Yesterday, #Arabica #certifiedstocks dropped an impressive 70k and the #calendarspreads are going bananas. Calendar spreads in Arabica #coffeemarket are notoriously boring (unlike #Robusta), and yet this year spreads have been ANYTHING BUT BORING. #Spec interest in the spreads has driven a lot of the #bullish #price action there but this has been instigated by some very real #fundamental concerns.
The short answer to why spreads are rallying is that calendar spreads are known for being a fundamental #trade, and the fundamentals are strong. However, there is a lot more to the story here. Let’s begin by examining what the calendar spreads are, and that should help to explain why they reflect fundamentals.
What are Calendar Spreads?
To understand Calendar spreads, we have to understand #futures.
Traders can buy and sell commodities “forward” (forward in time, in the future) but in order to enable this flow of goods (without taking price risk) traders #hedge these #forward trades with corresponding futures months.
These futures months have a natural “curve” to them that increases with time to account for the price of holding coffee and carrying it forward. This naturally occurring progression of increasing futures prices is called “#contango” or “#continuation” and is generally considered a little #bearish.
Think of it like this:
If a roaster asks a trader to sell them coffee right now, the trader would quote them the spot (present moment) price.
If the roaster asks the trader to sell them the coffee in 6 months, the trader would charge them the spot price, plus 6 months of “carry” costs (warehousing, financing, insurance, etc).
This difference in prices between the futures contracts generally reflects those carry costs.
However, if there is increased demand for one particular period in time, then that futures contract will rise in value relative to the others. Since this is contrary to the normal structure of calendar spreads, this is referred to as “backwardation” or “inversion.”
Trade houses keep close watch on the difference between the futures months because it has a financial impact on their business of trading hedged coffee. This difference between any two futures months is called a “calendar spread” or “switch”.
A calendar spread can be traded indirectly on the exchange by buying one futures contract and selling another futures contract from another month (called “legging” into a position), or they can also be traded directly on the exchange as its own derivative. Either way, the net effect in the trader’s futures account is to acquire two opposing (long and short) futures in different months.
Calendar spreads are an essential part of futures trading because futures contracts expire. If an individual trader wants to maintain their position past expiration, they must “roll” their contract forward.
As an example, if a trader has a short hedge approaching expiry in March, they can roll their hedge forward into a May position by “buying the switch” or “buying the calendar spread” (buying the H future and selling the K future). This has the effect of transferring their short hedge to the next calendar month, but the cost of doing it is the price of the calendar spread.
Why do Calendar Spreads reflect the fundamentals better than outright futures?
You may have heard that calendar spreads reflect the fundamentals better than the futures themselves. This is repeated for a fairly simple reason: when we offset two futures months against each other, we are removing a lot of the market noise and isolating supply and demand factors.
Let's consider the "noise" for a second. Many different factors influence futures prices.
Those of us in the coffee world are constantly watching currencies, for example, especially the Brazilian Real. We also need to be mindful of inflation, and macroeconomic commodity trends that lift the prices of all commodities regardless of fundamentals.
Technical analysis and momentum indicators also can be drivers of price in the futures markets for many commodities. However, these tend to give the same signals across the futures curve since the futures months largely move in tandem.
However, since macro and technical factors tend to affect all futures months concurrently, spread trading (buy one futures month and sell another futures month against it) eliminates this extraneous price movement. What we are left with, is the individual S&D factors for this particular time periods.
Because we are eliminating a lot of the noise, calendar spreads tend to be much less volatile than individual futures months. This makes calendar spreads an ideal trading vehicle for specs, hedge funds and prop desks that focus on fundamental analysis because they can increase their leverage while keeping low volatility.
How does the Certified Inventory affect Calendar spreads?
The key reason that the futures price reflect the price of actual physical coffee beans is because of certified inventory. Certified inventory is an arbitrage vehicle that allows physical traders to bring down the futures price if it is overvalued vs physical coffee or bring the futures price up if it is undervalued vs physical coffee.
This process is called “convergence” and it is where the price of the physical converges with the price of the futures during the delivery period.
Because of convergence, when there is an abundance of certified inventory in the present, sellers compete with each other and push the price of the front (spot) futures month down. This front month selling continues until the difference between the front month and the next forward futures contract are paying full carry expenses.
Once this equilibrium price is reached, sellers are lured away from the front month and will sell their coffee forward because it is now functionally paying the same price as the present month. This dynamic pushes the curve into a continuation curve.
However, this dynamic changes when demand is stronger than the available supply. During periods of tightness, buyers bid up the front month of the futures curve to encourage owners of coffee to sell coffee now for use in the physical market (decertifying coffee). This front month buying pushes the calendar spread into inversion.
Thus it's not exactly that certified inventory drives spread prices, certified inventory is really the meeting point of the S&D equation. When prices are high, the market is trying to attract supply and discourage consumption. When prices are low the market is trying to stimulate consumption and discourage production.
When looking at the certified inventory, we observe the trend and anticipate periods of tight or loose balance sheets.
Why are spreads rallying now?
Currently, the global coffee market is in a period of deficit, and potentially back-to-back deficits if the Brazilian coffee crop is as bad as many are predicting. Arabica prices are rallying to encourage supply/discourage demand and this is being facilitated by the speculator.
However, since prices are rallying in the futures markets and the differential (hedged) markets, consumers are looking everywhere for any cheap coffee they can find to offset these costs. This includes going to the certified inventory and decertifying coffee for consumption.
Another phenomenon is also contributing to the drawdown: #logistical problems. Certified inventory is stored in destination markets, not in origin producing countries. The Baltic freight index has rallied dramatically since the start of the global #COVID crisis. This is one of the most visible signs of the staggering increase in shipping costs.
The increased costs of shipping coffee from origin makes the coffee sitting in destination markets (including certified inventory) cheaper by comparison. This is encouraging consumers to buy and consume certified inventory.
As if this weren’t enough, shipping is not only more expensive, it is also less reliable and backlogged. A slew of missed, delayed and canceled shipments has forced roasters to cover their needs locally in the spot markets. Traders are decertifying coffee to meet this demand.
However, there is a disconnect here.
Looking at the 5-year chart of certified inventory, we are not yet below the levels where the Arabica certified inventory was in late 2020. At that time, the spreads were in carry and the coffee market was a 100 cents cheaper. What’s different now?
In Dec of 2020 the market was talking about a new phenomenon: the largest delivery of washed Brazilian coffee to the certified inventory that the market has ever seen. This ended up happening and exceeded pretty much everyone’s expectations. Over 1 million bags of washed Brazilian coffee were tendered when initial expectations were for 500-700k. This practically doubled the certified inventory.
Fast forward to today, and we have drawn down practically all of that amount at a dramatic rate that shows no signs of slowing. Brazil was supposed to have a bumper crop this year, but the drought, and later the frost has turned the bumper crop into a disappointment.
The certified inventory looks set to drop below 1 million bags and it doesn’t look like we can count on Brazil to fill the gap.
There should be two questions on every coffee trader’s mind right now:
1) which origin is now going to resupply the certified inventory?
2) what price will coffee have to go to draw out that coffee?
Specs are engaging with the spreads right now in a dramatic way. Recall that we mentioned earlier that calendar spreads are an ideal way for speculators to put on large positions because of the reduced volatility in calendar spreads. The Managed Money Net position is very high and the spec is very engaged.
Spreads are not rallying merely from the fundamentals, they are rallying because there is reduced liquidity in these months from lack of hedging and an increased interest from the spec. This is a powerful combination in the back months. However, looking at the front months, we can see that this bullishness isn’t necessarily warranted in the present.
Finally, I will conclude with an observation. Markets are forward looking. The specs understand this, and they are engaged in the calendar spread price action across the curve.
If the market is unable to supply the necessary coffee to the certified inventory, the spec will do very, very, well (I should say, “continue to do well”) as the consumers are forced to price ration coffee in the present. However, this is a precarious position.
The speculator does not have his/her position on as a hedge which means they are vulnerable to moves in price. If the markets do see a supply of coffee on the horizon this will trigger origins to sell coffee while prices are high and the specs will be falling over themselves to get out of low liquidity cover months. This has happened in the past (2014) and it can happen again.
That said, let’s not get ahead of ourselves. For now, the market needs to find coffee to meet demand and an inverted futures curve is the markets way of doing just that.