Volatility and Inversion in the Calendar Spreads

The #Arabica #coffeemarket was inverted by 5 bps in N22/U22 as of 7:18am. This is VERY unusual. I'm not trying to be alarmist here, I just want to highlight that this is a unique time in the #coffee #markets.

I will examine why this is unique below, but here is some context for those who are unfamiliar with market structure.

Contango

Market structure can be a bit daunting for those new to #commodities or coffee, but its one of the most essential concepts for #roasters, #merchants, #producers and #traders to understand. If you already understand market structure, you can skip the next couple of paragraphs.

The futures market is built around delivery of physical goods at certain delivery months that extend out into "the future". As of Jul 27th, the nearest or "spot" futures month is September 2021, the 2nd month is December 2021, then March 2022 and so on.

Each of these months has a price and the difference between two months is called a #calendarspread. Typically the front month spread is the cheapest, and each subsequent month is a little bit more expensive (often 2-3c in Arabica). The reason for this is simple, it costs money to store and hold coffee.

If you are a #trader holding coffee and someone wants to buy it from you now, you would give them the "spot" price. If someone wants to buy coffee from you now, but have it delivered in 6 months, you would charge them the spot price plus the "carry" cost, or the cost to #warehouse and insure coffee. This the reason that the nearby months are usually cheaper than the further out months and this natural "#structure" is referred to as "#continuation" or "#contango".

The other important thing to note here is that hedgers actually receive this "carry cost" as a cash payment in their #futures account when they are #hedged. Without going into the details here, when a #merchant is long the #physical and is short the #futuresmarket they receive a small cash payment every contract month roughly equivalent to carry costs to store the coffee and maintain their hedge.

#Backwardation

The exception to this normal structure is when there is a premium on coffee right NOW. If there is a shortage of coffee in the present, then customers will bid up the front price of coffee and the hedger is no longer incentivized to store the coffee and maintain their hedge. They are incentivized to lift their hedge and sell the coffee. This is called an "#inverted" market or "#backwardated" structure.

A #contango market is not always #bearish, but a backwardated market is always bullish. See Hank's interview (below) around the 2 min mark for more on coffee spreads.

This is what we are seeing now in the coffee markets, although it is not in the front month, it is prices being bid up in the middle (around K22/N22 to be more precise).

The pressure here is coming from 3 directions.

First, Roasters are anticipating shortages in this timeframe (the period before the next crop) so they are bidding up coverage.

Second, Specs are bidding up prices here for the same fundamental reason as the roasters. However, the downside is limited to cost of carry for calendar spreads so this is actually a clever trade for the spec. It is a "free call" type of trade.

Third, exporters and merchants are facing a cash crunch from #margincalls based on the dramatic price rises and increased margin requirements. These traders are forced to lift hedges or protect them with calls (which has the same effect on the flat price).

The challenge here is also the #liquidity. Most of the activity plays out in the spot months, so the renewed activity in the back ironically is making these more volatile. The activity and volume is higher than normal, but not enough to absorb the directional trading and #shortcovering taking place.

Whether or not the inversion continues will largely depend on the #fundamentals and how the #Frost plays out this week, as well as #demand recovery and the #flowering over the next few months. However, the trend over the last few weeks (even before the frost) has been for firmer and firmer backmonths. The market seems to be anticipating a problem playing out here.