Competing Forces in the Cocoa Market

The cocoa futures market is undergoing a dramatic transformation that is rapidly increasing production stability and supply yet, the market is at its highest prices since July of 2011. The market is currently caught between the pressures of efficiency driving the market lower over the long-term and short-term demand doing its best to buck this trend. These are exactly the types of scenarios that create trading opportunities for the commercial traders we follow. Their outlooks and bank accounts are skewed toward long-term corporate growth which allows them to focus on value principles that will remain intact for prolonged periods rather than tuning their operations strictly to the whims and trends of personal sense gratification.

The Ivory Coast is the world’s largest producer of cocoa. Prior to 2011 it was presided over by Laurent Gbagbo who ran the country in typical West African fashion for more than 10 years. The open elections of 2011 led to a brief civil war when Alassane Ouattara was elected President and Laurent Gbagbo refused to cede the Presidential office and used his cronies in the military to hold off the inevitable. The regime change was inevitable because Ouattara, who is a former International Monetary Fund (IMF) economist, has the full support of NATO as well as the military backing to support a more democratic and transparent government. The installation of Ouattara should eliminate much of the political volatility that has been a hallmark of the cocoa futures market for many years.

President Ouattara, who was educated here in the U.S. at Drexel University, is quickly modernizing the Ivory Coast’s cocoa markets. There’s been rapid development in soil reclamation, fertilization and education. Most cocoa is grown by individual farmers on small plots of land and is harvested by hand as it has been for hundreds of years. The application of modern agronomy techniques will cause the Ivory Coast’s cocoa production to increase rapidly over the coming years. The combination of infrastructure improvement and political stability supporting free trade and as well as modern farming practices will increase yield and depress prices once the changes are fully implemented.

The effects of these changes are already reflected in the magnitude of their success. Nestle and Mars have joined the World Cocoa Foundation’s “Cocoa Action” campaign along with firms like Cargill to double production by 2020 in the Ivory Coast and Ghana. Last year, the Ivory Coast had a record cocoa harvest and is likely to exceed last year’s production again this year. Back to back record crops on higher yields are direct physical evidence of the impact these changes are making and will continue to make into the future. These gains will progress along the normal limit approaching zero (asymptotic) curve as the easier gains are taken off the table and continued progress becomes harder to achieve. In the meantime, cocoa supplies will continue to grow in both size and yield.

Meanwhile, growing Asian demand has outstripped current supplies. While production is up over 7% year over year, demand is up more than 10%. Most of this is tied directly to India, China and Russia. Commercial cocoa processors saw the growth in demand coming and were huge buyers under $2,200 per ton in both 2012 and 2013. In fact their purchases in 2012 were the strongest since May of 2004. Cocoa processors clearly put a floor in prices around $1,400 and now, $2,200 per ton. Finally, we suggested in April with, “Cocoa Prices Set to Surge” it was clear that their purchases between February and March would push the market higher as they took supply off the table.

This brings us to the current trade. Commercial traders are selling into this rally just as hedge funds are increasing their bets on further price increases in the cocoa futures market. Hedge funds are not subjected to the same cash flow constraints of an operating business. Commercial traders manage the ebb and flow of their business based on input prices and storage capacity and associated fees versus their production timeline. Commercial traders are becoming wary of the market at these levels at this time. We believe that siding with the economic force of modern production efficiencies in agronomy and selling cocoa at these elevated prices is a better short to medium term outlook than placing new money to work on the long side of the market at the current multi-year highs.

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