Coffee Is Just Starting To Heat Up

Feb. 13, 2014

Introduction

Over the past year, coffee prices lost 34.4%. Despite last year's losses, coffee is rapidly turning around due to an impending supply crunch, short squeeze, bullish technical patterns, and increasing macro demand.

Impending Supply Crunch

Over the past two weeks, coffee gained 20.1% due to concerns of a potential drought in the northeast and southwest regions of Brazil. Brazil is of central importance to the coffee market because it is the world's largest producer of coffee. Now that concerns of a Brazilian drought are looking increasingly likely, coffee's surge does not appear to be over. The graph I created below illustrates Brazil's effect on the supply of coffee using historical data from the International Coffee Organization.

As seen in the graph above, Brazil has a monumental effect on the global supply of coffee, and any supply disruption in Brazil hurts the global supply. Adding to supply crunch fears, the ICO (International Coffee Organization) has warned about the worst leaf rust outbreak since 1976. The ICO says:

The current epidemic of coffee leaf rust affecting all countries of the region with a 53% incidence is the worst seen since this pest appeared in Central America in 1976.

Leaf rust is a fungus that affects the leaves of the coffee plant, causing the leaves to develop pale-yellow blotches. Leaf rust devastates coffee plantations as each fungus produces an additional 300,000-400,00 spores over a 3-5 month period.

Impending Short Squeeze

As a result of coffee's poor performance over the past three years, coffee has become a safe haven for short sellers. Below, I have created two charts using 161 data points from the CFTC (Commodities Futures Trading Commission).

As the data show, coffee has been an easy short for traders in 2013. Over the past year, net short interest greatly expanded. The large increase in short positions will allow for continued short covering as shorts are caught off guard by the supply crunch in Brazil.

Bullish Technical Patterns

Due to the recent pop in coffee, the chart looks increasingly bullish.

As seen in the weekly chart from stockcharts.com above, multiple indicators are quickly turning bullish after long periods of bearish signals. Firstly, the breaking of long-term resistance on the RSI (relative strength index) indicates that coffee has newfound momentum that has been absent for the past several years. Secondly, the moves above both long-term resistance and the 50-day moving average highlight coffee's new strength. The Parabolic SAR (a momentum indicator), has also lined up nicely below the candlesticks. A final momentum indicator, the MACD (bottom), is also printing an incredibly bullish signal.

Increasing Macro Demand

While the supply side of the coffee equation moves prices higher, demand should help move coffee higher as well. In order to calculate how much coffee demand will grow in the future, I created the Coffee Consumption Importance Index. Statistics are from the International Coffee Organization and the World Bank. The index is calculated by multiplying the number of 60-Kg bags a country imports by its percentage population growth. Those two statistics represent how much demand for coffee will grow. The product is then divided by 10,000 to provide smaller numbers for comparison. The graph I created below shows where the world's 25 top coffee importers fall on the index. Given that the U.S. is an anomaly, with a reading of 1805, A separate graph is needed to compare the U.S.

The above charts highlight the growing demand for coffee, especially in established markets such as the U.S. and Belgium.

Conclusion

I suggest that investors take advantage of the new strength and momentum in coffee. Investors can buy shares or options of the iPath Dow Jones-AIG Coffee Total Return Sub-Index ETN (JO) and shares of the iPath Pure Beta Coffee ETN (CAFE). I especially advise investors looking to use options to spread to avoid paying too much in risk premium after the recent 20% move.