Squeeze in Robusta Spills into Arabica

(Edit: An earlier version of this article erroneously quoted the MiFiD position limits rather than the ICE Eur Delivery Limits. This has been corrected.)

Those of you following the #Robusta #market have seen why this #commodity has the nickname "GoBusta". Since Jun 21st the U/X #calendarspread this market has gone from full carry at -22 to a $24 #inversion as of 11:18am this morning. This likely reflects a "squeeze" in the market exacerbated by firm connie #diffs, #seasonality and international #freight rates. Today we even saw this spill over into a sympathetic rally in the #Arabica Mkt with the U/Z Arabica spread trading at -2.45 today.

How did this happen?

Let's start by looking at who trades the spread: mostly, its the trade houses. Exporters and trade houses are long physical in their inventories that they will sell to importers and roasters and this physical coffee is hedged with futures. Every few months when the futures contract expires it gets rolled by the trade to maintain their hedge.

When coffee is plentiful the market pays carry of ~$11/MT to roll (so for a 2-month calendar spread thats about $22). In other words, when you buy the nearby month contract and sell the next month, you gain a small profit that is roughly equivalent to the cost to store coffee. So the market is functionally paying the trade to hold this coffee in storage. This is what generates the futures curve we call "#contango" or "#continuation".

This manifests in the calendar spread market as a negative price. So full carry for U/X Robusta is around -22$/MT. Purchasing something with a negative cost means that you receive cash in your account for maintaining your hedge (rolling your hedge forward).

If the calendar spread is trading more than this cost, then the market is telling you coffee is needed now. So rather than rolling their hedges forward traders would simply allow their futures to expire and deliver coffee during Notice Period.

This is why the first place that we should look when evaluating spreads is the #CertifiedStocks. If certified inventory is plentiful then the cert holders will deliver coffee rather than pay up to roll their spread forward.

However, the Robusta certs are not particularly low, at least on a 5 year basis. So this is where we start talking about a "squeeze". A #squeeze happens when those certified stocks are owned by what we call "strong hands". This means that the companies that own this inventory have the capital to withstand any margin calls on their hedges (if their coffee is hedged) and are not interested in delivering their certified inventory even if they are offered a hefty premium.

The reason for doing this is simple: to drive up the price of coffee. They may have lifted their hedges and want to drive up the price on their inventory. They may own futures and are willing to sell their futures back when the squeeze rallies the spreads, or they may simply want to accept delivery of physical coffee.

Spot Month Position Limits

This is made easier because of the position limits on Robusta vs Arabica. Position limits are the amount of contracts that can be held until delivery without any reason given to the exchange. Arabica currently has a spot month position limit of 1700 contracts and there are 127k lots of open interest in September, so the position limit is about 1.4% of OI.

Robusta has a much larger limit of 7,500 contracts with only 58k contracts of OI in U, so this is about 12.9% of the market. So a futures buyer can hold up to 12.9% of OI and accept delivery of those contracts without giving an explanation to the exchange. This is why it is MUCH easier to squeeze this market than in Arabica.

The other factors pushing the squeeze are the seasonality, the strength in conilon diffs and international freight rates.

The largest producer of Robusta is Vietnam, and Vietnam's harvest begins in October. This means that the September contract is seasonally one of the tightest of the year just before the world's largest supplier is able to deliver. Current freight rates out of Asia are very firm right now, so the cost of delivering current crop coffee from the world's cheapest supplier of Robusta is much higher than it has been historically.

The next largest producer of Robusta is Brazil. Brazilian Robustas are known locally as conilons and the conilon prices are very high right now because internal Brazil demand is strong. Since this normally cheap coffee is now more expensive, the usual buyers of this coffee are looking to draw cheap coffee out of the certified inventory and so they have purchased the futures and are willing to simply wait for the contract to expire and accept delivery.

All of this has made for a very strong calendar spread in Robusta's Sep/Nov. What happens from here is up to the participants. It becomes a game of chicken. If the spread goes high enough, the futures holder may simply sell the futures and take profit. If not, the trade houses that are short spreads have to decide whether they want to pay up to roll their hedges or start delivering their coffee to the exchange.