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Lay of the Land

#Coffee has confounded both bulls and bears with a sideways movement after one of the most dramatic bull markets in a generation.


Since the initial rally 260c, certified inventory has fallen to 23-year lows and calendar spreads have inverted to levels not seen since the Brazil frosts of the 1990s. So where is coffee headed to from here?



My view is that coffee probably has one more rally left in her, but then she is done, and the bear market will start.


However, price predictions are a bit misleading. Predicting commodity markets with certainty is foolish, markets are complex and there are multiple potential outcomes. Instead, a good analyst discusses probabilities.


In this article, I will discuss describe the lay of the land, how we found ourselves where we are, and also share why I believe that the likely outcome is a rally followed by a sell-off. I will conclude by highlighting what I think are other potential outcomes.




Fundamentals

When evaluating the fundamentals I like to start top to bottom to ensure that we do not lose the forest for the trees, and in coffee, the top of the forest is the annual #Supply and #Demand Balance sheet.


The long-term #fundamentals have the #coffeemarket in a two-year deficit after the surplus of the 2020 crop, and looking forward to a return to surplus in the 23 crop year.




Coffee has a biannual cycle due to the biannual nature of the Brazil crop where the market tends to alternate year of deficit with year of surplus. However, we find ourselves in a scenario of 2 years of deficit because the off-cycle 21 crop in Brazil was devastated by drought and the current on-cycle 22 crop was doubly ravaged by frost and drought.


This has crushed global supply and ignited coffee prices to 200c and beyond.




Destination inventories in Europe, the USA and Japan all saw massive drawdowns, not only from the deficits but also from covid-induced lockdowns that skyrocketed freight prices and snarled logistical efforts to ship coffee.


Supply problems in #Colombia and #CentralAmerica further accelerated the deficit and triggered rallies in differential prices across key washed coffees.


The combination of high freight prices, high differentials and slow transit times triggered another phenomenon: certified stock consumption (more info on Cert Stocks here). With all of the delays and added expense to import coffee, it became financially attractive to decertify coffee and sell it for consumption.


This certified stock draw triggered impressive rallies in calendar spreads leading to the largest #backwardation since the #Brazil #frosts of the 1990s.



On top of all of this is the speculator.


Usually, the spec long helps to accentuate rallies, and they did so in this case, especially at beginning of the rally during the frost. However, #volatility has knocked out the spec, and low hedging combined with low spec activity has dropped open interest and liquidity down to 2017 levels which has exacerbated volatility.


This is the present moment in which we find ourselves.


However, while there is a lot going on, the truth it was fairly predictable.


Numerous #analysts, #tradehouses and pundits discussed the historic deficit, the frosts, the droughts and how it would trigger a dramatic rally.


In my own work, on Jun 28th when coffee was trading in the 160s, I wrote about how there was a major frost predicted and that the market seemed to be discounting it. I concluded the article with the following statement:


"The #deficit year this year will be drawing down global stocks to very low levels and the market will be relying on a large #22/23 crop to replenish those stocks. If the #22/23 crop is compromised, then we may be in a situation where we need to price ration coffee. If that is the case, it will be a heck of a bull coffee market."


This did indeed happen, and it has been a heck of a bull market.


We are now in the worst of deficit. The 22/23 crop is being harvested, and there is evidence that it may be even worse than people thought.





However, if all of this was predicted over a year ago, the question is where will the futures market go now? The answer is it will look forward 1 year.


The conventional wisdom is that high prices plus coffees biannual nature mean we would have a massive 23/24 crop and that would trigger a large surplus that would bring down prices.


Bear in mind that this surplus is still after 2 years of deficit so it won't necessarily crush prices, but it should lower them below 200c and keep them there.


For now, I would say the odds of a good 23 crop are higher than a poor 23 crop. This is based on several things: 1) discussions with agronomists and farmers/traders on the ground in the know, 2) the biannual nature of coffee in Brazil, 3) positive rain forecast for the wet season starting in October.



However, there is the distinct possibility that the size of the 23 crop will disappoint. There are two main factors that would favor this possibility: 1) extensive damage from frost/drought requiring replanting or skeletal pruning and 2) a drier than usual dry season this year.


For now, my assessment favors a solid 23 crop, but the jury is still out.


Macro

One of the overlooked factors in the coffee market is the #macro environment.


#Currency fluctuations have a major impact on prices and coffee’s rally has both accelerated and been dampened from the impact of these.


The #USdollar and the #BRL both have a key impact on coffee. The BRL has an impact because it induces selling both from specs in NY and London and Farmers in Brazil. BRL has devalued to historic lows which has been a huge negative impact on the coffee market.


[More information on how the US Dollar impacts the coffee market, or the BRL and its impact on coffee.]




The USD also has a major impact on coffee as coffee futures are priced in USD terms. This means when the USD rallies, the price of coffee in USD terms (futures for example) falls. When the USD falls, coffee futures rally.


The USD has rallied dramatically as the FX market has anticipated rate increases from the #FederalReserve to combat #inflation. So far inflation has not been brought under control so we should expect these rate hikes to continue.


Going forward our best guess is that the dollar continues to rally as the economy is strong and inflation still has a long way to go before it is under 2%. That said, the USD has already rallied quite a bit so there is a question mark there.



For the BRL, the Brazilian Central Bank just announced that their rate hiking cycle has ended, so we are likely to see that currency tumble. Add to that bearishness the Brazilian elections this October and the country's fiscal woes and the outlook does not look rosy.


Unlike the Fundamentals, the coffee market tends to incorporate the macro view in the present because FX hard to predict and coffee professionals are not currency professionals. Therefore I would expect that currency strength for the USD and weakness for the BRL is not fully priced into the coffee markets.


Certified Inventory

The certified inventory is trickier because while we have enough coffee to last us the surplus one year forward, the supply of certified inventory could fall to very low levels before we see it replenished.


The lack of certified inventory in the present (and the current trajectory) mean tha market must invert spreads to draw in new inventory and discourage consumption of inventory.


New certified inventory only arrives in size when physical prices of coffee is cheaper than delivering to the exchange, and this requires cheap differentials.

However, differentials react to supply and demand for now the market is still tight. We do not anticipate a major collapse in diffs until probably year's Brazil crop and thus it is hard to see when the end of demand for certs will come.


We may be in a situation where backwardation persists for a year but terminal prices come off. The next major supply of certs at this point seems to be 23 crop washed Brazils and the following 23/24 October crops.



Going Forward

There is still a great deal of bullish sentiment in the market, the spec position is largely cleaned out, and the market is likely to adjust their Brazil crop even lower, this combined with the inversion means that there is still a strong possibility of a rally occurring nearby.


The spec has largely been absent, and if they re-engage on the long side, then we could see an impressive climb. However, the Brazilian coffee farmer has been holding back their sales and I don’t see why they wouldn’t sell if the price rallies. We also have October crops coming in a few months that will be sold as soon as they are harvested.


Finally, from a technical perspective, we often see a secondary rally after the initial sell off from the highs. This is where those who missed out before participate and those who are long add to positions. However, this is secondary rally is more of an emotional whipsaw rather than based on fundamentals and it fails unless there is no information. It is not clear whether this secondary peak has already occurred or not.



New information that can change the outlook is the Brazil 23/24 crop. If we fail to get a good flowering or if there is an indication that this crop will not be good, then the bull market will likely resume or at least prices will remain elevated.


There is a significant chance that the crop does fail: maybe 20-30%. That is 1 out of 3 or 1 out of 5…not odds that you would want to bet the farm on.


However, my assessment of a strong to good crop is more like 45-60%. If that occurs, then coffee prices are destined to fall.

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