Coffee market lay of the land
After two years of deficit, the market is looking forward to a return to surplus in the 2021 crop year. Image: Vanessa L Facenda
Extreme weather events, regional conflicts, low inventory levels, and roller coaster coffee prices are just a few of the problems that has plagued coffee year 2021/2022. In a special article, exclusive to T&CTJ, Ryan Delany, co-founder of and chief analyst at the Coffee Trading Academy, assesses the recent coffee year (21/22) as it comes to a close (30 September) and offers an outlook on the coming CY (22/23, beginning 1 October).
Over the last several days, coffee has rallied to USD 242c per lb, its highest level since peaking at 260c early in the year. Calendar spreads are inverted to levels not seen since the Brazil frosts of the 1990s, certified inventory levels languish at the lowest levels in over two decades and physical prices are sky high. The coffee market is in the midst of an extraordinary time, yet with the excitement of rallies and sell-offs it is important to step back and gain some perspective.
So where is coffee market headed to from here?
Arabica is in a precariously tight situation that lends itself to rallies and volatility, and this tightness is very much front-loaded into the present. However, the coffee market is ‘forward looking’ (after all it is a ‘futures’ market) and so we need to project forward to understand where the coffee market is headed to from here.
In the original version of this article, I predicted a rally followed by a long-term sell-off. I still have the same conclusion, but now that the rally has begun in force, it may last longer than I had originally thought.
In this article, I will outline what to expect over the short, medium and long term and how it will impact the coffee market. While the outcome of lower prices is assured in the long-term (two + years), in between then and now, there is a lot of volatility that will depend heavily on currencies, supply and physical prices.
When evaluating the fundamentals, I like to start top to bottom to ensure that we do not lose the forest for the trees, and in coffee, the top of the forest is the annual #Supply and #Demand Balance sheet.
The long-term fundamentals have the coffee market in a two-year deficit after the surplus of the 2020 crop and looking forward to a return to surplus in the 2023 crop year. This the fundamental basis for my ‘bullish now, bearish later’ view.
The further forward in time we look, the more comfortable the balance sheet looks. This plentiful forward supply is largely driven by Brazil, but other origins will pitch in too. Especially with high prices over the last year encouraging growth in coffee.
Global supply will grow in 2023 and Brazil will likely be producing record crops again by the 2024/2025 crop. Loose balance sheets manifest in bear markets and weak differentials this is what will ultimately collapse the calendar spreads and send coffee prices back down to the lows, but we are a couple of years out from that point yet.
Presently, we are in a supply crunch driven by Brazil’s biannual cycle. Brazil is the world’s largest producer of coffee, and this biannual cycle is a major factor in world supply. In the last two years, the Brazil supply suffered a one-two-punch: the off-cycle 2021 crop in Brazil was devastated by drought and the on-cycle 2022 crop was doubly ravaged by frost and drought. This effect made an already down-year worse and stunted the recovery-year.
These back-to-back disappointing crops created back-to-back global deficits in coffee, decimated global inventories and ignited coffee prices to 200c and beyond.
Destination inventories in Europe, the USA and Japan all saw massive drawdowns, not only from the deficits but also from Covid-induced lockdowns that skyrocketed freight prices and snarled logistical efforts to ship coffee.
Supply problems in Colombia and Central America further accelerated the deficit and triggered rallies in differential prices across key washed coffees.
The combination of high freight prices, high differentials and slow transit times triggered another phenomenon: certified stock consumption (more info on Cert Stocks here). With all the delays and added expense to import coffee, it became financially attractive to decertify coffee and sell it for consumption.
This certified stock draw triggered impressive rallies in calendar spreads leading to the largest backwardation since the Brazil frosts of the 1990s.
Calendar spread inversions are rare in Arabica (due to tight position limits by the CFTC) but they will occur in the front month when there are shortages of certified inventory. While consolidated in the front month, this inversion has been persistent down the futures curve as the market does not anticipate a replenishment in certified stocks anytime soon.
Moreover, is the influence of the speculator.
Coffee managed money long positions
Usually, the spec long helps to accentuate rallies, and they did so in the case of the rally that peaked early in 2022. However, volatility knocked out the spec, bringing their positions down to the lowest point of the year. This, combined with low hedging dropped open interest and liquidity down to 2017 levels that has exacerbated volatility.
However, recently, the Robusta market has led a return of the speculator (Managed Money Longs) back to the coffee markets and prices are at their highest point since the peak back in February.
The return of the speculator has been instigated by a growing consensus that the 2022/2023 Brazil crop was worse than expected. This is the crop that was damaged by frost in July of 2021 and that damage turned this present crop from an expected surplus to a second deficit year.
This is the moment in which we presently find ourselves.
However, while this seems current and exciting, the truth is, this is all old news. The current deficit was widely predicted across the board a year ago.
Numerous analysts, trade houses and pundits discussed the historic deficit, the frosts, the droughts and how it would trigger a dramatic rally.
In my own work, on June 28th when coffee was trading in the 160s, I wrote about how there was a major frost predicted and that the market seemed to be discounting it. I concluded the article with the following statement:
“The deficit year this year will be drawing down global stocks to very low levels and the market will be relying on a large 22/23 crop to replenish those stocks. If the 22/23 crop is compromised, then we may be in a situation where we need to price ration coffee. If that is the case, it will be a heck of a bull coffee market.”
This did indeed happen, and it has been a heck of a bull market.
We are now in the worst of the 22/23 deficit. The 22/23 Brazil crop has just been harvested, and there is evidence that it may be worse than originally thought (although this is not universally agreed upon, a few key players think the harvest is actually better than they thought).
However, if all of this was predicted over a year ago, where will the futures market go from here? The answer is it will look forward to supply one + years out.
The conventional wisdom is that high prices plus coffee’s biannual nature mean we would have an improved 23/24 crop and that would trigger a surplus that would bring down prices. While the 23/24 Brazil crop is unlikely to be a record, it will likely be 10-25 percent higher than this current crop and return the global supply to a meaningful surplus.
Bear in mind, however, that this surplus follows two years of deficit so it won’t necessarily crush prices, but it could lower them below USD 200c and keep them there.
Precipitation in Brazil
For now, I would say the odds of a solid 68 – 72 million bag 23/24 crop are higher than a poor crop in 23/24 (60 million or less). This is based on several things: discussions with agronomists and farmers/traders on the ground, the biannual nature of coffee in Brazil, and a positive rain forecast for the wet season starting in October.
Despite this forecast, there is the distinct possibility that the size of the 2023 crop will disappoint. There are several main factors that would favour this possibility:
- extensive damage from frost/drought requiring replanting or skeletal pruning,
- a drier than usual dry season this year,
- damage to the plants from cold (not frost).
We will see our next indications of how the 2023 crop will perform with the blooming during the wet season in October. For now, my assessment favours a solid 2023 crop, but that is subject to change in the next month or two.
Irrespective of the fundamentals, the currency market has been a key influence on coffee prices in the past, and it will continue to have a significant influence going forward.
The US dollar and the Brazilian real both have a large impact on coffee. The BRL has an impact because it induces selling from coffee farmers in Brazil (as well as specs in New York and London who are wise to this dynamic). The BRL has devalued to historic lows which has been a huge negative impact on the coffee market.
The ‘greenback’ also has a major impact on coffee as coffee futures are priced in US dollar terms. This means that when the dollar rallies, the price of coffee in dollar terms (futures for example) falls. When the dollar falls, coffee futures rally.
The US dollar has rallied dramatically as the FX (foreign exchange) market has anticipated rate increases from the United States Federal Reserve to combat inflation. So far, inflation has not been brought under control so we should expect these rate hikes and dollar strength to continue.
Going forward our best guess is that the dollar continues to rally as the economy is strong and inflation still has a long way to go before it is under 2 per cent. That said, the USD has already rallied quite a bit and there are some warning signs that the US and global economies are at risk of recession. A recession in the US could put the federal reserve’s monetary tightening policy at risk which may reverse dollar strength. However, a global recession may actually strengthen the dollar if capital flows start flowing towards safe-haven assets.
For the Brazilian Real (BRL), the Brazilian Central Bank recently announced that its rate hiking cycle has ended, so we are likely to see that currency come under pressure. Add to that bearishness of the Brazilian elections this October and the country’s fiscal woes, and the outlook does not look rosy.
Unlike the Fundamentals, which are forward looking, the coffee market tends to incorporate the macro view in the present because FX movements are hard to predict, and coffee professionals are not currency professionals. Therefore, I would expect that currency strength for the USD and weakness for the BRL is not fully priced into the coffee markets.
The certified inventory is trickier because while we have enough coffee to last until the surplus in 2023, the supply of certified inventory could fall to very low levels before we see it replenished. These low inventory levels may persist well into 2023 and if certified inventory levels stay low, it is likely to keep calendar spreads high and will be supportive for the coffee market.
Over the last several weeks, we have seen a counter trend rise in the International Coffee Exchange (ICE) inventory, but this should not be taken for a trend shift. Since the lows in mid-August, inventories have risen from the lows of 550k bags, to 660k bags with another 130k still in the pipeline to be graded. However, the prevailing opinion is that these are not fresh coffees being delivered to the exchange, but rather previously certified coffees that are being resubmitted to the exchange to reset their aging penalty. Moreover, even with these stocks back on the exchange, inventories will still be at very low levels.
If certified inventory stays low, then the spreads will need to continue rallying to ration inventory and encourage delivery of new stocks.
Generally speaking, new certified inventory only arrives in size when physical prices of coffee are cheaper than delivering to the exchange, and this requires cheap differentials.
Regardless of how differentials react to supply and demand in the future, for now, the market is still tight. We do not anticipate a major collapse in differentials until at least next year’s Brazil crop and thus we don’t see a large influx of coffee likely to the ICE until that point. This means that we may be in a situation where backwardation persists for a year even though terminal prices may come off before then. The next major supply of certs at this point seems to be the 2023 crop washed Brazils and the following 23/24 October crops.
There is still a great deal of bullish sentiment in the market, as evidenced by the recent rally back up to USD 240c. The spec position is still largely cleaned out in Arabica (although it has started to pick up again), and the market recently adjusted its 22/23 Brazil crop lower. This, combined with the inversion, means that the present rally has potential to continue.
However, Brazilian coffee farmers have been holding back their sales explicitly waiting for a rally and I don’t see why they wouldn’t start to sell with the price heading back towards the highs. We also have October crops coming in a few months that will be sold as soon as they are harvested.
Finally, from a technical perspective, we often see a secondary rally after the initial sell off from the highs. This is where those who missed out before participating, and those who are long, add to positions. However, this is secondary rally is more of an emotional whipsaw rather than based on fundamentals and it fails unless there is new information.
There are several pieces of new information that can change this. Certified inventory may appear from an unexpected place and collapse the spreads, currency markets could go very weak or very strong, or the October crops could be much better or worse than expected.
However, the primary piece of new information that will change the outlook is the Brazil 23/24 crop. If we fail to get a good flowering or if there is an indication that this crop will not be good, then the bull market will likely resume or at the very least, prices will remain elevated.
There is a significant chance that the 23/24 crop is poor: maybe 25 percent (some of the reasons why are mentioned in the sections above). That is a one-in-four chance…not odds that you would want to bet the farm on.
That said, when predicting the future, we are not dealing in absolutes but in probabilities. My assessment of a decent to good crop in Brazil is 65 percent (with 10 percent chance of a great crop). If we get at least a decent crop, it will tip the scales into surplus for the first time in two years.
Putting this all together, we can see that the fundamentals and the shortage in certified stocks are strong bullish factors in the present. These can push coffee and calendar spreads up higher, and volatility elevated for longer than is comfortable. However, high prices will attract selling from Brazil and discourage consumption. We will see selling from the October crops hit the market in the next few months. If the 23/24 crop is not compromised, then there is a time limit approaching this bull market; and you will not want to be the one holding the long position when that happens.
- Ryan Delany is the founder of and chief analyst at Coffee Trading Academy (CTA) and has been managing price risk in the coffee industry for over 12 years. Prior to founding the CTA, Delany professionally advised clients around the globe in coffee price risk management, he is a Q Grader, a physical trader with a background in commercial, specialty and certified coffees and worked as the coffee and cocoa analyst/trader for a soft commodities hedge fund. Delany graduated from Harvard College and is a US Marine Corps veteran of Operations Enduring Freedom and Iraqi Freedom.