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Bad to Worse: Frost Update 7/22/2021

In my post from a few days ago, I said that the extent of the damage was not yet known. In the two days since then, the situation has gone from bad to worse. This is now likely the worst #frost in #Brazil since 1994, and it came at a time when the market cannot afford to lose the #production. Initial estimates from the July 19th/20th frost was 1 - 2 million bags lost. Now, the estimates have more than doubled to 3 - 5 million.


In the paragraphs that follow, I am going to quantify the frost risk and talk about what to expect.




Let's start with the numbers:

This would be bad in a normal year, but this year it is approaching catastrophic. To quantify that word, my price estimate for a catastrophic frost is 95c. Typical frost seasons I use 15% of that as my baseline, and I raise and lower it depending on the forecasts. Even with the early warning that I gave my clients on Monday, I never expected that risk to rise above 30-35%. This morning I raised it to 60%.


In 4 days the market has gone from a low of 155.65 to a high of 195c--that is nearly a 40 c move.



This has caught a lot of us unprepared. I have been hearing frost hype for every year of my career and not once have I seen it more than a "meh." However, frosts like this one are the reason that we have a collective memory to be wary of the season.


Margin Calls:

The fact that this market has caught people off guard has a very important consequence--#MarginCalls. Those of us in the industry know exactly where I'm going with this, but for those who are unaware, #Margin is a good faith deposit of cash that the trader puts in their trading account to cover any adverse price movements.


If their position goes against them, the trader must put more money in to cover the difference in price. If they cannot afford to pay the margin, then their positions are liquidated. What's worse, is that when volatility goes up, the amount of margin required per contract also goes up.



For #producers and the #trade who hold short hedges against long physicals. This means that a rally will have a margin call to put up cash. A BIG rally, will have a BIG margin call. Large companies and #tradehouses have lines of credit that they are given to cover these margin calls, but when those credit limits are reached then this becomes a cost. The #volatility can have career ending and company ending consequences.


Thankfully the #Commercial short position is not massive, but it is still higher than it has been on a seasonal basis over the last 6 years--151,499 lots to be exact. To put that in perspective, if you're a smallish tradehouse with 1,000 lots hedged. You have had your #hedges go against you by 13 million dollars in 3 days (35c x $375 per contract X 1,000 = $13,125,000). That is not a sustainable rate of loss.


Volatility:

The other key factor here is that 10c rallies on a daily basis are also not sustainable. #Volatility to the upside will inevitably become volatility to the downside. Even if all data points are extremely #bullish, if the buying dries up because maximum fear has been reached then there will be rapid declines.


For comparison, look at the bull market from the Brazil #Drought of 2014. There were plenty of bulls who got wiped out by buying at the wrong time.



This become particularly bad when hedgers are forced to liquidate a hedge from a margin call, and then the price collapses shortly after. This can exacerbate the business ruining climate of a dramatic bull market.


Specs:

Last but not least, let us not forget the #specs. This kind of a price movement will attract many a tourist into our little market. The #coffeemarket does not often break $2, but when it does there is a good chance it goes to $3. Many trend followers make good money by simply buying the break out. We should expect that they are in the market already and that they will be adding to positions.



This is on top of a recent clean out in spec long positions. The most recent #COT shows the Spec Long position is lighter than it has been since April so the potential to grow the spec position is very big.


This will exacerbate the volatility in the market as trend followers are fair weather friends (so to speak). If the market goes against them, they will dump their positions and go short without a second thought.


Going Forward:

In the short term, frost season is not over yet. We do still have more potential frosts to deal with and I'm hearing that there is at least one more that could have an impact.


Also in the short term, there is a strong possibility that emotions have overestimated damages right now. There is a strong possibility that tomorrow or even later today, we all say, "my gosh we overreacted." So the downside risk is very much there.


Looking forward to the long-term the real risk is the possibility of a 2 year #deficit. The 21/22 deficit was bad, but stocks were there to cover it and the market anticipated a healthy bumper crop in 22/23 to mitigate that. Now that healthy bumper crop is looking like an "ok" bumper crop at best. There are still a lot of developments between then and now: there's potential to get worse (drought, more frosts, currency moves) and more potential to improve (overestimated damages, improvement in weather, better husbandry).


However, the market needs to price risk, not hope. A large deficit in 22/23 would mean we have to price ration coffee (ie there is not enough to go around so coffee needs to price some consumers out). We are not there yet, we are nowhere near there yet. But we just got a lot closer.


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