Another Opportunity in Coffee- Waiting For More Upside Percolation

Coffee has been one of the most volatile commodities that trade on the futures exchange. Since 1973, the soft commodity has traded from lows at 41.50 cents to as high as $3.3750 per pound.

The most recent high in coffee came in late 2016 when the price rose to a high at $1.76. Since then, the price had made lower highs and lower lows leading its most recent low at 92 cents in September 2018.

As an agricultural commodity, the weather in the growing regions around the world each year dictates the path of least resistance of its price. At the same time, diseases like leaf rust can wipe out a crop in the blink of an eye. Coffee also has a limited shelf life as the beans lose potency and flavor over time. All of these factors increase price variance in the coffee futures market.

In the coffee market, there are two types of beans. Arabica beans are most popular in the US and other areas of the world. Robusta beans enjoy popularity in Europe and are the main ingredient in espresso coffee.

The coffee beans that trade on the Intercontinental Exchange are Arabica beans, and the world’s leading producer is Brazil.

Last Friday, the price of nearby ICE May coffee futures settled at $1 per pound which I believe is at the bottom end of its pricing cycle and an opportunity for buyers with a strong stomach for risk.

A multi-year bottom and recovery in 2018

In September 2018, the price of coffee fell to its lowest price since 2005.

Source: CQG

As the monthly chart highlights, at 92 cents per pound, coffee reached a thirteen-week low on sufficient supplies to meet global requirements. At the same time, the decline in the Brazilian real against the US dollar softened the blow for Brazilian producers who continued to sell coffee at the lowest price in more than a decade in US dollar terms.

In a sign that the coffee market had reached a level that was at the bottom of its pricing cycle, the price exploded higher, and one month later it was back above $1.25 per pound on the nearby futures contract.

Source: CQG

The weekly chart illustrates that coffee moved to a high at $1.2550 per pound in mid-October. The recovery of over 36% in just five weeks was impressive in the coffee futures market. Since then, the soft commodity resumed its bearish price pattern.

Coffee falls back to below the $1 level

In October, the price of nearby coffee futures rose to $1.2550 which broke the pattern of lower highs as the price rose above the peak from the week of May 29, 2018, at $1.2495. However, coffee ran out of buying sending the price back below $1 per pound. In mid-December, nearby futures fell to 95.75, a higher low compared to the bottom in September. Most recently, the price of the expiring March contract fell to 96 cents per pound, another higher low.

On Friday, February 22, the price of March futures settled at 96.45 cents with the now active month May contract at $1.00 per pound. Critical technical support for coffee stands at 92 cents. Below there, the next level on the downside stands at the 2005 bottom at 84.45 cents.

The bottom end of a pricing cycle

Fundamental supply and demand balances can move the prices of commodities over time. Raw material prices tend to rise to levels where production increases, demand slows, and inventories begin to build leading to price tops. On the other side of the supply and demand equation, commodities typically decline to prices where production slows, demand rises, and inventories start to drop.

Trend following longs and shorts who take advantage of bullish or bearish market sentiment can push prices through the top or bottom end of pricing cycles, but they tend to find levels where they run out of buying and selling and reverse course. I believe we witnessed a move to at or near the bottom end of the pricing cycle in the coffee futures market in September when the price fell to 92 cents per pound. The recovery that took the price over 36% higher in a little over one month was a sign that the market rejected the lowest price level in years.

When it comes to agricultural commodities like coffee, the supply side of the fundamental equation can be fickle. Each year is a new adventure when it comes to the size of crops which contributes to the wide price variance in the futures market. The weather can distort prices and create periods of enormous price volatility.

On the demand side of the fundamental equation, the population of the world increased from six to over 7.5 billion since the turn of this century. Twenty-five percent more people in the world in less than two decades means that the addressable market for coffee and many other commodities is steadily increasing. At the same time, dietary requirements in China, the world’s most populous nation, are changing rapidly. The tea drinking nation has developed an increasing taste for coffee which adds to the demand side of the equation.

While coffee supplies were more than ample to meet requirements in 2018, there is no guaranty that will continue to be the case in 2019 and beyond. A weather event or the outbreak of a crop disease could cause explosive price action in the coffee market.

Risk-reward favors the upside in the coffee futures market at the $1 per pound level and below. Given the price history, it is likely that coffee is at or near the bottom end of its pricing cycle.

It can take a long time for a commodity to reverse from the bottom and move towards a top in its pricing cycle. However, one factor that sent prices lower in 2018 could send them much higher in 2019.

Watch the Brazilian currency

Brazil is the world’s leading coffee producer, and in 2018, the Brazilian real tanked against the US dollar.

Source: CQG

As the chart shows, the real-dollar relationship fell from a high at $0.32005 in January 2018 to a low at $0.23725 in late August, a drop of 25.9%. Around the same period, the price of nearby Arabica coffee futures fell from $1.3125 to 92 cents or 30%. For local producers, the price of coffee only fell by 4.1% which accounts for their willingness to sell coffee into the declining market in 2018 and not alter their production.

In October, Brazil elected Jair Bolsonaro as their new leader. President Bolsonaro pledged to clean up corruption and foster a more business-friendly environment in the nation with South America’s leading economy. The real has recovered to the $0.2677 since his election. A continuation of gains in the real would be supportive of the price of coffee as local prices would need to appreciate to keep up with the move in the currency market. Therefore, while the weather and crop diseases always have the potential to lift the price of coffee, a stronger real against the US dollar could also cause a move to the upside.

In September and October, the real appreciated from below $0.24 to a high at almost $0.28 against the dollar. The move in the real came at the time when coffee moved from 92 cents to over $1.25 per pound.

Coffee will eventually percolate on the upside

Risk-reward favors a significant recovery in the price of coffee futures sooner rather than later. However, commodities like coffee are not for the faint of heart. Coffee and other agricultural commodities have a habit of rising or falling to irrational levels during their pricing cycles.

I believe that we are at or close to the bottom of coffee’s pricing cycle, and the recent move back to below the $1 per pound level is another opportunity to hop on board the coffee market before it begins to percolate on the upside again.

I am a scale-down buyer of coffee futures or ETN products that replicate the price action in the coffee market like JO. I will leave plenty of room to add on further price weakness as picking a bottom is a dangerous game. When I first started trading commodities in the early 1980s, one of my colleagues in London warned that traders and investors must be careful when it comes to picking a bottom as many wind up with nothing more than a dirty finger.

Source: CQG

With weekly historical volatility at 16.36%, down from almost 33%, call options in the coffee market have become less expensive. A call option in the volatile coffee market will limit risk to the premium paid and could be the most prudent approach to a long position while waiting for the next period of percolation.