A Perfect Storm Is Brewing in the Coffee Market

Source: http://www.flickr.com/photos/ikhlasulamal/

Source: http://www.flickr.com/photos/ikhlasulamal/

Over the past couple of years, agricultural commodity prices have been trending downward. The price of coffee in particular has been hit hard, having fallen from $3/lb in 2011 down all the way to $1/lb toward the end of last year.

The weakness in coffee prices was due largely to weak demand coming from Europe because of that region’s weak economy, as well as strong output from the world’s largest coffee producer — Brazil. If we couple these particular fundamental aspects of the coffee market with broader declines in commodities and agricultural commodities in particular, it is no wonder that coffee lost two-thirds of its value.

However, things have started to pick up in the coffee market. As Europe’s economy begins to grow again Europeans are importing more coffee. In fact, coffee exports to Europe rose a whopping 37 percent from October to January. Furthermore, dry weather in Brazil  has adversely impacted this year’s coffee crop. As a result, the price of coffee has been surging in 2014, having reached $1.43/lb, which is more than a 30 percent gain for the year.

I think the price of coffee has further room to run. If dry weather continues in Brazil, then there will be a significant global shortage of coffee. Brazil produces over 2.5 billion kilograms of coffee annually. This is more than twice what the second largest coffee producer — Vietnam — produces (900 million kilograms.) Furthermore, while the coffee price is well off its $1/lb low, it is still more than 50 percent off of its 2011 high. In fact, the coffee price is even further below its 1977 all time high of about $3.50/lb. If we figure in inflation over the past 37 years, this means that coffee prices are extremely depressed compared to what they were back in the 1970s. Consequently, the price of coffee is set to rise both in the short and longer terms.

Investors interested in investing in coffee can buy the iPath Dow Jones-UBS Coffee Subindex ETN “JO”. Investors can also buy the iPath Pure Beta Coffee ETN “CAFÉ.” The latter fund uses derivatives in order to eliminate the disparity between futures contracts when one contract expires and the fund has to sell it in order to buy another. Ultimately, it hasn’t made that much of a difference. Since CAFÉ first started trading, JO is down 62.75 percent and CAFÉ is down 61.6 percent.

Rising coffee prices will also have a residual impact on coffee companies. Companies such as Starbucks (NASDAQ:SBUX), Tim Hortons (NYSE:THI), and Dunkin Brands Group (NASDAQ:DNKN) buy a lot of coffee. If the price of coffee rises, then these companies will have higher costs. This means either lower margins or rising retail prices, which will deter some customers from buying. Therefore, investors in these companies may want to consider selling their positions.

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