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Breaking the Robusta Inversion

Updated: Feb 10, 2022

#Tradehouses have shipped at least 18,000 MT of #Robusta from #Indonesia and #Vietnam to #Europe in the month of January and there are more shipments on the way. These shipments are notable for 2 very specific reasons:

1) these were shipped “break bulk” ie without containers,

2) reports indicate that some (not all) undisclosed portion of these are intended to be certified. The net effect of this news is a collapse in the front month robusta #spreads.

This is potentially a game changer in #coffee--at least for Robusta spreads, but there are still a lot mitigating factors.

In this article, we are going to look at why the spreads are inverted, why that matters to the #trade, and what impact certifying will have on the #coffeemarket.

Why Spreads are Inverted?

Calendar spreads are a trade that reflects a long and a short future of different calendar months. The price of a calendar spread is expressed as the differential reflecting the difference between the present value of these two futures contracts. The natural order of calendar spreads are a negative price reflecting the increased costs of “carrying” coffee in a warehouse.

Calendar spreads “invert” when the demand for nearby coffee outpaces the costs of holding coffee. An inverted market is expressed as a positive price. This is relatively unusual in most markets, and it is unequivocally bullish. The market is telling us that buyers are willing to pay a premium for coffee right now.

This is exactly the case right now in both coffee markets. Arabica and Robusta are both inverted. This is very rare in Arabica, and less rare in Robusta. However, its no wonder that both markets are inverted, Arabica certified inventory (the deliverable quantities of coffee that can be exchanged for a futures contract) is at a 20 year low. Robusta certified inventory also low—near the bottom of its 5-year range.

Why this Matters to the Trade?

An inverted market is great for long specs, and terrible for the hedged trade. The reason that it is good for specs and bad for the trade is the same: because futures contracts expire.

If a spec holds a long contract that is about to expire, and they want to maintain the long, then they roll it forward (sell the expiring contract, and buy the next contract).

This is a calendar spread trade.

In an inverted market, the long holder sells the nearby expensive contract, and buys back the cheaper forward month. Thus, just by maintaining their long position, the spec receives cash deposits in their account.

The trade by contrast is short futures. They purchase physical inventory, hedge it with futures, and sell it to roasters. Every time that they roll their hedge (short future) forward, they must buy the future expensive in the nearby month and sell it cheaper in the further out month. They are functionally paying a fee to hold their hedged coffee.

The message of low stocks and inverted spreads is clear: deliver coffee.

How does Certifying Matter?

We said that an inverted market essentially charges the trade a fee to hold their coffee. There is, however, a way to avoid paying this fee. Remember that a future is exchangeable for physicals. Therefore, if a trader is holding a short future against a long physical, they can simply hold that short until expiry and deliver the physical.

The spec, by contrast, does not usually have this option. Most specs can’t simply accept physicals and store the coffee in their garage. Unlike the trade, the spec must sell their future before delivery period. If the trade holds large quantities of certified coffee, now they have the upper hand. They will simply refuse to roll their coffee until the price is in their favor. Meanwhile the specs will be competing with each other to sell out their contracts…otherwise the exchange will be calling them up and asking where they want the 37,500lbs of coffee that they ordered.

This is how the market incentivizes the production and certification of coffee. Therefore deliveries of fresh coffee to be certified are exactly what the doctor (ie the market) ordered.

If there is no coffee available to be delivered, then the trade won’t be able to use this option. They either have to hold unhedged coffee or pay the fee to roll their hedges. Unfortunately for the trade, this seems to be the case in the Arabica market.

The market is rallying until we can reach a price where it makes sense to deliver coffee to the exchange.

The robusta market is different though. The price of Arabica has pulled up the Robusta market and Vietnam, Indonesia, and Brazil all had decent crops. With the good crops and high terminal markets we can see differentials (physical cash prices) drop. This provides an opportunity to take some of the new crop to certify and deliver to take some of the sting off these calendar spreads.

It appears to be working. Take a look at the front month RCH/K spread since January. It has dropped $50 and even with the Robust market rallying $30 and the Arabica market up 10c, the spreads is down $4 today.

What’s Next?

Despite this impressive news, let’s take a deep breath here.

We mentioned the break bulk shipping in the first paragraph. It is great that the trade is innovating and figuring out new was of shipping coffee to deal with this unprecedented pandemic-inspired container shortage. However, there is no end to the shipping problems in sight here. Forecasts expect high shipping prices through 2022.

If anything, the breakbulk shipping is indicative of the desperation of the problems being faced in the industry right now. Coffee isn’t shipped breakbulk for a reason, containers are preferable.

Moreover, just because coffee will be certified, doesn’t mean it won’t be consumed. It's great that Vietnam and Indonesia are shipping coffee. Farmers grew it, consumers bought it, that’s what coffee is for. However, the high logistical costs suggest that there will still be a demand for spot coffees.

The problem is not solved, just because we ship 18k MT of coffee one month. If this were delivered today, it would only bring the Robusta certified inventory to 110k MT. Not exactly an all-time high.

However, this is a step in the right direction.

The function of high prices is to ration demand and to attract supply. The current inversion is incentivizing the trade to find coffee and to deliver it. We should expect that to continue in Robusta for as long as it is economically viable. In Arabica, for better or for worse, we are still waiting to find a price where this makes sense.

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