Recently a #coffee researcher friend of mine and I were discussing one of the key topics driving the #coffeemarket today: the disastrous #certifiedinventory and its dramatic impact on #calendarspreads.
In this article, I will discuss the current "spreadpocalypse" the #inverted calendar #structure in the market, why I think we may be in the worst of it right now, and how I anticipate this to play out over the coming months.
If you are less confident in your #commodity futures knowledge, don't worry, I explain how calendar spreads work and how its related to certified inventory below, but if you are more experienced you can skip right to the juicy bits at the end where I discuss the spreadpocalypse and predictions.
Calendar spreads
To understand the spreadpocalypse, we have to understand the most important component of the futures market: time.
Unlike a #stockmarket stock, or #cryptocurrency, a futures market is three dimensional. That third dimension (and the key component of a futures market) is time.
While stocks and #crypto have a temporal aspect as well (they move up and down over time), the price always represents their present value.
A futures market by contrast, has multiple contracts with multiple prices every day that represent delivery months in the future. This set of prices is called the futures curve or futures "structure" and it represents the anticipated future availability of coffee.
The prices along this curve have a special relationship with certified inventory.
When I teach commodity futures in my classes, I tell my students that a commodity future is just a standardized #forwardcontract. In other words, every futures contract represents a commitment to trade a standardized quality of coffee, in a standard amount, at a standardized time.
That standardized quantity and quality of coffee is an exchange “certified” lot. For Arabica, this is 37,500 lbs of “washed” coffee.
Every day the futures market shows the c/lb valuation of that contract. These certified lots of coffee (referred to collectively as "certified inventory" or "certified stocks") are central to the spreadpocalypse and we will come back to them shortly. However, as mentioned above, the key component here is the time.
Each futures contract represents a corresponding delivery month. A September future represents a contract to trade a single lot of certified coffee for September delivery, a December future represents a contract to trade a single lot of certified coffee for December delivery, and so on. What is notable here is that each of these contracts all have different prices, and that there is a unique relationship between these price differences.
The difference between each futures market price is called the “calendar spread”, and this difference in price between contracts is actively traded on its own. We’ll look at why in a second, but what’s important right now is to understand that there is a normal relationship between these contracts and that right now, it is way out of whack.
Contango
The normal relationship between futures months is for each subsequent contract to be priced slightly higher than the previous contract and this normal relationship is called “contango” or “continuation” in trader speak. This normal situation is contrary to what we are seeing now, more on that in a minute.
The normal Contango situation is actually highly logical and appropriate, and it has to do with the cost to “carry” coffee.
Think about it from the seller’s perspective, if you own coffee in a warehouse, then every month you will have to pay the warehouse to store your coffee (perhaps 1c/lb per month). If someone wants to buy your coffee today, you will charge them one price (say $2.00/lb). However, if someone wants to buy your coffee in 6 months, you will charge them the same price, plus 6c of warehouse costs, so the in the example above it would be 2.06c/lb. One year forward, would be 2.12c/lb.
Since a futures market contract is just a contract to deliver certified coffee, it has a similar “carry” cost built into the futures curve.
Explanatory Slide from Our Coffee Traders Course
Now here’s where it gets a bit nutty.
If there is a shortage of coffee in the present, then buyers will pay a premium above and beyond carry costs for coffee right now. This will invert the normal, continuation curve and make nearby delivery prices (sooner delivery months) more expensive than far out months. This is called “inversion” or “backwardation” and it is very rare in Arabica, and very bullish.
An inversion is relatively rare in Arabica due to peculiarities of the market regulation (specifically small position limits), but it does happen. An inversion is bullish though, because it says that there is a shortage of coffee and it is the situation that the market is currently experiencing.
KC Spread Curve from Our Premium Market Report
Moreover, we can actually see this shortage in real time with the daily certified stocks report.
Certified Stocks
The coffee industry is notoriously opaque, there is no government report that comes out and says what production or global stocks are. However, the certified stocks indicate the global supply of coffee that can be exchanged for a future and it is reported on a daily basis. This means that the certified stocks are a key driver of both spot price (the nearby delivery month) and the calendar spreads.
Lately we have seen a dramatic decline in certified inventory that has been the key component of inverted and rallying calendar spreads, and we can use knowledge about how the certs work to anticipate this, and when it will change.
Since certified stocks only accept a standardized quality of coffee and we can look at which coffees are available to add to new certified stocks, and what incentives will suggest that stocks will be taken away.
Arabica Certified inventory come from washed coffees from origins that now include Brazil, the world’s largest producer of Arabica (Brazil was excluded until a few years ago). This is important because Brazil has become the key supplier of certified inventory.
When Brazil had a bumper crop in the 2020/21 crop year we saw 1.5 million bags of washed Brazil coffee certified for sale on the exchange and this dramatically increased certified stocks.
However, this all changed last year when events conspired to shift the dynamic.
The Inversion
The global #coronavirus #pandemic led to a #logistical nightmare not seen in my lifetime and this directly impacted global (and specifically certified) coffee stocks.
Government stimulus checks and expansionary #monetarypolicy imposed simultaneously with shuttering cities and factories created impressive global demand for goods, but stymied production. This led to inflation and transportation shortages as demand outpaced supply.
What this meant is that shipping problems increased the cost #of shipping and also created massive delays in getting coffee from origin. This made problems for the #roaster community and incentivized consuming certified inventory.
While #destination markets had a buffer stock of coffee supplies in warehouses around the world they are also dependent on a steady flow of coffee shipments coming from origin to replenish supply.
The combination of high prices for shipping and delays in shipments incentivized looking for supply locally and this led to a global drawdown in destination market inventories. #Tradehouses started buying futures and holding them to delivery so that they could receive coffee to sell in the spot market which drove up nearby futures market prices.
This was further exacerbated by the global deficit in coffee in the 21/22 crop year which contributed to higher physical coffee prices which disincentivized certifying new coffees to the exchange. All of this was manageable because the 22/23 crop was supposed to be a bumper crop in Brazil. However, this was not meant to be.
Spreadpocalypse
A #drought and then the worst #frost in 25 years turned what should have been a record crop in 22/23 into only a modest increase over the previous poor crop in #Brazil, this manifested in back-to-back #deficits. The deficits led to rallies in futures markets and in #physicalprices and further drew down stocks.
The Brazil problems had a direct impact on certified inventories because, regardless of whether certified stocks come from Brazil or from another origin, they tend to function as replacements for Brazilian natural coffee. Therefore when the prices for Brazilian naturals are high, it further incentivizes roasters to take certified coffees off the exchange and consume them.
This also poses a problem from the supply side. When prices for physical coffees are high, the trade is more likely to sell them to a roaster for consumption rather than tender them to the exchange. This creates an imbalance where new coffees are not being certified for sale on the futures market but coffees are being removed from the certified inventory for consumption.
While many origins can provide coffees to the exchange, there are two key origins that provide the most coffee to be certified.
The first is #Honduras, which is the largest of the central American producers and it usually has the cheapest physical prices. Therefore it is often the first to have coffees that are economically viable to certify.
Unfortunately, Honduras had a not-so-great crop last year and are forecast to have a similar crop this year. What’s worse, increased prices for #Colombia, #Guatemala and other origins have led to increased prices for all Central American coffees. This has disincentivized exporters from trying to certify Honduran coffees for sale on the exchange. Prices may come down with the harvests in October, however, it seems unlikely that they will come down sufficiently to make them economically viable for certification and tender.
As the world’s largest producer of Arabica, Brazil would be the main supplier of coffees to the exchange, however, high physical prices from the impact of the lower crop will disincentivize traders from certifying this coffee.
The Future
It is possible that as we get into the flow of the Brazil Arabica harvest, and later the central American origins, these fresh coffees will satisfy the needs of roasters. While the high prices in calendar spreads are unlikely to attract new coffees to the exchange in the short term, they may perform their function in disincentivizing the consumption of existing certified coffees.
There is also another potential source of certified coffees that is somewhat disconnected from the #supply and #demand of coffee: financing.
Financing is a major consideration for commodity traders as margins are very small in commodities. This means that tradehouses require vast amounts of financing to maintain inventories and hedges. #Banks however, like collateral. One thing that banks understand is that certified coffee can be easily converted into cash.
Therefore since banks look at certified coffee as valuable collateral, we could see traders certify coffee as a way to secure financing. Anecdotally, I have heard that this could be a substantial contributor, but I don’t have any numbers as to how large this could be so I have to remain somewhat skeptical.
The most likely, “sure-thing” on the horizon is the 23/24 crop in Brazil. And to be fair, this is pretty far from being a sure-thing. We still have a frost season and drought season to get through. However, if the crop can make it through those two potential obstacles then indications point to an excellent crop. An excellent crop, combined with an improved logistical situation and currently high futures prices are strong incentives to pull coffee to destination and to certification.
However, this is all a year forward.
In the present, we are in the thick of the spreadpocalypse. Spreads have rallied hard and, in many cases, reached new highs for the year. However, the spreads themselves do offer a glimmer of hope. The spread curve has actually pulled forward suggesting that we may actually be in the tightest period of the year right now, before the crop in Brazil peaks this summer and the winter crops start in October.
Whether we are in the worst of it now, or the worst is yet to come I don’t know. One thing that I do know, however, is that markets are forward looking. If no weather disasters happen in the next couple of months, the market will be looking toward the coming relief and this could push the futures curve back into balance.
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