Everyday I send out a #certifiedstocks #report to my free and premium subscribers because it is one of the most relevant and useful benchmarks for the #coffee industry to “calibrate” to. Yet one of most common questions that we receive is for clarification on the #certstocks.
“Why should we care about the certified stocks?”
To be fair, there are several important and not well understood facets to this report. In this article we will outline what this report shows and how to interpret the data, and we will close with an update on what is happening in the cert stocks right now.
The Role of Certified Inventory and Futures
When we trade #coffeefutures, or any #commodityfutures, there is an expectation that the #futures prices reflect and correlate with the price of the physical #commodity. If this correlation did not exist, the futures market would be worthless as a tool to hedge and the commercials would cease their trade in it.
The Certified Inventory (“Cert Stocks”) are the reason that this correlation exists.
The futures market is essentially a standardized forward contract. In other words, each future is a promise to deliver or accept delivery of coffee in exchange for USD, priced in cents per lb.
In a normal bilateral forward contract between two parties, the grade of coffee is careful articulated in the contract and confirmed with samples ahead of time. This process of grading, sampling and delivery often takes weeks and months and is not possible in the fast electronic trading of the futures market.
To facilitate rapid, confident transactions the futures contract only accepts standardized lots of coffee that have been inspected, graded and “certified” by the exchange. These lots of coffee are “certified inventory.”
How Certs Influence the Futures Market
The certified inventory ensures that the correlation between physical coffee prices and futures prices is not a theoretical exercise, but rather direct match during notice period.
Every futures contract expires during its respective delivery month, and just before expiry is the “notice period.” During Notice Period any trader still holding a long future can be “assigned” an actual lot of certified coffee and will be liable for the full price of the futures contract (37,500 lbs times the futures price). Any short holder of futures can “tender” a lot of certified inventory in lieu of closing their short position and will be due the full price of the contract.
The futures price will converge with the physical price of coffee during this period as there is an arbitrage opportunity here for savvy traders. If the price of physical coffee is underpriced vs the futures contract, traders will buy the physical coffee and sell the futures. This brings up the price of physicals and lowers the price of futures. If the price of physical coffee is expensive vs the futures contract, traders will buy the futures and accept delivery to sell in the physical markets. This brings up the price of futures and lowers the price of phsycials. This process is called “convergence.”
As we can see from the above process, certified stocks influence the futures market directly as the “supply” in the global supply and demand for coffee. When certified inventory is high, this generally reflects “loose” fundamentals and is bearish for prices, and when inventory is low, it generally reflects “tight” fundamentals and is bullish. There are some exceptions to this rule such as during the ramp up of Washed Brazils in 2020, but it generally holds true.
The global balance of coffee outside of certified inventory (and the expected future balance) also influence coffee prices, but the Certs are in a very real way the realized version of global supply. We can, at times, see disconnects between certified inventory and global supply, particularly in the supply of natural coffee (since certified coffee is only washed). However, with the addition of washed Brazil’s to the contract this closed a large portion of the disconnect since there is a strong correlation between supply of washed Brazilian coffee and the supply of natural Brazilian coffee.
How to Interpret the Certified Inventory
We can see from the above that the cert stocks have a large influence on the futures market, but there are a few key areas that we can look at to gain some insight into the dynamics of the coffee market.
Total Levels and Trend
The first area that we want to look is the total level of coffee in bags. Remember that cert levels have an inverse relationship to price. If stocks are low, that is bullish for the futures market and if it is high it bearish.
Therefore context is important here, we want to look at how the total levels are and then anticipate what the trend is. In many cases, we can tell the trend just by looking at the charts. However, we also want to look at the economics of the physical coffee market to understand why the trend is moving in the direction that it is and forecast whether it will continue or change.
Decerts – “Demand”
Every day our Daily Cert Stocks Report we show how many stocks were decertified. Decerts make up the “demand” portion of the Certified Supply and Demand. Remember that at the end of the day coffee is a perishable food item that is meant to be consumed. Therefore when coffee is decertified, we assume that it is going to be roasted and consumed.
Pending – “Supply”
To add new supply to the certified inventory, that coffee must be graded by the exchange. This does not happen in an instant, it requires sampling, grading and cupping by exchange approved graders for a lot to be approved as certified coffee.
When coffees are submitted to the exchange to be certified, they are reported as “pending” certification. If many coffees are submitted all at once to the exchange this can build up quite a backlog of coffees! These pending stocks are not yet able to be used as certified coffee, but the market is aware of them as potential supply. When these stocks get very large, 100k or more, this can be considered quite bearish.
After pending coffee lots are graded, they come out of pending stocks and are labeled either “Passed” or “Failed.” This can be important to watch, as it gives an indication as to the pass rate of the stocks that are pending.
We saw an example of this just recently, when a large amount of washed Brazilian coffee was submitted to the exchange. The market was closely watching the pass/fail rate to see how viable the large amount of pending stocks would influence the actual levels of supply.
On the second page of my report, I show the locations of where the certified coffee is stored. This is important for 2 main reasons.
First, the potential users of the coffee care about where it is that they will receive coffee if they accept it in exchange for a future (called “stopping” coffee). If coffee is primarily stored in a convenient location for the end-user that will incentivize them to take delivery.
The second reason is just to understand what the certified coffee inventory represents geographically. For example, now the certified inventory is primarily stored in Antwerp. Therefore when we look at the certified inventory, we know that this is more representative of European stocks as opposed to North American.
Similar to location, we can also see what the origins make up the coffee inventory. This gives us quick insight into when the coffees were certified, as those of us who watch the certified stocks keep tabs on which origins are certifying at which time.
The qualities also provide insight to the potential consumers who may find certain qualities more attractive, especially if prices in the physical market are expensive.
There is actually a lot more to the certified inventory then we have outlined here, but the key relationship is to remember that inventory is inversely related to futures market prices. It is important for those of us who participate in or analyze the coffee markets keep track of what inventory levels are. For my subscribers, I keep the headline information that is important as the subject line of the email. This is the easiest way to keep track of it. However, you can always open the email report to get more information or to get some context from the charts.
If you have any other insights that you want to add, feel free to include in the comments below!