighing on the price which is an unsustainable situation. Moreover, it is a violation of WTO rules which could result in actions against India and other nations dumping raw materials like sugar on the international market. When subsidies guaranty production for domestic consumption for national security purposes, they can be useful tools. When government-subsidized products flood international markets, they damage economic conditions in other nations where governments do not provide aid to producers. The current situation in the sugar market could continue over the coming weeks and months.

It is highly likely that a poor crop, change in government policy, or an increase in demand will cause the price of sugar to rise in the future. The longer the current situation exists in the sweet commodity, the more dramatic the eventual price recovery. If production begins to fall around the world in response to the lowest price in a decade, it will not be long before the price of the volatile sugar market explodes to the upside. Sugar has a long history as a volatile commodity. At 10 cents or under with demand growing because of demographics, the odds favor that the sweet commodity will find a bottom sooner, rather than later.

Sugar can be one of the most volatile commodities that trade, in past years daily historical volatility had exceeded 100%. At the end of Q3, daily historical volatility stood at 26.87%, which was 7.61% higher than it was on the final day of trading in Q2 2018. As we move forward into the final quarter of the year, technical support for sugar stands at 9.83 cents and 9.44 cents per pound with resistance at 11.80 and 12.97 cents per pound.

Coffee Review

Coffee was the number one, the best-performing commodity of 2014 registering a gain of 43.19%. In 2015 it was the worst performing soft commodity. Coffee futures fell 23.95% in 2015 but recovered by 8.17% in 2016. In 2017, the price of coffee moved 7.92% lower. Q1 brought more of the same for the Java market as the price slipped 6.38%, and in Q2 it fell another 5.63%, and in Q3 the coffee futures market added to losses falling another 8.12% making coffee 18.82% lower through the first nine months of this year. Nearby ICE coffee futures closed on September 28, 2018, at $1.0245 per pound. The price range over the first nine months of 2018 was $0.92 on the lows to $1.3135 on the highs. Coffee closed Q3 just above the $1 level and closer to the lows than the highs for the year. Coffee has been making lower highs and lower lows since November 2016 when the price peaked at $1.7600 per pound.

Source: CQG

The weekly chart highlights that coffee futures have been in a bear market since November 2016. At of the end of Q3 2018, coffee had not violated the pattern of lower highs and lower lows meaning that technical resistance has been falling with the price of the soft commodity. Meanwhile, price momentum on the weekly chart is in oversold territory and has crossed to the upside after the bounce from the Q3 low.

Coffee and sugar have a lot in common these days. Brazil is the world's leading producer of coffee and sugar, and the decline in the Brazilian currency weighed on the price of the coffee futures market. At the same time, both soft commodities could be at or close to the low ends of their pricing cycles.

Starbucks (SBUX) made a significant investment in China and planned to open at least 5,000 outlets in the world's most populous nation. At the same time, other coffee shops have increased the demand for coffee from the traditionally tea-drinking country. Therefore, the addressable market for coffee continues to grow alongside demographic trends of increasing population and wealth around the world. However, the trade issues between the U.S. and China could derail SBUX's plans for their Chinese presence. The demand for coffee continues to grow, but the perfect bearish storm in the coffee futures market is also a copy of what happened in the sugar market. A weakening Brazilian currency and excellent growing conditions leading to increased supplies and inventories have weighed on the price of coffee futures sending them to their lowest level in over one dozen years.

Cocoa Review

Cocoa was the best performer in the soft commodity sector in 2015. In fact, cocoa was the only commodity that posted a double-digit gain in 2015 and won the gold medal for performance across all of the raw material markets that I cover. Cocoa was the worst performing soft commodity and the worst performing commodity of all in 2016 posting a loss of 33.79%, and the losing continued in 2017 with a decline of 11.01%. However, in Q1, cocoa was not only the best performing soft commodity, but it also posted the biggest gain of all of the sectors rising 35.1% for the three-month period. In Q2, the price of cocoa fell 3.13%, but in Q3 ICE cocoa futures put in the worst performance as they declined by 16.92% but was still 8.72% higher over the first nine months of 2018. Cocoa suffered the worst decline in Q3, but it is still the best-performing member of the sector in 2018. As of the close of business on September 28, 2018, nearby ICE cocoa futures were trading at $2057 per ton. Cocoa futures traded in a range of $1836-$2914 per ton over the first nine months of 2018, but cocoa futures did not violate the bottom or top end of the trading range in Q3. The highs for cocoa futures came in Q2 and the lows during Q1.

Source: CQG

The weekly chart of ICE cocoa futures illustrates the significant price recovery that took the soft commodity to highs of $2914 per ton in late April and early May. Since then, the price of cocoa has made lower highs.

Cocoa traded to highs of $3,422 per ton in early December 2015 and then fell to lows of $1769 in June 2017. A 50% retracement of the move from the highs to lows, was at $2,595.50 per ton. In mid-March, cocoa reached and exceeded that level, and it kept on going reaching a peak of over $2900 per ton. However, the primary ingredient in chocolate confectionery products left a gap on the weekly chart from $2320 to $2430 per ton which acted as a magnet for the price in Q2. In early June 2018, cocoa filled the void, and in Q3 it traded to a low of $2035 on the nearby ICE futures contract and it approached that level as Q3 ended.

Price momentum on the daily chart is in oversold territory while the weekly, and monthly charts are in neutral territory. Cocoa fell from over $3400 per ton in December 2015 to lows of $1769 in June 2017. It then recovered to a high of $2914 one year later and is now approaching the recent lows again as we move into Q4.

Cotton Review

Cotton was the worst performing soft commodity in 2014; it moved 27.33% lower for the year. In 2015, the price of cotton appreciated by 4.99% and in 2016 cotton gained 11.65%. Cotton moved 11.3% higher in 2017. The positive price action continued in Q1 of 2018 as the futures market for the fluffy fiber posted a 3.60% gain for the three-month period. In Q2, the price of cotton moved 4.81% higher, and in Q3 it declined 10.10%. Nearby ICE cotton futures have moved 2.38% lower over the first nine months of 2018.

Source: CQG

As the weekly chart highlights, cotton made a higher high and traded at 96.50 cents per pound in mid-June before the profit-taking and selling took the price down below the 80 cents per pound level. On the active month futures contract, cotton traded in a range from 75.11 cents to 96.50 cents during the first nine months of this year, and it did not move outside of that band in Q3. Nearby ICE cotton futures settled on September 28 at 76.76 cents per pound.

Cotton is a highly volatile commodity, and in March 2011, cotton traded up to an all-time high of $2.27 per pound on supply shortages. Following the all-time high, the price moved progressively lower until finding a low at 55.66 cents in March 2016. As the weekly chart highlights, the fluffy fiber futures have been rising since October 2017 making higher lows and higher highs. In the September WASDE report, the USDA told markets that cotton inventories and production increased while led to the recent downside correction in the price of the fiber. Moreover, the trade issues between the United States and China have weighed on the price of cotton. The U.S. is a producer, and China is one of the leading consumers of cotton in the world. Tariffs and retaliation distort prices and could interfere with the flow of cotton from U.S. producers to Chinese consumers. Tariffs and subsidies interfere with price dynamics as they distort supply and demand fundamentals.

China is a significant factor for the cotton market due to their demand for the fiber, and the slightly weaker dollar in Q2 did little to support the price of the fiber. The tariff issue could change that in the coming months if a trade and currency war develop and recessionary pressures cause demand for clothing to decline. However, a trade deal between the U.S. and China could cause a resurgence in demand for the price of cotton. Meanwhile, economic growth around the world has increased demand for those garments, which has been highly supportive for the price of cotton which has been making higher lows and higher highs since trading at the bottom of 55.66 cents per pound in March 2016.

Technical resistance for December futures is at the 83.93 cents level and then at the 89.98 level. Support is at 75.90 and 75.11 cents per pound. Trade issues could add lots of volatility to the price of the fiber over the coming weeks and months.

Frozen Concentrated Orange Juice Review

Trading FCOJ futures is a frantic business; I would not recommend it to anyone because of the lack of liquidity. FCOJ was virtually unchanged in 2015 falling by only 0.04%. In 2016, FCOJ gained 41.50% making it the best performing soft commodity. FCOJ moved 31.35% lower in 2017. In Q1 of 2018, FCOJ posted a 3.75% gain. In Q2, FCOJ was the best performing soft commodity moving 13.08% higher and in Q3 it posted a 7.49% loss for the most recent three-month period. FCOJ futures have moved 8.53% higher so far in 2018. Orange juice traded in a range of $1.3450 to a high of $1.7245 per pound so far in 2018 and settled on September 28, 2018, at $1.4760 per pound. FCOJ did not make a new high or new low in Q3. The high of the year came in Q2 at the end of May, and the low came at the beginning of the year in Q1.

Source: CQG

As the weekly chart highlights, a record high peak of $2.35 per pound came at the beginning of November 2016, but a downside correction followed that all-time peak. FCOJ rallied because of crop disease, citrus greening in Floridian groves and poor weather conditions in Brazil, the world's leading orange producing nation. The lower level of the Brazilian currency, the real, weighed on the price of FCOJ over the course of recent months. Over the past 40-plus years, FCOJ futures had traded as low as 37.4 cents and as high as $2.35 per pound. In Q4 of 2016, OJ rose to the highest level in history. Most recently, the FCOJ price rose to over the $1.70 level because of a shortage of oranges from Brazil, the world's leading producer of the citrus fruit, but the price has moved lower over recent weeks even though we are heading for the winter season in Florida. The price of FCOJ futures tends to be highly sensitive to weather conditions in Florida over the winter season as freezes can cause significant rallies in the futures market. OJ is a thin and illiquid market that is dangerous as it is susceptible to price gaps when the price is moving.

The Bottom Line and a Quick Look at Lumber

All five soft commodity prices moved lower during Q3. So far in 2018, three of the five have posted losses. Coffee and sugar are close to their lowest levels in over a decade as we head into Q4. I will continue to buy dips and sell rallies in many of the commodities in the sector in Q4 with special attention to sugar and coffee as I believe they are close to the bottom end of their pricing cycles.

The potential for supply issues is always a danger when it comes to these agricultural commodities markets, and supply issues can cause explosive price moves like the one we witnessed in the cocoa market during the first and second quarters of this year. Given the current low price levels, risk-reward favors the commodities that are at lows and multiyear lows.

When it comes to trade issues, cotton continues to be the only soft commodity directly impacted by the tariffs and retaliation as the U.S. exports the fiber to China. Therefore, cotton could continue to experience wide price variance over the coming months and into 2019.

It has been a busy quarter for the lumber market. In mid-May, lumber futures traded to another new all-time high when the price reached $659.00 per 1,000 board feet surpassing the February peak at $536.20 and the 1993 previous record high at $493.50.

Source: CQG

The long-term quarterly chart shows that lumber had been moving higher since September 2015 when the price found a bottom at $214.40 per 1,000 board feet. Lumber had been making higher lows since 2009 when the price trade to $137.90. The wood market gained 28.72% in 2016 and did even better in 2017 rising by 36%. Lumber continued to post gains in Q1 of 2018 of $15.11% and in Q2 of 10.39%. In Q3, the price of lumber plunged as it experienced a 39.50% correction. The wood market turned a gain into a loss in Q3 and had moved 23.13% lower over the first nine months of this year, and the price closed on September 28, 2018, at $344.40 per 1,000 board feet, $314.60 or 47.7% off of its most recent May peak.

Lumber is a commodity that is in the spotlight of the trade issues between the United States and Canada. Lumber is not a liquid market, and I would discourage anyone from trading in this market. However, lumber is a vital benchmark commodity, and it behooves all investors to monitor the price action as it provides clues about economic conditions and demand for industrial raw materials. The price of lumber moved lower over the past months as interest rates have moved higher causing a slowdown in the U.S. housing market. Lumber is also coming into a time of the year, the winter season when construction activity tends to slow. Moreover, lumber is a pawn in the trade issues between the U.S. and Canada who continue to negotiate the terms of a trade agreement, but the sides have not reached any compromise as of the end of Q3.

WOOD and CUT are top lumber products that trade on the stock exchange.

Soft commodities can be wild when it comes to price variance. In the world of commodities, those sectors and individual markets that are the worst performers during one period are often the best the next period. The low levels of sugar and coffee prices make the two members of this sector compelling candidates for price recoveries and long positions.

Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein, or any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction.

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.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.