The Brazilian Real Weighs On Coffee Prices

About: iPath Series B Bloomberg Coffee Subindex Total Return ETN (JO), Includes: BRF, BRZU, BZF, BZQ, EWZ, EWZS, FBZ, JJS, UBR
by: Andrew Hecht

The world’s leading producer of Arabica coffee beans.

A new government, but the market has not yet bought into promises.

Coffee dropped to the lowest price in more than a decade in late 2018.

After a recovery, the selling came back.

At under $1, coffee is at the bottom end of its pricing cycle and offers value - JO offers value for those who do not trade futures.

Coffee consumers around the world have been cheering because in September 2018 the price of coffee beans fell to their lowest level in many years at 92 cents per pound. After a brief recovery that took the price of the Arabica beans favored by US consumers back to $1.255 in October, the price turned lower again and is back below the $1 per pound level.

Coffee may not be the most elastic commodity when it comes to prices, and consumers are not likely to guzzle more java at low price levels, coffee can be as fickle as the weather, sudden crop diseases, and Brazilian politics. With the price of coffee close to recent lows and at what is likely near the bottom end of its pricing cycle, the soft commodity could be providing investors and traders with another opportunity to purchase coffee before its price begins to percolate on the upside.

The iPath Series B Bloomberg Coffee Subindex Total Return ETN product (JO) does an excellent job tracking the price of coffee futures for market participants that do not venture into the shark-infested and highly-leveraged futures arena.

The world's leading producer of Arabica coffee beans

The two leading types of coffee are the Arabica and Robusta beans. Robusta produces espresso coffee, the favorite in Europe and other areas of the world. The primary producer of Robusta bean is Vietnam. The coffee favored in the US and found at coffee shops like Starbucks (SBUX) and Dunkin' Donuts (DNKN) comes from the Arabica bean. Brazil is the world's leading producer of Arabia coffee.

Coffee futures on the Intercontinental Exchange call for the delivery of Arabic beans. In September 2018, the price of coffee futures dropped to their lowest level of this century and since 2005.

Source: CQG

As the quarterly chart of ICE coffee futures highlights, the price declined to a low at 92 cents per pound last September. After a rally to a peak at $1.255 one month later in October, coffee has dropped back below the $1 per pound level and the nearby futures contract was trading at 95.25 cents per pound on Monday, March 11. While abundant supplies sent the price to the lowest level in more than a dozen years last September, the weak Brazilian currency was partially responsible for the decline.

Source: CQG

As the weekly chart shows, coffee futures fell from $1.3135 per pound in early 2018 to the September low, a drop of 30%.

Source: CQG

Over the same timeframe, the Brazilian currency relationship against the US dollar declined from $0.32005 to a low at $0.23725 or 25.9%. Therefore, the price of coffee in local terms for Brazilian producers and those involved in the coffee business only decreased by a net of around 4.1%. The decline in the Brazilian real set the stage for price action in coffee prices. As coffee remains near its low, the real has only recovered to just under the $0.26 level against the dollar. However, there is a reason to believe that a recovery in the Brazilian real could be on the horizon that would provide support for the volatile coffee futures market in the weeks and months ahead.

A new government, but the market has not yet bought into promises

Last October, the people of Brazil voted to put a right-wing and business-friendly candidate in office to lead South America's largest country. Jair Bolsonaro swept into office on an anti-corruption platform. President Bolsonaro pledged to revive the struggling economy with reforms. While the value of the real stopped declining, it has not yet experienced a significant rebound as the world waits for him to put his promises into action.

If President Bolsonaro's new policies begin to take hold, it is likely we will see the real move higher which could ignite a bullish fire under the always-volatile coffee futures market and lead to upside percolation after a prolonged period of declines.

Coffee dropped to the lowest price in more than a decade in late 2018

Since 1973, the price of Arabica coffee futures has traded from lows of 41.50 cents to a high at $3.375 per pound. The most recent peak came in November 2016 at $1.76. A lot has changed in the coffee market over the past decades. While production has increased around the world in growing regions, the demand side of the fundamental equation points to ever-increasing consumption. The most significant factor is the overall increase in the number of people in the world. In 2000, there were six billion inhabitants of our planet. Today that number stands at a level that is over 25% higher at 7.557 billion, at last count. At the same time, as wealth has grown in Asia, more people are drinking coffee these days as the region of the world that favored tea is incorporating coffee into their daily diets. The bottom line is that more people, with more money, create ever-increasing pressure on the demand side of the fundamental equation for coffee beans.

When it comes to global supplies that have kept pace with demand over recent years, each year is a new adventure in the coffee market. Crop diseases like leaf rust and others can wipe out a crop in the blink of an eye. Additionally, a weather event could also have a devastating impact on supplies. Therefore, abundant supplies one year are no guaranty that the following year will yield the same production. Finally, the shelf life for agricultural commodities like coffee beans is far shorter than in other raw material markets. The beans lose their potency, flavor, and aroma over time which makes timely consumption a critical concern and the coffee futures market one of the most volatile when it comes to price variance. Coffee has a long history of doubling and tripling in price over short periods during deficit markets and halving or more during periods of oversupply. It is not uncommon for the coffee market to swing from oversupply to deficit and back again over limited time horizons.

After a recovery, the selling came back

In a sign that coffee fell to a level that was close to or at the bottom end of its pricing cycle in September 2018, the price jumped from 92 cents to $1.255 per pound in one month. At the same time, the election of a candidate that promised to clean up corruption in Brazil took the real-dollar relationship from under $0.24 to almost $0.28. The real retreated to just under $0.26 and coffee is now back at under $1 per pound.

For the price of coffee to remain at its current level, which is close to the lowest in more than a decade, the real will need to remain weak, and supplies of Arabica beans must stay in a glut condition. A combination of currency and agricultural supply considerations could be too much to ask for as the stars lined up for consumers in 2018, driving the price of the soft commodity to lows.

At under $1, coffee is at the bottom end of its pricing cycle and offers value - JO offers value for those who do not trade futures

While only Mother Nature knows if the growing conditions in Brazil will result in another year of bumper crops in 2019 without any devastating crop diseases, the Brazilian currency may be just as critical for the price path of the coffee market over the coming weeks and months. At the current price level, Brazilian producers could not handle a higher real as it would send production costs higher, and perhaps above the market price for the commodity. At the same time, any weather issues in Vietnam that impact Robusta output could cause the price of Arabica beans to appreciate as the lack of availability could cause substitution in markets that favor the beans that come from the Asian nation.

I continue to believe that coffee at under $1 per pound is a sale that will not last for very long.

The most direct route for a trade or investment in the coffee market is via the futures and options on the Intercontinental Exchange. Trading coffee futures is not for everyone as the price volatility can be extreme at times. The leverage and volatility in the futures area can be hair raising. The iPath Series B Bloomberg Coffee Subindex Total Return ETN product does an excellent job tracking the price of coffee futures. The fund summary for JO states:

The investment seeks return linked to the performance of the Bloomberg Coffee Subindex Total Return. The ETN offers exposure to futures contracts and not direct exposure to the physical commodities. The index is composed of one or more futures contracts on the relevant commodity (the index components) and is intended to reflect the returns that are potentially available through (1) an unleveraged investment in those contracts plus (2) the rate of interest that could be earned on cash collateral invested in specified Treasury Bills.

JO can be a highly volatile ETN product. With net assets of $70.33 million and an average of 43,301 shares changing hands each day, it is a liquid tool for those looking for exposure to the price of Arabica coffee.

A perfect bearish storm descended on the coffee market in late 2018, sending the price to its lowest level since 2005. At under $1 per pound, with a new government in place in Brazil, the potential for the soft commodity is compelling on the upside as coffee could be near the bottom end of its pricing cycle from both a commodity and a currency perspective.

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.