However, we are now beginning to see the first signs of how this inversion could break, facilitated by the inversion itself.
In this article, I will discuss in detail how the current fall in diffs is related to the gradual change in trade posture. I will also point out how this could be the first signs of a change in market dynamics that has the potential to alleviate the current delicate situation in which certified stocks find themselves.
“The cure for high prices, is high prices.” This is a common mantra repeated by commodity traders for a reason: it’s true.
Let’s see how it works.
The high diffs have been a decisive factor for the aggressive drop that we have seen in the ICE-NY stock levels throughout this year. This is because in the face of such high physical prices, traders saw a clear advantage in consuming stock held on the exchange.
In other words, if buying physical semi-washed Brazil coffee costs 9 over the market plus 12c of transportation costs, that is effectively +21c. By contrast, if you take delivery of certified coffee, you get past crop Brazil's at level money plus the aging discount.
At the same time, with high differentials, there is no economic attractiveness in delivering new coffees to the exchange. It's much more attractive to just sell the coffee outright!
The combination of these two factors was responsible for the drawdown in certified stock from 1.1m bags to the current ~415k levels over the last 6 months.
This dynamic is primarily bullish for the market, and especially the calendar spreads. Certs dropped as buyers took delivery and with no sellers of futures willing to tender coffees the front month calendar spread has inverted and continued rallying.
The market “speaks” to us in a way. When the calendar spreads invert, the market is saying, “we need coffee right now, we don’t need it later. Deliver it now.”
If you need to buy coffee in an inverted market, but can wait, you will buy further down the curve (i.e. later) where it is cheaper, and if you need to sell coffee you will sell it in the spot month ("now”). This normally pushes down the inversion back into carry, unless there is a true shortage.
This dynamic also applies to hedges. When the market is inverted, exporters who are hedged (long physical and short the futures) will be encouraged to sell right now rather than later. Let’s say the front month is inverted by 10c, in order to maintain their hedges, commercials will have to pay 10c just to hold the coffee!
Thus any sane commercial seller would offer a 10c discount on their nearby sales to avoid the roll. This is exactly what is happening, differentials in Brazil are under pressure as exporters try to avoid paying the cost of carrying coffee in an inverted market.
As of last week we saw some semi-washed Brazil coffees being offered at a discount to futures. However, reports also indicate that little business is being done.
If importers are not buying the coffee, and the inversions continue to rise then eventually the exporter will simply ship to the exchange and certify. No roll needed, no sale needed, and now you have new certified inventory.
This will have a knock-off effect on the market.
Spec Longs who were expecting to roll their coffee and collect a premium (inverted market), now start to see these premiums compress into roll period. The premiums are compressing because shorts are not buying back their hedges (rolling forward) they are delivering = “here’s your coffee”.
As the inversion comes down and moves back into carry these specs will no longer be “paid” to hold long positions. Now they will have to pay money for the privilege to hold long positions. If the market is not rallying on flat price, this turns longs into a losing position and the specs liquidate.
The compressing differentials will also signal that it is far less attractive to take delivery of certified coffee. Why buy old, certified coffee when you can buy fresh, new crop coffee cheaper?
Additionally, Brazilian coffees will face competition from new crop October coffees. This is already starting to happen with compressing differentials in Colombia. Whether the other origins follow suit, and whether coffees get cheap enough to actually start delivering to the exchange is another story.
However, ultimately this is the dynamic that will break the inversion.
In summary, compressing Brazil differentials are the first signs of a transition from a largely bullish Fundamentals scenario towards a more mixed and less risky scenario.
Transportation costs are still high (although they are coming way down). So it is not yet profitable to ship coffee to the exchange. However, the trend is shifting in that direction at the moment.
There is still disagreement as to the availability of Brazilian coffee this year. With most agreeing it was a disastrous crop. If differentials return to the highs, then this dynamic will shift the other way and we could start trending towards zero certs again.
Considering that over 60% of certs is made up of Brazilians, and considering that the Brazil diffs took a major hit in the latest 2 months (with naturals showing a big discount against future prices), it's reasonable to assume that there is less risk of certs drawing to the point of nearing zero and rallying KC into the 300’s.
Tenderable parity is not nearly as far away as it was a few months ago. Also, over the last 7 sessions, certs have stagnated and refuse to continue lowering. We remain on high alert to the fact that cert reductions can continue. We will definitely be looking to the certified inventory to confirm if the diffs will really be effective in mitigating the appetite for exchange coffee.
All this said, liquidity in the physical Brazilian domestic market has been quite weak recently. Commercials are reluctant to take on positions under such a volatile market with expensive cost of carry. The coffee market has been presenting high volatility, without a defined direction for months.
The interpretation is that the trade is not under pressure to buy and the producer is hesitant to sell.
While we cannot overstate the risk that the low ICE-NY exchange stock still presents to the market, differentials have been coming down across the board, and especially rapidly in Brazil. We don't know how low they will go, nor how long this trend will hold, but the economic viability of certifying new coffees seems to be getting closer.