Category Archives: Exotics

Paradigm Shift in the Cocoa Futures Market

Cocoa futures are one of the most volatile markets. This has been primarily attributed to three historical variables politics, antiquated farming methods and weather. Two of these three variables are being addressed directly while the third remains a wild card that may pull the trigger on a substantial rally in an agricultural market undergoing a complete paradigm shift.

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 Ouattara’s Presidency can already be seen in the decline of volatility in cocoa prices. Major chocolate producers no longer have to worry about civil war, the government closing ports or henchman attacking farmers on their way to collection stations to force the price higher. The price range in 2012 was $2,003 – $2,707, a measly 35%. The range for 2011 was more than 90%. In fact, the five-year average range is more than 50%. These wild rides are less likely to occur, as weather becomes the only variable left to move the markets.

This sets the stage for the current battle in the market. Cocoa futures have been on a steady slide since fall. The market appeared to be forming a technical bottom during this period. However, it was clear by the commercial selling that the bullish saucer base pattern, between $2,310 and $2,510, that had been supported by the small speculators had little chance of pushing the market higher. The slide through the 2013 price level is primarily attributable to the small speculators being forced out of their long positions at a loss.

The market has recently traded as low as $2,100. Commercial traders have been covering their short hedges and locking in futures supply line purchases since the market first fell through the $2,310 level. Commercial traders have been net buyers in nine out of the last ten weeks. Recently, weather issues have reduced estimates for the current mid crop harvest due to a lack of rain throughout the Ivory Coast as well as growing regions in Ghana, the second largest producer. These two countries account for nearly 60% of the world’s production.

The key price level is $2,000 per ton. The market traded below here once in 2011 and rallied $500 per ton in just a few weeks. Overall, the market hasn’t spent any time below $2,000 per ton since the commodity boom of 2007. We’ll side with the commercial traders and look for buying opportunities as the last of the weak speculators are forced out of the market. Perhaps, the best way not to miss out on the rally is to place a buy stop order above the market’s recent resistance level around $2,150. If this order gets filled in the May cocoa futures contract, place a protective sell stop at what becomes the low price of this move. We’ll look for a minimum price target of $2,310, the bottom of the old saucer formation.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Shifting Sentiment in the Sugar Market

 

We’ve spoken repeatedly about the value of food commodities
throughout this year. However, the sugar market supply will most likely outpace
demand this year. The sugar market is quickly replenished with multiple
harvests per year. The quick growth cycle combined with more normal weather
patterns in the primary producing regions should see this year’s crop make up
for the last two years of deficit production.

The sugar market was 2010’s most volatile market on a
percentage basis. Using the stock market and gold as a comparison, gold would
have had to reach $3,300 per ounce to match sugar’s rally for the year and the
Dow Jones Industrial Average would have had to fall to 4172 to match sugar’s
decline. Given this type of volatility it’s easy to see why we look to the
commercial traders’ actions to establish a sense of value in the markets. These
are the traders who focus solely on their market and build their business plans
around their ability produce sugar or, turn it into a finished product.

Commercial sugar traders have been exceptionally good at picking
out the major turns in this market and thanks to the Commitment of TradersReports, their actions are easy to trace. Commercial traders were active buyers
as the market traded down to $.20 cents per pound in early May. Since then, the
market has rallied more than 50% to over $.30 cents per pound. Remember, we
said sugar is a volatile market. This move higher has been fueled by two
factors. First of all, the refining margins on raw sugar have been
exceptionally high. This brought in quite a bit of recent demand but will
subside as the spread between raw and refined sugar narrows due to increased
production. Secondly, there has been significant speculative money put to work
on the long side of the market with investment coming from small traders, funds
and managed money.

The rally in sugar may be running its course as the spread
between raw and refined sugar tightens and the commercial traders see this
market as more and more overvalued. Through analysis of the weekly COT reports,
we can see that ownership of long positions is shifting from commercial, value
based buying and into the hands of speculative buyers. Last week commercial
traders sold more than 14,000 contracts, which were almost directly bought by
managed money and swap dealers.

The shift to a speculative stance in this market could leave
it vulnerable to a sell off if the fundamentals hold steady. Production in
Brazil, Thailand, Russia, France and India all appear to be near all time
highs. Much of this is due to extra planting based on the high prices received
last year. A rising tide may float all ships but an overloaded one will still
be the first to sink.

 

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Coffee Topping Out?

Traditional agricultural commodity markets have always been subject to supply disruptions. Think about the mid-west flooding of the mid 90’s, mad cow disease, Florida orange crop freezes as well as labor strikes and political coups. Almost two months ago, we talked about trading the coffee market. We noted that the two major growing regions both had weather related problems and that’s what was driving up the price. There’s one other primary reason for commodity market supply shocks and that is the lack of substitute goods.

 

All commodity markets have very specific contract specifications that must be met in order for a producer to deliver their product to the exchange’s warehouses. The coffee market in the U.S., which is the by far the most dominant, accepts delivery on Arabica beans through 19 global warehouses. Arabica beans only make up about one third of the coffee crop and are the source for premium coffee blends. Robusta coffee is much more common. Robusta coffee is used in instant coffee and coffee blends because it grows quicker, is a hardier plant and has high caffeine content.

 

The coffee market has seen supply shortages before. In 1996, total warehouse stocks declined to 321 bags. This meant the New York Board of Trade, now the Intercontinental Exchange, had just over 42,000 pounds of coffee on hand to meet global delivery demands. Consequently, prices shot up to more than $3 per pound at the exchange. By contrast, the current supply, which is down 44% for the year, puts the exchange’s coffee stocks at 1.7 million bags for December. Arabica coffee producers in Brazil and Central America ramped up production in the wake of 96’s shortage. Those trees began to produce around 2000 and the coffee market bottomed in 2002 on the flood of their second harvest.

 

Much of this coffee has been sitting in storage for years and remained in the system through a loophole in which producers would take delivery of their own old stock and then resubmit it for certification. The bags then came in as new stock. Recently, this coffee has been making onto the market. Coffee roasters have taken delivery from the exchange only to find that the beans they bought were unusable. As a direct result of this, the Intercontinental Exchange has rewritten the delivery specification for their coffee contract to protect the integrity of the exchange and in doing so, created an interesting setup for a commodity trade.

 

First of all, they are now penalizing warehouse stocks more than 720 days old. This closes up the delivery and retender loophole. Secondly, they are going to begin accepting robusta coffee beans at a discounted value as deliverable against the Arabica contract. This will open up the delivery ports of the ICE’s 19 world -wide warehouses to a global supply of fresh, deliverable coffee. Furthermore, this develops multiple production centers and weakens Brazil and Central America’s ability to monopolize the prices by controlling more than 50% of global Arabica bean production.

 

Commodity traders will see these changes manifest themselves in increased exchange liquidity, which translates into lower volatility with fewer and milder price spikes. Volatility will also be eased as Brazil continues pour money into the development of its own infrastructure with more than 1 billion dollars currently earmarked specifically for coffee production.

 

When we last talked about coffee, we noted that commercial consumers had been buyers of the market to lock in end line production costs. Trend following commodity index traders as well as small speculative traders have climbed aboard coffee’s upward trend as it has marched to 13- year highs. However, general coffee market sources have priced in a balance of trade ceiling around $2.70 per pound, which is about 15% higher than the current market price. The bearish combination of the exchange’s rewriting of the contract specifications combined with the market nearing its pre-forecasted top leads me to believe that commercial producers will begin selling this market in earnest in order to lock in their forward production at these attractive prices. We will watch this development closely. It has the makings of a bull market climax.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Trading the Coffee Market

Is the price of that morning cup of coffee doing more to wake you up than the coffee itself? Lost among the commodity headlines of gold, silver and oil prices, the price of coffee has risen to a thirteen year high over the last three months. Starbucks, Millstone, Caribou and others have all been forced to raise their prices to account for the increased price of their raw materials and the rise in prices has not been confined to high- end purveyors. Both J.M. Smuckers and Kraft Foods have been forced to raise prices on their Folgers and Maxwell House brands respectively.Currently, McDonalds is the only outlet able to hold their prices steady.

Coffee prices have risen 45% since the beginning of June due to serious production issues in multiple geographic locations. The extended length of the Asian monsoon season has affected the harvest of India, Vietnam and Thailand. These countries are responsible nearly 30% of global coffee production. While an extended rainy season has delayed the Asian crop, Brazil’s has been hampered by lack of rain. Brazil is the world’s largest producer and according to the Brazilian Coffee Council, the drought they’ve suffered through could cut production levels to the lowest output in four years.

The fact that retailers have been able to keep their prices reasonable, raising their prices around 11% on average is a testament to the necessity of the futures markets and their role in the economy. The futures markets were originally designed to allow producers and end line users of commodities to create binding contracts that specified the delivery date, price and quantity of the given commodity. Coffee retailers have been able to stay ahead of the rising prices by hedging their price risk in the coffee futures market. Contracts that were purchased prior to June have the benefit of the stable prices that coffee had been trading at for nearly two years.

Trading agricultural commodities entails an understanding of the price risk associated with each individual market. Broadly speaking supply and demand are the two types of risk that need to be accounted for. Agricultural commodities have a supply risk factor factored in to rising prices. This protects against any setbacks created during the growing season by the weather as well as accounting for any labor unrest during the harvest season. This is exactly the opposite of the risks associated with investing in the stock market. The fear is on the downside and there is a built in risk premium to the downside. The stock market deals with demand based risk.

Commercial traders are made up of two groups, the commodity producers who control the supply of a commodity and the end line consumers who create demand for the given commodity. These two groups are responsible for the battle to create value. When a market gets over valued, commodity producers come into the market and sell the crop they expect to produce within a given time frame. Conversely, when the price of a commodity falls below a perceived fair value, end line consumers like Kraft Foods and J.M. Smuckers will come into the market and stockpile the commodity to meet their future production needs.

This is the battle that’s currently unfolding in the coffee market. Coffee retailers are being forced to pay higher prices to ensure their raw materials for future production while coffee producers are taking advantage of the higher prices to make up for their lack of output. Tracking the movement of commercial trader positions through the commitment of traders report shows that end line consumers were large purchasers of coffee futures beginning at the end of June. We can also see that their buying appears to have peaked in early September. This cycle ensured delivery of the necessary raw materials through the end of the year.

Right now, the producers still have control of the market and we will continue to look for opportunities to buy selloffs in the coffee market. This allows us to put the purchasing power of major retailers behind us as well as the seasonal strength that tends to accompany the coffee market harvest period and into January. Our opinion will change when we begin to see the coffee producers rush to get their future crops sold. Whether the rush comes at higher prices or lower prices isn’t as relevant as the fact that farmers believe they won’t be able to sell their crops at these prices in the near future.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Major Turning Point

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.

Today’s price action appears to have trumped the
deflation/reflation argument that has been building over the last month. Many
of the markets have been rallying on small speculative buying as seen in the portfolio
rebalancing by the major long only funds.

Looking at the Commitment of Traders reports over the last
few weeks, we can see an increase in the net long positions of small
speculators in the following markets:

Swiss Franc, Japanese Yen, Canadian Dollar, Unleaded Gas,
Wheat, Beans, Bean Oil and Meal, Corn, 10yr. Notes, Eurodollars, Live Cattle,
Hogs, Copper, Orange Juice, Coffee, Sugar and Dow Jones futures.

The commercial hedgers have gladly stepped in to take the
short side of these trades with their numbers building as we’ve neared the
October – November resistance in many of these markets. Obviously, the interest
rate sector is the exception, although, there is strong short hedging taking
place at these levels.

There are a few major reasons for the resistance at these
levels. First, the U.S. Dollar Index has a strong bias towards setting a high
or low for the coming year in the first two weeks of January. If the Dollar’s
trend is going to be higher, the global demand for American commodities will
decline. Secondly, portfolio rebalancing by the major index funds for 2009 is
going to balance smaller gold weighting against heavier crude oil weighting.
Today’s collapse in crude oil futures is an indication that they may have filled their
need for crude. This also helps explain Gold’s inability to rally through $900
even on weak U.S. Dollar days. Lastly, the economic numbers continue to get
worse with each release. Last week’s ISM numbers were the worst since 1980.
Unemployment this Friday should continue to rise and eventually head north of
8%.

This is a very brief outline of the weakness I’m expecting
in many markets in the near term. Please call with any questions.