Coffee Insiders: Is it Time to Hedge?

Andres Agredo, Nov 08, 2016

COP $1,050,000 was the settlement for domestic coffee price in Colombia last Friday, November the 4th, a price not seen by our producers since more than 5 years ago.

These are certainly good news for growers, bearing in mind that one year ago the price was at COP $700,000 and three years ago was below COP $400,000, prices that, in addition to the small crops due to the renovation program performed by the National Growers Federation by those times, had under real pressure the whole Colombian coffee sector.

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Source: National Coffee Growers Federation

Domestic price is settled primarily based on the Arabica Coffee in New York, which closed last Friday at U$ 1,7135 for December contract, near two years high, and on the USDCOP, which closed at $3,060, still near all-time highs reached early this year.

But a good question made by coffee producers by these days is if this is an ideal point to sell some of their future production, locking in attractive prices and hedging the risk of a future fall in prices.

At this point it’s important to analyze what supports the recent bullish move in coffee prices, both in domestic and international ones. As it’s known, the coffee market ended 2015/16 in deficit for the second consecutive year, with an -3.3 million bags estimated deficit between production and consumption in coffee year 2015/16, as it’s shown as follows:

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Source: International Coffee Organization

Given that coffee is one of the most volatile commodities in the world, we’re now wondering if the recent strength will be consistent in the future or, it’s just temporary and prices will fall again in coming months. And that makes a lot of sense as in recent years we’ve seen Arabica Coffee trading over U$ 2 in New York, and then just months later being trading again around U$ 1 per pound.

But there are differences between the recent bullish move in prices and those that occurred in early 2014, October 2015 and even this year in July. At those times, the fundamental reasons were linked primarily to fears of supply shocks propelled by climatic factors, such as frosts and droughts especially in Brazil, the world’s largest coffee producer and exporter, as well as the trucker’s strike in Colombia, the second largest Arabica Coffee producer and exporter. These conjunctural factors were joined by rapid rises not only in futures prices, but also in their implied volatility, which is derived from options prices and which tends to rise when there are fears among market participants, such as the one that can be generated by a potential commodity supply shock.

At those times, the 30-days implied volatility of coffee options reached levels around 45% and 60%, quite above the 35% average, while in October and November of 2016, it has been near that average without surpassing 37%, as it’s shown as follows:

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Source: IVolatiliy

What we can deduct from this chart is that there is no a flagged nervousness among market participants at this point. Even having in mind that next year crop expectations are lower than last year in Brazil due to its biennial cycle, as well as to lack or unseasonal rains in some areas, there are no marked fears of a potential supply shock or a coffee shortage.

After large coffee exports in late 2015 and early 2016, thanks to their attractiveness in a Brazilian Real and Colombian Peso deep devaluation environment, which although diminished stocks, they had accumulated enough in 2012/13 and 2013/14 to allow the market to remain well supplied, even during these last two years in deficit.

Also, both Colombian coffee production and exports have rebounded in October, which is something that months ago would have made the price fall, but this time it has been affected nothing at all.

But if we analyze global coffee consumption in the last four years, it has grown consistently at an average annual growth of 1.3%, which in my opinion, is an indicative that in the future it should remain consistent and even potentially rise, due to the growing consumption not only in traditional large consumers such as USA and Europe, but also in producing countries, as well as to the growing trend for Specialty Coffee preferences, and the growing consumption in Asia, especially in China, where many tea drinkers are turning to coffee.

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Source: International Coffee Organization

In summary, we believe that the recent bullish move in coffee prices seems to be due not to a conjunctural supply shock fear, but to an structural change in the fundamentals of the demand-supply balance, in which demand projections are to grow consistently with risks to the upside, whereas supply projections are more uncertain with risks to the downside. Also, in the future there could be more deficit years, and even if there is a surplus, it’s possible that stocks in major producing countries won’t have the chance to be replenished in an environment of local currency devaluation and large exports as a result of that.

So from this, we can deduct that what we are actually seeing in coffee prices looks like the beginning of a long term uptrend and not the correction of a long term downtrend. However, U$ 1.70 – 1.80 area for New York could act as a strong resistance and develop a temporary downside correction in the coming weeks, being possible that the price reach the U$ 1.60 – 1.55 area again, but then to recover and reach U$ 2 – 2.30 by next year.

We have also advised our partners in the Colombian coffee belt and connections among the whole production chain to hedge some of their short term (3 – 5 months) production now to lock in attractive prices, because in coming weeks domestic prices could correct lower and trade again below COP $1.000.000. However, we believe and have advised them that no longer term production should be hedged, as domestic prices could remain trending higher for the next two or three years, surpassing the all-time high COP $1.164.375, and even going near to COP $1.300.000 levels.

Seguridad Financiera SAS / Commodity Trading Advisor, NFA Member.

Disclaimer: Past performance is not necessarily indicative of future results.

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