Coffee Builds A Case For A Recovery

Coffee is a ubiquitous beverage, and its consumption has been rising around the world. Arabica coffee beans trade on the Intercontinental Exchange. The agricultural commodity is part of the soft commodities sector, and the world’s leading producer is the South American nation of Brazil. Over recent weeks, the never stable political environment in Brazil and the rest of South America caused the real and Argentine peso to move appreciably lower. Last Friday, the IMF provided Argentina with the biggest rescue package in history at $50 billion. The lower level of the Brazilian real reduces production costs in the nation that is the leading producer of Arabica beans. At the same time, the price of coffee beans in real-terms moved higher which encourages selling during a year where the crop production was strong.

However, coffee is currently trading at a price that is at the lower end of its commodities cycle which means that risk-reward favors a long position in the coffee market at this time.

Commodities prices are cyclical

In the world of commodities, tariffs and subsidies, as well as currency differentials, can impact and distort prices. However, raw materials tend to be efficient economic animals. Economic theory teaches that the price of a raw material will drop to a level where production declines, inventories decrease, and demand increases. Prices tend to rise to levels where demand falls, and inventories rise as production increases. The cyclical nature of raw materials can provide significant clues when it comes to the path of least resistance for prices. When prices fall to the bottom end of their long-term trading ranges, they tend to find lows. While prices can remain at highs or lows in on overbought or oversold conditions for extended periods, the cyclical price behavior eventually returns commodities prices to equilibrium levels and extensions on the up or downside over time.

Demand is an ever-increasing factor

Demand for agricultural commodities has increased because of demographics, and coffee is no exception. In 2000, there were six billion inhabitants of our planet, and today that number stands at 7.479 billion. The 24.65 percent increase in population means that the demand for all agricultural products is one a one-way street higher. At the same time, the aging of the population means that coffee drinkers are living longer lives. The increase in wealth in Asia has changed dietary habits, and over recent years Starbucks and coffee shops have been popping up all over China. The bottom line is that more people, with more money, are consuming more agricultural commodities each day. The addressable market for coffee consumption in the world remains on an upward trajectory which increases the base price of all foods, as well as coffee and other soft commodities.

Supplies are as fickle as the weather

The most dramatic moves to the upside in the world of commodities typically comes from the supply side of the fundamental supply and demand equation. A weather event that impacts crop yields or a disease like leaf rust can wipe out crops in growing nations. While coffee has not suffered from adverse weather conditions or crop disease over past years does not mean that the potential for a supply-side event is not a possibility at any time. Supplies are as fickle as the health of crops, but in Brazil, almost picture perfect conditions have created a glut condition. The Arabica coffee futures market has been moving lower since November 2016 on the back of adequate supplies to fill demand requirements around the world. However, that can change in the blink of an eye. In the coffee market, beans have a limited shelf life as they deteriorate and lose the properties that are necessary to produce a delicious cup of coffee with a caffeine kick that most drinkers not only enjoy but depend on each day. While the price of coffee has moved to the downside side since late 2016 and consumers have enjoyed plenty of supplies, a higher price will not necessarily cause a decline in demand. The caffeine addiction of a growing world detracts from the economic principle of price elasticity.

Coffee can be highly volatile – technical signals

Coffee can be one of the most volatile commodities that trade on the futures exchange. The long-term chart could be telling us that the soft commodity is close to or at a significant bottom these days.

Source: CQG

As the monthly chart highlights, coffee has been on almost a steady path to the downside since November 2016 when the price of the beans reached $1.76 per pound. The high in 2016 was a far cry from price peaks seen over recent years as poor weather and crop disease in 2011 to over the $3 per pound level. However, the price had been steadily deteriorating since late 2016 reaching a low at $1.1245 in May. On Tuesday, June 12, July coffee futures were not far off that bottom as they were around the $1.17 level. The monthly chart shows that open interest has been climbing as the price moved to the downside. At 275,757 contracts on June 11, the metric is close to the highest level in history. However, price momentum and strength metrics have declined into oversold territory. Monthly historical volatility is at the lowest level in decades at 8.49%. Coffee continues to trade near lows and critical technical support stands at the November 2013 low at $1.0095 per pound. Given the power of global demand thanks to an ever-increasing addressable market of coffee drinkers, the chances of a move to that level or below are low while the odds of a recovery are rising. With less than 20 cents of downside potential coffee has become a compelling trade on the long side. The price in 2011 rose to a high of $3.0625, which is $1.8925 cents above the current level. The high in November 2016 at $1.76 was 59 cents above its current level. The risk-reward profile for coffee, with its growing demand and fickle supply profile, is currently one of the most compelling stories in the commodities market.

Another positive sign for coffee futures is that while it made a lower low in mid-May at $1.1245 per pound, it finally broke the pattern of lower highs earlier in the month when it rose to $1.2595 on the July contract. The widening of the spread could be an indication of increasing volatility in the coming weeks and months.

BJO for those who do not trade futures

When prices are at or approaching significant bottoms, they can bounce around lows for long periods before they finally decide to stage a recovery. When it comes to coffee, the futures market has a long history of explosive and implosive price behavior. These days, the odds of an explosion are much higher than they are for an implosion. The most direct route for a long position in the coffee market is via the futures and options on futures on the Intercontinental Exchange. When it comes to options, the low level of historical volatility makes call options an inexpensive route to a long position in the futures market.

For those who do not venture into the volatile and leveraged world of futures, the Barclays Bank PLC IPath B Coffee ETN product does a reasonable job replicating the price action in the ICE coffee futures market.

Source: Barchart

BJO was trading at $46.33 on June 12. With $47 million in net assets and an average of 17,365 trading each day, BJO is building liquidity and is an appropriate vehicle for small positions on the long side in the coffee market.

The coffee futures market is building a case for a recovery, and now could be the perfect time to begin a program of scale-down buying from the current price level to hop on board before volatility increases in the future.

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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