Dropping Off The Table

I can't think of another Macro Economic topic which affects our industry, from grower to consumer, more than the Commodity Price for coffee. I blogged earlier this year in support of the possibility that prices still had room to move up, and listed many reasons I believed contributed to increased prices. I feel that we touched the top of the market last week and that we will see a weakening of prices throughout the year. As part of an ongoing series of personal opinions and observations I want to express my belief that coffee prices are due to fall significantly this year for the following reasons.

1. The market price for coffee is to be viewed within the context of commodities in general. Commodities are an investment class which has been on a Bull Run for several years due in large part to the low returns to be had in bonds and notes and the devastation of the equity markets beginning in 2008. Commodities have attracted huge sums of speculative investors employing permissive leverage ratios to force the market up. Recently exchanges have increased the capital requirements for leveraged accounts, which will reduce the participation, thereby reducing the liquidity in the markets. Reduced liquidity means lower prices. The other thing about leverage is that while it is very lucrative in a contango market, when things go backwards, margin calls come in which necessitates selling. The more the price drops, the more margin calls, the more the price drops, the more margin calls...

2. Reports have been surfacing of brokers and exporters hoarding coffee at origin in an effort to keep prices high. While it is impossible to determine how much coffee is being hoarded, what I can predict is that when the hoarders start selling, they will all sell. More sellers than buyers moves the price down at an accelerated rate which feeds developing panic should things turn bad.

3. I perceive a disconnect between a natural price for Commodity Coffee, and the current price. Those of us who've been around the block a few times remember the spikes and valleys, but through the process gain an understanding of what price is a fair representation of the value of commodity coffee. That fair value is not $0.45 or $3.05, but somewhere in between. My guess, and it is a guess, is that an equilibrium price for coffee is approximately $2.00 per pound. In my view, this is not so high as to encourage new and inefficient participation, but not so low as to discourage participation. We can all find a price that feels right to them, but to me $3.05 is not it.

4. As I've blogged about in the past, the relative weakness of the US Dollar is responsible for at least 30% of the current "C" price. If the USD shows any real strength, (not a spike resulting from a flee from the euro) the commodities will drop very quickly. The USD has been weak since the government began printing money in an effort to provide needed liquidity once the credit markets seized. We already know the program referred to as Quantitative Easing will end in June of this year, reducing the money supply. When a government reduces the amount of currency circulating, the value of that currency rises, which is a bad thing for commodities. Also, North America currently has very low interest rates set by each government as a "Key Interest Rate". Those rates are one tool the Federal Reserve or in the case of Canada, the Bank of Canada, control economic activity. If the rates are low the Reserve thinks it needs to encourage economic activity. Moving the rates higher is a sign that activity is picking up and the Reserve needs to control activity by making it more expensive to finance things. The rates also are reflected in the Bonds issued by each government. When interest rates increase, the attractiveness of American Bonds increases making the USD rise. This is of course a very different situation from some Euro Countries that need to raise bond rates to encourage someone to buy them accounting for the risk of default. If the US Dollar index moves into more historical range as a result of any of these factors, the price for coffee will drop to close to the $2 level.

5. I may be wrong, but I think the market participation of the BRIC countries is overstated. Brazil, Russia, India and China are not doubt huge markets, but while they will need rare earths, raw materials and fuel to grow, coffee will need to destroy well entrenched cultural preferences to gain any traction. I understand that Brazil has made great efforts to increase coffee consumption which is intended to support a domestic industry, but there will be no similar efforts on the part Russia, India and China to alter beverage habits of their citizens. When markets like coffee increase unexpectedly it is easy to point the finger at the huge populations across the Pacific Ocean and expect the general public to accept it as plausible. I just don't believe it.

6. Coffee right now is not a good buy, it's a good trade. For the vast majority of participants buying a contract is a trade they expect to sell before taking delivery. In some particularly volatile sessions, traders hold a contract for less than an hour, and in some cases less than 5 minutes. These are the individuals setting the price, and when they feel the better trade is to short the market, that's the way it will move. Reduced liquidity resulting from margin calls will feed the fire.

For these reasons I think we can expect the "C" to find a level somewhere near $2 by the end of the year except in the case of unforeseen weather events. Time will tell if I'm right, but my feeling is when it starts to move down, it will drop off the table.