Coffee is one of the world's most important commodities. The Wikipedia Encyclopedia reports that there is about 500 billion cups consumed every year. It remains to be one of the world’s most popular beverages. There about 25 million small producers worldwide who depend on the crop for a living (Wikipedia.com). One of the largest producers is Brazil. They produce almost 1/3 of the world’s coffee and employ over 5 million people. It is evident that coffee has become a huge part of their society. Here in the US, many people associate coffee with StarBucks™. However, investors and traders associate coffee with the symbol KC, and affiliate it with the exchange it’s traded on, the infamous New York Board of Trade. Coffee is a commodity with extensive international demand, and thusly the coffee market and prices are directly dependent on international supply and demand. As you can imagine, coffee remains to be an important export in today’s global market, and is one of the top agricultural exports for over 12 countries worldwide. Many large investors, hedge funds and investment gurus have been advocating the purchase of coffee because of its value compared to the rest of the commodities. Jim Rogers, a multimillionaire and commodity icon, is one of the most public advocates of buying commodities right now, especially coffee. He has advised investors to avoid buying commodities that have already experienced huge price rallies (e.g. crude oil). Rogers said, “If you're going to buy something, buy coffee or cotton or sugar” (Bloomberg). Rogers particularly favors these agricultural commodities because they are trading well below their historical highs. To properly determine exactly how high coffee may go, we first need to interpret both the fundamental and technical aspects to this market.
Fundamental Conditions
Coffee remains incredibly undervalued within the current market conditions and is currently trading in the middle-to-lower range of its capacity, well below its all time highs. I feel this market possess incredible upside potential. Numerous analysts are expecting coffee prices to continue to rise from expectations that the inventories will be lower in 2008. In January 2008, coffee rose to a two-week high as reports that inventories were dropping in Europe and the United States. This year is anticipated to have declining supplies combined with record low carry-over stocks. The demand for coffee is strong as countless investors are purchasing commodities as protection against rising consumer prices. There have also been reports that coffee stockpiles in five warehouses monitored by ICE Futures have dropped 2 % this year. There is also speculation that that the dry weather that Brazil had in July through October 2007, had delayed flowering in Brazil.
Investors and roasters are currently intensifying the need for the soft commodity. The global consumption of Arabica coffee beans is expected to progress about 3.4 % for this trading year. Ralph Hawes, a market analyst in a London-based firm stated, “Speculative demand was joined by light industry buying from a continuous flow. Given the enthusiasm from funds, they at least will be pressing for yet higher levels given the chance.'' We could see some of the lowest coffee stockpiles in 2008. In the 2006-2007 season there was a surplus of 4.6 million bags. Barclays is estimating that this figure could shrink to 0.4 million bags this year. Anytime we couple lower supply with increasing demand, we look for prices to rise considerably. One analyst notes, “Coffee production is strong. Usage is stronger.” We see the current market condition as possessing a great potential buying opportunity.
Another factor that is contributing to rising coffee prices is the week U.S. dollar. The dollar's slump has greatly enhanced the appeal of commodities as a hedge against inflation. In addition, the falling dollar makes raw materials priced in U.S. currency cheaper for buyers holding other currencies. In a soft commodity conference in Dubai, Jean-Pierre Jentile, the soft commodities director of Societe Generale Bank, said positive comments about the soft markets. He stated, “If we have an economic slowdown, commodities across the board are perceived as having a safe-haven value. We’ll see more and more capital going into these markets.” Within the agricultural sector of commodities, Jentile projects the most substantial gains to be in coffee, cocoa, grains and soybeans. “Coffee and cocoa may gain as much as 10 % this year,” he stated. Most agree that the situation with the dollar will get worse before it gets better. The forces behind the dollar’s weakening have been building for years and could continue to be a large contributor to the bullish trend in commodity markets like coffee.
Technical Indicators:
Along with the mounting fundamentals conditions that may lead to higher coffee prices, there are four major technical indicators that forecast higher prices as well.
The first technical indication is the emergence of an ascending triangle. As seen in figure 1.0, coffee prices have been trending higher since 2002. Shortly after the start of 2005 coffee prices soared to a multi-year high of approximately $1.37 per pound, only to retrace back below $1.00. Since 2005 coffee prices have not had the momentum to break above the former high, but what is so significant is the fact that coffee continues to make higher lows. These higher lows are creating the ascending triangle formation. An ascending triangle formation is classified as a continuation pattern which implies that coffee will continue on its trend started in 2002 and may even gain the momentum to reach $2.00 a pound!
The second technical indicator pointing to higher coffee prices is the Moving Average Convergence/Divergence (MACD). Looking at figure 1.0, the MACD’s short term moving average has crossed over the longer term moving average. This implies that market may be making break out to the upside. What is also important to notice is the increase in the oscillators. The oscillator measure momentum and momentum is exactly what we want to see for the coffee market.
The Third and final technical indicator pointing to higher coffee prices is a 55 day moving average. Moving averages can help a trader identify trends in a market. In this case, figure 1.0 has a 55 day moving average (solid blue line) that is below the price of the commodity. Meaning, the last 55 days, the coffee market has been increasing in value.
Figure1.0
The Trade
Now that we have complied fundamental and technical data that in my opinion point to higher prices, the next step is to formulate a trading strategy and plan. For an options trader there are several strategies to choose from, each giving the trader a distinct advantage. I believe given the nature of coffee, a bull call spread will work most effectively. The benefit of using a bull call spread in this case is the fact that we will have limited risk exposure to market. The second benefit is that time decay can affect spreads at slower pace as apposed to simple long options.
It is important to remember that not all trades are successful. In fact, the reality is that a trader is more likely to be wrong then right. So, risk management and a back up plan is imperative. If over the next few weeks coffee can not make a clear break through its resistance level of $1.38, it may be advantageous to purchase an out-of-the-money put for protection or profit.
Trade Recommendation:
July Coffee Bull Call Spread
Buy 160 call and Sell 180 call for 300 points
Cost: $ 1,125 + commissions
Profit Potential: $ 6,375 - commissions
Total Risk: $ 1,125 + commissions
The writing is on the wall, and experts agree that coffee prices are moving higher. Based on history, there is still a tremendous amount of upside potential in coffee. For investors who desire to capitalize on undervalued markets, I believe now would be a great time to start accumulation long positions in market that maybe remembered as the “hot” coffee market of 2008!
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