Coffee Keeps On Trying To Recover

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

A multiyear low last September and then a recovery in October.

A lower low in April and another comeback.

The weather in leading growing regions is always the most influential factor for agricultural commodities.

In coffee, the Brazilian currency is as crucial as the weather.

Limited downside and explosive upside in both the real and the coffee futures market.

The price of coffee had been falling steadily since trading at a high at $1.76 in November 2016. Until September 2018, the soft commodity did nothing but make lower highs and lower lows. The coffee futures market on the Intercontinental Exchange did not even challenge a significant previous high for two years until last October when it finally recovered to a level that ended the bearish trading pattern. However, the price of coffee did not continue higher, and in 2019, it fell to another in a long series of lower lows. In April, the price of coffee fell to its lowest level since way back in 2005. It had been fourteen long years since Arabica coffee consumers around the world saw coffee at such a low level.

Meanwhile, the price action in the coffee futures market has been a lot like that children's story "The Little Train That Could" since late last year. The story, written by Atty Piper in 1930, is a tale of perseverance that teaches kids if they keep on trying and working hard with an optimistic spirit, they can eventually conquer a goal. Coffee has been trying to rally from the lowest price level in years, and ultimately, it will prevail.

The iPath Series B Bloomberg Coffee Subindex Total Return ETN (JO) is an alternative for those who wish to position on the long side of the coffee market without entering the highly-leveraged and volatile future arena.

A multiyear low last September and then a recovery in October

When the price of ICE coffee futures fell to 92 cents per pound in September 2018, it was the lowest price for the soft commodity since 2005. Last August coffee futures declined below the $1 per pound level for the first time since 2006. The move to the downside came on the back of increased supplies that created a glut in the Arabica coffee market.

Source: CQG

The weekly chart illustrates that coffee fell to a level where both relative strength and price momentum indicators declined into deeply oversold territory on the weekly chart. During the week of September 17 when coffee hit its low at 92 cents, the price put in a bullish reversal trading pattern that gave way to a significant recovery. The price of coffee futures rallied to a high at $1.2550 per pound during the week of October 15, a move of 36.4% in one month. Not only did the price of coffee recover, but it ended the pattern of lower highs that had been in place since November 2016 as coffee rose above its first level of technical resistance at $1.2495 per pound. However, the price stopped percolating on the upside after reaching that goal, and in 2019, selling returned to the coffee futures market with a vengeance.

A lower low in April and another comeback

Last December, the price of coffee returned to below the $1 per pound level as the market could not sustain the recovery rally. The price continued to drop in 2019, and in early April it fell below the 2018 low at 92 cents.

Source: CQG

The chart shows that coffee declined to 86.35 cents per pound during the week of April 15, and until the end of May, bounced along the lows threatening to test the 2005 bottom at 84.45 cents per pound. However, after making a marginally higher low during the week of May 20 at 86.75 cents per pound on the nearby ICE futures contract, another bullish reversal led to another significant recovery rally. The coffee futures market moved to the most recent high at $1.1305 on the continuous contract this week, a rise of 30.9% from the lows. Coffee has been a bucking bronco as the price continues to attempt to sustain a significant price recovery.

The weather in leading growing regions is always the most influential factor for agricultural commodities

The price of coffee, like all agricultural commodities, is highly sensitive to the weather conditions and crop diseases in critical growing regions around the world. When it comes to coffee, Brazil is the leading producer and exporter of Arabica beans to the world. Since November 2016, ideal growing conditions when it comes to the weather and the absence of crop diseases like leaf rust has caused sufficient supplies that have more than met all requirements around the world.

The weather or an outbreak of a crop disease always has the potential to change the fundamentals for agricultural products like coffee in the blink of an eye. The extreme price variance in agricultural commodities is because of the fickle nature of the crop each year. Coffee is not a commodity like metals or energy. Gluts are a year-to-year affair because coffee loses its potency and aroma over time. Therefore, each crop year is a new adventure in the coffee futures market. The forward curve in coffee illustrates the uncertainty over futures production even during periods where the market is in a condition of oversupply.

Source: RMB/ICE

The chart shows that the active month September futures were trading on July 11 at $1.0615 per pound. The price for delivery in May 2022 was at $1.3635, almost 28.5% higher. The contango or forward premium reflects the uncertainty of future coffee crops and the lack of significance of the level of current stockpiles.

While weather and crop diseases are the most significant factors for the coffee market, the level of the US dollar versus the Brazilian real also plays a substantial role when it comes to prices.

In coffee, the Brazilian currency is as crucial as the weather

The US dollar is the reserve currency of the world and the benchmark pricing mechanism for most commodities. The Arabica coffee futures on the Intercontinental Exchange use the dollar for pricing. However, since Brazil is the world's leading producer of the beans, local costs of production are a function of the level of the local currency, which is the Brazilian real. A weak Brazilian real versus the US dollar caused the production costs for coffee to decline, and it causes the price to rise in local terms if the dollar price remains static. In 2011, when the price of coffee futures hit a high at $3.0625 per pound, the real versus US dollar currency relationship reached a peak at $0.65095. On July 11, the real versus the US dollar in the September futures was trading at $0.26555, 59.2% below the 2011 peak. At the same time, September coffee futures were at $1.0615 per ounce, 65.3% below the 2011 high. However, in Brazilian currency terms, the price of coffee was only 6.1% lower than it was in 2011 when the US dollar price was at almost three times higher.

While the weather and crop diseases can cause explosive moves in the coffee market, it would be a mistake to discount the potential impact of a move in the currency market when it comes to the dollar-real foreign exchange relationship.

Limited downside and explosive upside in both the real and the coffee futures market

Late last year, Brazil elected Jair Bolsonaro as its President. After decades of corrupt governments, President Bolsonaro pledged to clean up corruption and reinvigorate the nation's economy for the benefit of its citizens. Brazil is the most populous nation in South American with the largest economy. Brazil is not only the world's leading producer of coffee; the commodity-rich nation is a leader when it comes to many other agricultural and other raw material markets. In many ways, Brazil's climate and geography make the country a supermarket to the world.

China has invested in Brazil over the past years, and one of President Bolsonaro's warnings to the citizens of his country during the campaign was that future policies could come from Beijing rather than Sao Paulo if Brazilians continue to allow China to buy significant stakes in their companies and raw material production. President Bolsonaro embraced many of the policies and initiatives of US President Trump on the campaign trail.

If the Brazilian leader is successful and corruption declines, it is likely the economy will improve, and investment capital will flow back into the nation. A recovery in the Brazilian economy would likely lead to a rise in the value of the Brazilian real against all world currencies as the foreign exchange instrument had been under siege since 2011. The real fell to almost one-third its value over the past eight years.

Coffee's dollar price moved lower with the real, and it would likely move higher with the Brazilian currency when it begins to recover over the coming weeks and months. One of the primary reasons for my bullish expectations for the coffee market is that I expect a significant recovery in the value of the Brazilian real versus the US dollar.

The most direct route for a long trading or investment position in the coffee market is via the futures and futures options that trade on the Intercontinental Exchange. Any investment in coffee comes at a price as contango, or the forward premium is another cost to consider. The longer it takes for the price of coffee to move higher, the most expensive when it comes to rolling contracts from one month to the next because of the forward premiums.

The iPath Series B Bloomberg Coffee Subindex Total Return ETN provides an alternative for those who do not venture into the futures arena. Any investor or trader with a traditional equity account can use JO for a position in coffee as the ETN does an excellent job replicating the price action in the futures market. 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 has net assets of $88.38 million and trades an average of 94,803 shares each day, making it a liquid product. The ETN charges an expense ratio of 0.45%. The price of September futures rallied from 96.25 cents on June 19 to a high at $1.1565 on July 5, or 20.2% higher.

Source: Barchart

Over around the same period, JO rose from $33.01 to $39.35 per share or 19.2%.

After trading to the lowest prices since the mid-2000s twice since last September, coffee continues to attempt to stage a sustainable price recovery. The success could be a function of the path of least resistance of the Brazilian real versus the US dollar if the weather continues to cooperate, and there are no crop diseases that impact supplies. I continue to be bullish on the prospects for the price of coffee and believe that the volatile soft commodity will begin to percolate on the upside sooner, rather than later.

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.