Few beverages in the world have the ubiquitous appeal of coffee. Coffee is much more than a drink many people start their morning with or enjoy throughout the day for the pick me up provided by the caffeinated drink. Coffee is also a centerpiece when it comes to social interaction.
There was a great line in the movie “Good Will Hunting” that demonstrates how coffee is a part of our culture in the U.S. and around the world. When Will meets Skyler the first conversation goes like this:
Skylar: You’re an idiot. I’ve been sitting over there for 45 minutes waiting for you to come and talk to me, but I’m tired now and I hafta’ go home, and I..I couldn’t sit there any more waiting for you.
Will: Well..I’m Will.
Skylar: Oh, and by the way, that guy over there…the Michael Bolton clone…he wasn’t singing with us, so to speak.
Will: Yeah, I know. I kinda’ got that impression.
Skylar: Good. Okay. Well, I’ve got to go. Gotta’ get up early and waste some more money on my overpriced education.
Will: No..I didn’t mean you. I–
Skylar: Oh, that’s all right. There’s my number. Maybe we could go out for coffee sometime?
Will: All right, yeah. May-maybe we could just get together and eat a bunch of caramels.
Will: When you think about it, it’s just as arbitrary as drinking coffee.
Skylar: [laughs] Okay, sounds good.
Source: Movie Quotes Database
Arbitrary or not, coffee is a commodity that a large percentage of the ever-increasing world population consumes on a daily basis. For more than one and one-half years, consumers have benefited from a steadily declining price of the beans.
A bearish price pattern since 2016
As the weekly chart highlights, the price of coffee futures that trade on the Intercontinental Exchange found its most recent top at $1.76 per pound during the week of November 7, 2016. Since then it has been all downhill for the price of the soft commodity as producers have been receiving less for their beans and consumers have enjoyed the benefits of a cheaper cup of Joe.
Open interest in the ICE coffee futures market increased steadily as the price moved lower, reaching its most recent record high at 276,784 contracts at the end of March. Rising open interest when the price is heading lower is typically a technical validation of a bearish trend in a futures market. However, price momentum has declined and is currently in an oversold condition which could be a signal that the mature bearish trend in the coffee futures market is running out of steam. Additionally, weekly historical volatility has declined to 9.75%, which is close to a historic low in the commodity that tends to have a penchant for wide price variance.
Abundant supplies from producing countries keep the pressure on coffee
On the fundamental side of the equation for coffee, abundant supplies creating surplus conditions in the market have weighed in the price of the beans. Brazil is the world’s leading producer of Arabica beans which are most popular in the United States. Brazilian output combined with production from Columbia and other significant world producers have been sufficient to meet global demand. At the same time, the elasticity of demand is low in coffee given its ubiquitous appeal around the globe. In other words, even if the price were to move higher, coffee drinkers would likely pay more for their daily fix. However, for around eighteen months, elasticity has not been tested as the price has yet to recover to a level that would test the declining level of technical resistance in the coffee futures market.
Technical resistance declines with price
The weekly chart shows that the decline in the price of coffee has rarely tested a previous high and since a brief recovery to just over the $1.30 per pound level at the start of 2018, the price of coffee has been on a one-way journey to the downside.
As the daily chart of the now active month July futures contract illustrates, the bearish trend has been almost picture perfect since the start of this year. The most recent recovery rally has taken the price of July coffee futures to $1.2250 on April 27, which is the first higher high in many months and a positive sign for the future path of least resistance for the price of coffee futures. As the price of coffee has moved to the downside, the level of technical resistance has also declined. However, the weight of supplies has prevented coffee from staging any significant recovery, and the pattern of lower highs remained intact until last week. Friday’s rally could be a first step in ending that pattern.
The market has become accustomed to the bearish trend
Consumers have become accustomed to lower coffee prices. Significant buyers of the beans like Starbucks (NASDAQ:SBUX) and Dunkin Donuts (NASDAQ:DNKN) have enjoyed lower java prices as it has steadily reduced their cost of goods sold and increased earnings. Each time I stop into a Starbucks or Dunkin Donuts these days, I marvel at how prices have not come down to reflect the price of the primary input in their products. Lower coffee prices have created an earnings bonanza for these two companies and others that depend on the price and availability of the soft commodity.
Each year is a new adventure in the world of coffee production. The weather in the major growing regions of the world determines the path of least resistance for prices. Moreover, crop diseases like leaf rust can wipe out a crop quickly. However, in 2017 and 2018 output has been sufficient to meet all demand and then some causing the price to drop. Since coffee production is a year-to-year affair, it is difficult for consumers to find liquid long-dated hedging vehicles for their requirements. Additionally, the forward curve in the coffee futures market reflects the uncertainty of crops over coming years.
As the forward curve of ICE coffee futures shows, while nearby prices remain just above the $1.20 per pound level, next year at this time the price is above $1.30, and in 2020 it is over $1.40 per pound. In 2021, the price is at over $1.50 if a consumer can locate a seller willing to provide liquidity for a crop that is three years into the future.
Meanwhile, consumers are becoming a bit too comfortable with low prices these days and producers are hoping they will be paying a lot more in the future.
Coffee can be highly volatile, and the bear market will end with a bang
Those who read my pieces regularly will know that I stress the significance of demographics on the demand side of the fundamental equation for most commodities. When it comes to feeding the world, and coffee is a staple in many people’s diets, more people with more money are competing for finite supplies each day. In 2000, the total number of people in the world was around six billion. Today, that number stands at 7.469 billion. In Q1, the world added another 19 million consumers, and many will turn out to be coffee drinkers.
The quarterly chart of ICE coffee futures shows just how volatile the beans can be at times. The all-time peak for coffee futures came in 1997 at $3.18 per pound. In 2011, coffee rose to a slightly lower high at $3.0625, but since 2001 the price of the beans has made higher lows. I believe that demographic factors have increased the floor price for coffee, and many other agricultural commodities, over the past two decades. To keep the pattern intact, coffee futures will need to hold the $1 per pound level. However, as technical resistance levels have been dropping with the price, and open interest indicates that there is growing speculative interest in the market. It may only be a matter of time before coffee finally challenges one or many of the resistance levels that have formed over the past year and one-half.
I am a scale-down buyer of coffee futures and call options as I believe we will eventually see a significant price recovery. For those who do not venture into the futures markets, Barclays recently replaced their JO ETN product with BJO.
BJO is in the process of building liquidity, and the ETN product has a total of $28.7 million in net assets as of April 26 and trades an average of 8,940 shares each day. July ICE coffee futures settled at $1.2240 per pound on April 27, and I believe that demographic factors limit the downside in the coffee market and risk-reward continue to favor the upside. Coffee consumers continue to jump for joy these days as the price remains near the recent low. However, if the price moves significantly higher over coming weeks and months, people around the world will continue to consume the beverage as the power and lure of the caffeinated drink and the not so arbitrary social connection it creates melts the elasticity of demand.
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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.
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.
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