Cert Stock Horror Show-Case Study of 1996

Halloween is coming this month, and in keeping with the spooky traditions of this month I want to share a number with all of my #coffee friends that should send a shiver down your spine. That number is 1.7.

1.7 is the amount of months until #certifiedstocks hit zero using the past month’s rate of drawdown.

As always, I try to share a balanced view, and there are some rays of sunshine in this story, but I think that all of us in the #coffeemarket need to be aware of just what is the potential here.

In this brief article, I am going to talk about what can potentially happen if the market hits below 100k bags, what is the current trend, and what may derail that trend.

Last Time

The last time that cert stocks were below 100k bags was over a three-year period from Feb 1996 until Feb 1999. During that period the market was a very different place because Brazil was not part of the ICE “C” contract (the “C” stood for “Centrals” as in “Central American Coffee”).

This lack of a washed #Brazil in the old contract is important because it meant that there were two competing S&D’s: the global #SnD of #Arabica which used the C market to hedge (to include Brazil), and the S&D of #mild coffees eligible for certification (excluded Brazil).

Essentially this means that a heavy Arabica supply (Brazil largest producer) can keep prices depressed from hedging pressure even if mild coffees were in limited supply. However, this was only true to a point.

Brazil hedging in the futures market pushed futures prices down below the value of a mild coffee. Since futures prices of a mild contract can be redeemed for mild coffee, the cheap futures prices were used to take delivery of mild coffees.

This phenomenon led to a draw down in certified coffee in the 1990s.

Think of it like this, if a mild coffee from origin costs 150c, and a future costs 130c, then traders will buy the future and hold it until delivery, thus buying coffee at a 20c discount. On top of this, holders of certified mild coffees would not simply sit on certified inventory if it was selling for a higher price in the physical market. These mild, certified coffees were being decertified, sold and consumed.

Now I mentioned that this only happens to a point. That point is when these coffees run out.

The hedgers of Brazilian naturals could not tender the Brazilian naturals against the futures. That means that they needed to lift their hedge (buy) before First Notice Day or roll it forward.

This rolling of hedges (buying the nearby future, selling the further out fu

ture) rallied coffee calendar spreads. From Feb 1996 to Dec 1996, the Z96-H97 Calendar Spread rallied from 0 to +18. During that same period Certified Inventory stayed mostly under 100k bags, hitting lows below 1k bags!

Ultimately rallying spreads were not sufficient to draw in certified inventory and flat prices first went sideways, and then rallied--HARD.

From Jan 1997 to Jun 1997 prices rallied from 116c/lb to 316c/lb in just 6 months.

This rally ended up being short lived, because Brazil’s biannual cycle kicked in to record highs in 1997 along with renewed production from the Mild producers. This included good production from Colombia and the Central American origins as well, which facilitated the falling of prices and the return of coffees to the exchange to take advantage of high terminal prices while they lasted.

The lack of washed Brazils in the certified contract last time around meant that there was a buffer between certified inventory and the world’s largest producer. This translated into futures prices that stayed fairly low from hedging pressure while certified inventories were at critical levels.

This Time

This time around, certs are once again approaching critical levels, but the exchange now accepts washed Brazilian coffee. This addition of Brazil to the contract works like an outlet for supply and demand into the futures market.

This works both ways. During the abundance of 20/21 crop year, 1.7 million bags of washed Brazils became certified inventory. During the down year of 21/22, 1.7 million bags of washed coffees were removed from the certified inventory.

Brazil will likely be the savior of the certified inventory in the future…but not this year. After the frost in 21, the 2022 crop was a major disappointment, futures and diffs have both been high, and there is little incentive to certify new coffees. On the contrary, there has been a lot incentive to decertify and consume coffee.

Up to a point.

That point, is when prices become so high as to discourage consumption of certified coffee and to encourage new coffees to be certified.

This bring us to where we are today.

Current trend is 1.7 million bags of decerts over the last year. This works out to 141k bags per month. At the current level of 426,000 bags, this means there are 3 months of stocks left until 0.

However, drawdown has accelerated over the last month, with 246k drawdown in the last 30 days alone. This works out to 1.7 months at this rate, until we have 0 stocks left.

In practice, we are very unlikely to ever hit 0 bags of coffee.

Why? Because in theory, prices should rally high enough to make stop the drawdown and to attract new certified stocks.

This is the risk to prices. Prices are already well above 200 and have been for a year, yet this has not been sufficient to attract new certified inventory nor discourage the drawdown. Calendar spreads have already rallied from +0 to nearly +9c.

So how far will prices have to rally to attract new stock?

Looking Forward

Looking forward we do have a ray of sunshine and a light at the end of the tunnel.

The ray of sunshine in this piece is the coming October crops. We don’t really know how they will impact the certs going forward.

Looking at tenderable parity, it is unlikely that prices will fall enough to make it profitable to deliver to the exchange. However, in the past, it has been rare indeed that prices actually get to tenderable parity but we still see increases in certified inventory. So it is very possible that we see certified stocks increase over the coming months.

Companies do certify coffee for other reasons, most notably to get financing. This is possible going forward and it may alleviate the price situation somewhat. It does not look to me like these coming October crops will resolve the situation though.

The light at the end of the tunnel is the 23/24 Brazil crop. So far (knock on wood), the blooming looks to be progressing well and indications are of an excellent crop. However, the plants did see excessive dryness over the winter that may have caused irreparable damage to the trees.

This is still unknown. Often times some stress to the plant during the dry winter is good for the coming crop, with the coffee plant over producing the next season. However, the stress is only good to a point. We will see if that point has been reached or not with the bean development over the coming months. If we get a disappointing crop in 23/24, we may have a sequel to this scary movie.