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The Frost Rally is Over—Whats Next?

Updated: May 4

#Coffee prices have crossed the 200 day SMA 4 out of the last 5 trading sessions, and last week marks the first time that this key support has been breached since the start of the current bull-market in 2020.


Whatever the future may bring, the frost rally did its job and rallied prices from the 140s to the 260s, but now it is time to declare the frost rally over and done with. The market now needs to look to the future, and our assessment of the future will determine where prices go from here.



I hold a view that I think is a little controversial. Most of the in-the-know-people that I have talked to are bullish, but a contrary opinion is valuable to test the strength of your own.


With that in mind, in this brief article, I will share my view of the future of Arabica prices (some bullish risks over the next 2-3 months but generally bearish over the next 6-12 months). I will outline my logic for it and I will also highlight some key areas where I may be wrong.


Fundamentals

I consider the #fundamentals#supplyanddemand to be the primary driver of prices in the #coffeemarket and these fundamentals are what lead me to be bearish.


Prices are always relative, and that is why we need objective assessments of what we think prices will be. For this, the #pricemodel is unmatched. It is easy to say I’m bullish or bearish because x or y news event happened, but those terms are meaningless unless we take into account where prices are currently and what we think fair value is.


Let’s look at fair value first. My price model is made with two basic inputs: 1) stocks-to-use ratio and 2) the Brazilian Real #BRL. If you are unfamiliar with price models, all that you need to know is that stocks and price are inversely related. When stocks are high, prices are low, when stocks are low, prices are high. This makes intuitive sense and is also the model proposed in classical microeconomic theory.



Currently, #stocks (and especially #destinationstocks) are low. This is quite bullish, and as such the model projects high prices as fair value. My model has fair value between 170 and 210 depending on how much weight I give to the Brazilian currency.


Based on this assessment of fair value, we are currently somewhat overvalued. This is what is limiting my bullishness in the short term. The situation is tight, but the market is already pricing in tightness.


Even if we consider the fact that coffee has come off 25% from the highs, coffee is still high in nominal terms. This means that the market is starting from a high bar, and in order for prices to remain high, the situation needs to remain bad.


My view is that the #supply situation will improve, and this improvement in supply will lower prices in the model. This is the function of high prices, it stimulates supply. If the market is able to perform its function, then supply will come forward to alleviate the high prices.


The risk is that supply will not materialize in sufficient size, and if supply cannot be generated we will have to destroy #demand. Demand destruction is where the possibility of a catastrophic rally lies. To truly destroy demand, the market would need to rally to some insane price levels, however, I think that is unlikely based on the current information available.



Remember, the market is far less concerned with what the fair price of coffee is right now, and much more concerned with what the fair price of coffee will be in 6 -12 months.


I would assume that the supply situation will improve during the 22/23 crop year (although only modestly), but that the 23/24 crop looks quite promising and will significantly help buoy supply.


First on the 22/23 crop year. I assume that we are in a small deficit for the 22/23 crop year, and that high prices and the seasonality of crops should assist in pulling coffee out of origin in the short term. More importantly, it will incentivize investment in coffee over the long term. More on the long term in a moment.


In addition to the current harvests, flow to replenish destination stocks would have to come from the two key holders of origin stocks: Brazil and Vietnam. Prices in the 200s are likely to pull that coffee out, and the market could stage another rally or two into the 230s or 240s to facilitate that.


Brazil started from a very high position in stocks from their impressive 2020 crop but this has already been depleted after the deficit this year. Vietnam is probably doing a bit better for their size, but their crop is ~50% of the size of Brazil crop so there will be less to draw from. This is why I think the ability to rebuild destination stocks is limited and it is why I think there is still bullish risk in the short term.



However, as mentioned above, current high prices will incentivize investment in coffee in the long term. Yes, fertilizer prices are very high, but prices are also high so the farmer will have money and incentive to invest back in to their farm. Prices have already been high for 1.5 years so the incentive to start planting more coffee and investing in current farms has already started.


The two “gorillas” of the coffee market, #Brazil and #Vietnam have received strong rains during their growth seasons suggesting that Brazil has good potential for a strong bounce back from new growth in 23/24 and that Vietnam will have a good harvest from the crop on the trees in 22/23. Other origins are more mixed…and notably #Colombia.



Other Factors

Aside from the price model, we have multiple other factors to consider, of what we can predict now, I think they tend favor the bears.


Before I discuss the bearish factors, I need to mention that weather is a major bullish risk that we really can’t make a strong prediction on now. If we get another frost or drought, we all know what the outcome will be and it will change the math dramatically.


Coming to the bearish factors, the US dollar is ripping and we have barely started the rate hike cycle. If this dollar strength continues than it will necessarily deflate commodities (as they are priced in USD terms. The BRL is potentially very overvalued as their rate hike cycle may be coming to an end, and their election cycle is about to begin. A weaker BRL would be a strong factor in pulling out more coffee and incentivizing production.



Finally we have the spec position. The spec is a fickle friend, and we all know that their days are numbered as longs. The market is paying the spec to stay long with the inversion, but the Robusta inversion has already collapsed, and the Arabica inversion is tenuous at the moment.


We have to ask ourselves how much of the inversion is due to spec buyers who believe they are buying “free calls” (limited downside and unlimited upside). When momentum shifts sufficiently to the downside, these specs will sell their longs and go short and the market will revert to carry. This is a position the spec is much more comfortable with…being short in a carry market.

Watch Out For

I mentioned that there many areas where I could be wrong here and that could spark a bull run to new highs. The biggest area where I could be wrong is that if the consensus Brazil crop estimates are too high and the bullish outliers are correct. Some analysts are making some very dramatic calls for very low crops. They could be right.


If the Brazil crop is 47 million bags instead of 59 million bags and the majority of agronomists are wrong… There is little that the market can do except ration demand. “Katie bar the door” as a mentor of mine is fond of saying.


It’s also possible that macro environment moves in the opposite direction. Some global economic event could contribute to a situation where dollar strength collapses and sends commodities soaring. This isn’t that difficult a scenario to envision and it could come from several different areas. Similarly, the BRL could start a new era of historic strength and throw my assessment out of whack.

Conclusion

That said, I think the default assumption has to be a “reversion to the mean”. In sum that means that high prices will do their job and incentivize production and pull coffee out of origins. Weather events will be closer to normal, inflation will return to normal levels and the spec will revert to their favorite risk-premia short position. If these things happen then it seems likely will also revert to its mean and that means prices with a 1 on the front.

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