A Coffee ReportThe Global View By Rodrigo Costa

Differentials converged!

The news of Osama bin Laden been killed by the US in Pakistan initially provoked a wave of selling for commodities (especially precious metals and energy) and a spike for equities, but then with the risks of a revenge either by Al Qaeda or terrorists groups linked to them took the markets back to where they were.

Well, but that was on Monday (and I started writing this paragraph on Tuesday), so it is old news already. Today’s reasons for the sell-off in equities and commodities seem to be related to the below than expected job creation in the US (number released by ADP) and lower services activity in April. It is true though that the fall was steeper for the European equity indices after retails sales declined the most in one year in March. The 78 billion euro aid package that Portugal got did help the Euro initially, but after PIMCO, the world’s biggest mutual fund, said that the Euro is overvalued not reflecting the risks of the region, the currency aired gains and settled unchanged.

Maybe none of the above or all of it is the response for the volatility we have seen in the market. The reality is that nowadays as all markets are integrated/linked somehow by algorithms that “decide” to sell coffee if “tea” falls, or the other way around, so once one scream “RUN” everybody takes the same direction. In fact it is not that fair to say for coffee, as it was holding well until yesterday when most of the commodities were lower, and it actually managed to make a new
high, so, it is not that bad.

Tuesday’s settlement, virtually unchanged after making a new high in a narrow range, encouraged
some bulls to book profits today but it took almost 10 cents for the market to finally find scale down buying, therefore the fall was more stretched than other markets, aside from silver – which by the way has lost 21% since Friday, losing the post as the best performance commodity of the year to gasoline now.

Technical Focus: Arabica on ICE broke important supports and now July contract needs to hold above 290.00 cents to avoid a test of 286.00 and 280.00 If the first support is respected it would not be surprising to see a bounce and new attempts to make new highs. London did not have such a bad performance (almost a key-reversal) and it needs to hold above 2500 to resume the uptrend.
Fundamental Focus: If someone was bullish Arabica coffee for the past 2 years pointing at the strong differentials as the main reason (as I was in May last year), the argument now can no longer be used. If it is temporary or not it remains to be seen but differentials for pretty much all deliverable mild-coffees are trading near or below the premiums/discounts that ICE pays.

The increasing number coffee being certified in the warehouses is a proof of an absence of demand for green beans, and the offers in the FOB are at the cheapest level in 2 or 3 years. For natural-coffee though the story is mixed. While the cost of replacement in Brazil is trading at single-digits or flat against the board, African’s are at 60 cts discount. It seems like the former is very strong because exports are still running to cover their shorts and the available coffee (not much) is in strong-hands. Of course once the new-crop coffee starts flowing the diffs will ease, as we are seeing deals done for the second semester in line with historical levels. A recent article published by Bloomberg mentioned that farmers in the major-origin are rushing to harvest and prepare and sell their coffee, to take advantage of the current prices – way to go Brazil!

The devaluation of the Real, which is trading at the lowest level against the greenback since the beginning of April, if continued might help to put a cap on coffee for now, but if tomorrow risk is “on” again all we are saying will seem like crap (once more).

It is interesting to notice that the fund position has not been changing much on the coffee market, giving the impression that only the short-term guys have been more active lately. It is understandable that longer-term players had adopted a more cautious approach to the market as prices are trading at 14 or 34 years high (1st and 2nd position) and it should be difficult to convince investors that there are much more upside-room when even the less efficient producer is making 100% profit growing coffee. Especially when the biggest icon in the coffee market,
Starbucks, mentions that current prices are not sustainable…

Volatility will remain high, and besides the possibilities of seeing new-highs for coffee given the lack of origins selling and the eventual perspective of more money flowing in as inflation remains a concern, the physical market had finally aligned to the future market, which is a strong point for bulls to be in red-alert.


The Conclusion

Inflation threats that keep forcing the BRICS to raise interest rates (Russia and India just increased it in the last days) are transpiring further in developed countries, and it did not helped to avoid a risky-asset liquidation today. It is early to call for the top on commodities, but economic numbers showing slower industrial and service activities, and a slower growth of jobs in the US could diminish the appetite for investors to put more money on these markets.

While coffee still has a bullish story based on low inventories and a smaller crop in Brazil that will take the 11/12 S&D into deficit, one should think if these factors are not already priced on the market. Differentials on mild-coffees are trading at or below deliverable levels and it certainly take away the argument that has been used for someone to buy coffee in the past 2 or 3 years. Certs are increasing as demand for green-coffee is quiet, partially blamed because of the season.

Weather disruption seems to be the only premium that can be build on this market (frost and drought), while on the other hand a bigger than expected Brazilian crop can the surprise-effect for the scarcity not to be as tight as many are expecting for the 1st quarter of 2012. Longer-term investors might not be convinced that getting long Arabica now is a good opportunity after it had rallied more than 110% and when farmers are being able to make more than 100% profit growing it.

I am not saying that producers do not deserve it as many have lost money for several years in a row, but when the icon of the market, Starbucks, says that coffee prices are not sustainable at current prices and the physical has converged to the board, it does not hurt for bulls to book profits after a nice ride, and for traders to ask themselves: who will provide support for this market if specs stop-buying it?

Have a nice week and good trades.

Rodrigo Costa

Newedge Coffee Group