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Margin Requirements and Frost #3: What to Expect

Updated: Jul 27, 2021

Today, the #coffeemarket (#Arabica) rallied +26c at the highs today to 215.20 in September based on #margin increases and renewed #Frost Risk. These are numbers on the terminal and daily changes that we haven't seen since the 2014 #drought.


Helping to drive prices higher today was the fact that the #ICE exchange raised #MarginRequirements on Friday from $4050 to $7500 / lot. This is a 2/3 increase that #Traders had 2 days over the weekend to come up with. Those that are not able to come up with the increased margin requirements have their positions liquidated.


Let's put some numbers on that. If we use the numbers from last week's post, if you are a tradehouse with a 1,000 lots hedged that's 4.05 million dollars of initial margin, that just increased to 7.5 million dollars. That's a $3.45 million dollar outlay on top of the $17.65 million dollars lost in price action over the last 5 trading days (207c - 160 = 47c, 47c x 375 * 1,000 lots = 17.65 million).



On top of this, we have the continued frost forecasts. This had warmed up over the weekend, but is today once again showing frost. #Speedwell, my paid weather service, is projecting Frost based on the #EuropeanModel in #Machado and #CaboVerde. These are the same two regions projected last time the frost hit, so it is POSSIBLE that we have another frost of similar magnitude in the same areas.



It is far too early to be estimating damage from a frost that hasn't yet materialized, and the fact of the matter is we haven't seen many frosts occur in the same area, but I reached out to @Judith Ganes and a few other friends and analysts to try and talk through what might happen.

Evaluating a Second Frost Frost in Same Area:

Cold temps act like water in that cold air sinks and runs downhill. So it is likely that the cold air will likely settle in the same low-lying areas that were hit last time.


More or Less Damage?

The answer to whether a second frost would cause or more or less damage is not as simple. The damage itself comes from the fact that the plant is mostly water, so when it freezes, the ice crystals damage and fracture the cell walls and microstructures in the plant.



When one portion of the tree out part of the plant is damaged by frost, it opens up a vulnerability (analogous to cracked walls) where subsequent frosts can penetrate deeper into the plant and cause more damage. That said, if a tree, leaf or branch died from the first frost, it can't die again, so in that sense a 2nd frost could cause less damage.


Let's talk specifics. There are several different biological parts of the tree that will be affected by a frost.


New Growth:

The area that I usually focus on for a frost, is the "new growth". #Newgrowth is the "green shoot" portion of the branch that extends from the existing branch and where the #flowering occurs that will turn into next year's buds and #cherries. This portion is particularly vulnerable to frost because the branch and membranes are thinner so frost can more easily penetrate the interior of the branch and damage the structure.


If this portion turns black and falls off, there is less room for the tree to flower and bear fruit and the plant has already exhausted resources that cannot be replenished.


This is the portion of the tree that is most immediately concerning because damage here directly impacts the 22/23 crop: the bumper crop that the market NEEDS to replenish the stocks drawn down in 21/22 from this year's large deficit.



Leaves:

The Leaves are one of the most vulnerable parts of the plant and so are often the first to get damaged by frost. These are essential to the overall health of the plant and its ability to provide nutrients for itself and support the following crop.


However, the leaves also form a more macro protective layer almost like a blanket that protects the plant by keeping cold air out. Now that many of the leaves have burned off in the previous frost, a second frost would be attacking exposed stems and branches.

Cherries:

The cherries are the least worrisome part of the plant to be damaged by frost. Although there can be an impact on quality from cherries being frozen, the bean itself should not be impacted. So unless it falls off of the tree, a frost is unlikely to dramatically reduce this year's crop.


Buds:

I'm told that there was some early flowering this year and these will be vulnerable to damage from frost. Although there should not be a large amount at this point, any damage here is directly translatable into damage to the coming 22/23 crop.


Mitigation Factors:

There are some natural and man-made mitigating factors at work here as well. With the price skyrocketing by the day, you better believe that farmers will be taking steps to protect their crops. Depending on the size of their farm, they maybe be able to light fires or spray to mitigate the effects of frost, but would also suspect that the availability of these tools is in short supply.


This can also go the other way too. Farmer's may decide that rather than eke out a few berries from their trees, it is preferable to stump or prune this year to get a better yield in 23/24.


Also let us not underestimate #Brazil's capacity to bounce back a coffee crop. If the rains return when needed, that will go a long way to improving any damage done to the crop.


Final Considerations

First, its important to not get ahead of ourselves. There is a credible risk of frost, on top of the previous severe frost. However, this is still just a risk, a forecast, not a certainty. It can change. Moreover, a lot of worst case scenario is being priced in right now. This means that if the frost is light or non-existent, the market will have to un-price a lot of that risk.



We will need to watch and monitor the forecasts for the rest of the winter.


On the other hand, although forecasts are imperfect, for all the jokes that we make about predicting the weather forecasts are actually somewhat accurate. They get quite accurate within 3 days, and they get exponentially more accurate as we approach day 0.



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