With drought affecting Brazil, producers in other countries also benefiting.
[This article originally appeared on HardAssetsInvestor.com and is republished here by permission.]
Coffee prices exploded through this year on fears that drought conditions in Brazil could reduce coffee supplies. On the back of that rise, coffee-focused exchange-traded products have now raced higher, and are now among the year’s best-performing funds.
The iPath Pure Beta Coffee ETN (CAFE | B-95) and iPath Dow Jones-UBS Coffee Total Return ETN (JO | B-92) are now up year-to-date 54 percent and 58.5 percent, respectively. CAFE tracks an index of a single coffee futures contract whose expiration date is chosen to mitigate contango in an optimized exposure, while JO tracks a single, front-month coffee futures contract.
After declining since May 2011 from a high of more than $3.00, prices as measured by the ICE futures contract (KC) bottomed out in November at $1.04 a pound. Prices seemed to have found a base despite a large projected world surplus between $1.10 and $1.20 a pound. This all changed in the minds of traders at the end of January.
Prices broke out on Jan. 30 from $1.22 a pound. By last week, prices had reached $1.72 a pound, an increase of 40 percent.
Brazil is the world's largest producer of coffee, accounting for roughly one-third of total world production. The Brazilian harvest begins in May and lasts through August, typical for the Southern Hemisphere.
For the past several decades, production of coffee in Brazil has slowly shifted northward away from the cooler, frost-prone states of Parana and Sao Paulo and into warmer more northerly states; notably, Minas Gerais.
Periodic frosts had traditionally wreaked havoc on Brazilian coffee production, causing huge spikes in world prices. However, the shift northward in Brazil to warmer areas also meant a shift into areas more susceptible to drought.
December was a wet month in the key coffee-producing area of southern Minas Gerais, and soil moisture levels were considered good. So much rain fell in December in Rio de Janeiro, the state of Bahia and the state of Espiritu Santo that flooding and landslides left up to 60,000 people homeless. Then the weather took an abrupt turn.
The extreme dry conditions began in early January and were exacerbated by unusually hot summer weather. More than 140 Brazilian cities have now begun rationing water to approximately 6 million people. The rains started to return in mid-February, bringing a good amount of rain to Parana. Some scattered rain also reached up into the coffee-producing areas of Sao Paulo, Mogiana, Minas Gerais and Cerrado, but not in sufficient amounts except to alleviate critical immediate needs.
Before drought came on the radar screen, the USDA in its report of Dec. 12 projected total world production of coffee for the 2013/14 year ending Sept. 30 at 150.4 million 60 kg bags. Brazil was expected to produce 53.1 million bags. Total world year-end coffee stocks were expected to rise by 3.5 million bags to 36.3 million bags, the highest level in five years.
Not all coffee producers will be hurt by a potentially smaller crop in Brazil. Producers of washed arabica coffees, of the type deliverable on the ICE futures exchange, will benefit hugely.
Production of coffee from Colombia, Peru, Mexico and all of Central America is unaffected even though their prices have risen accordingly. From Central America, where the harvest runs from December through March, coffee is currently in full flow. Although as much as half had been sold prior to the run-up in prices, the balance of unsold production represents a windfall tolocal producers.
Trading in the ICE futures market has jumped dramatically, on some days 300 percent of the average of the previous three months. Trading for all of 2014 is up 50 percent compared with the average for 2013. The total open interest in the ICE futures market has also jumped from 154,000 lots to currently 163,000 lots since the rally began reflecting short covering, new speculative buying and fresh selling from other Latin American producers.
Money managers went into the rally net short 9,000 lots but have since reversed themselves. As of Feb. 18, they were net long 25,000 lots.
The full extent of any damage to Brazil's crop will probably not be known until May, when harvesting begins. The key will be whether the amount of rain in the next few weeks will be sufficient to make up the rainfall shortage and ameliorate the damage done in January.
Droughts can be tricky things to trade. It's never really clear when they started until after the fact. And it’s never really clear when the rainfall has been sufficient regarding when it ends.