COFFEE: FOLLOW THE SIGNALS AND DON’T BE FOOLED BY FAVORABLE WEATHER IN BRAZIL

The day-to-day speculation around the health of the Brazilian coffee crop has successfully driven market prices during the current harvest season. We added Coffee on the long-side in real-time alerts (ETF: JO) on Monday after an oversold signal.

From a quantitative standpoint, the ETF JO is currently sitting above both its TREND (intermediate-term) and TAIL (long-term) lines and we expect support at these levels:

  • TREND = $34.70
  • TAIL = $33.89

COFFEE: FOLLOW THE SIGNALS AND DON’T BE FOOLED BY FAVORABLE WEATHER IN BRAZIL - chart 1 levels chart

FOLLOW THE SIGNALS:

  • TRADE (3 weeks or less)
  • TREND (3 months or more)
  • TAIL (3 years or less)

When our internal quant signals (support and resistance levels over multiple durations) infer a bullish set-up over the intermediate and long-term, we look to market sentiment and overall positioning for confirmation on the immediate-term TRADE signals.

The price movement in coffee this week is not all that uncommon in the softs space (coffee in particular is the most volatile commodity in the CRB commodity index).

Based on the set-up of non-commercial players in coffee futures and options markets as disclosed weekly by the CFTC, capitulation in long positions likely added to the sell-off. We expect to see a marginally shorter market when this week’s “commitments of traders report” is released after the close:

The market was positioned 1.68x standard deviations longer vs. trailing 12-month averages while bullish market activity diverged from absolute prices.

COFFEE: FOLLOW THE SIGNALS AND DON’T BE FOOLED BY FAVORABLE WEATHER IN BRAZIL - CFTC Sentiment

We saw much higher relative volumes on the green days and lower relative volumes on the red days.

There is a difference between getting stopped out on a long-position, and consistent, healthy selling (getting this right is part of assessing real, inherent risk in any market):

  • Monday (BEARISH PRICE/VOLUME SIGNAL): Price Down, Volume Up
  • Tuesday (BULLISH PRICE/VOLUME SIGNAL): Price up, Volume UP
  • Wednesday (BULLISH PRICE/VOLUME SIGNAL): Price Down, Volume Down
  • Thursday (BULLISH PRICE/VOLUME SIGNAL): Price Up, Volume Up

There is a behavioral difference between a downward price move from large positions being stopped out on a long-position, and consistent, above average selling. We want to see consistent selling on above average volumes, with implied volatility bid-up to confirm market participants respect the move.

This week, we saw downside moves, on fewer trades, with implied volatility selling for -14.2%, -5.8%, and -2.8% below 1m/3m/6m averages. Implied volatility was selling for 53% last Friday and is now selling for 44%.      

At the money implied volatility is much lower on the week with a much flatter Dec. 14’ listed skew

COFFEE: FOLLOW THE SIGNALS AND DON’T BE FOOLED BY FAVORABLE WEATHER IN BRAZIL - Dec 14 implied skew 

With this set-up we’ll look to add to coffee on an oversold signal should nothing change from a fundamental standpoint.

We’re sitting on a loss but don’t believe the fundamental outlook for coffee has changed materially this week to support a -8.9% sell-off.

Coffee is the most volatile commodity in the CRB Index, and we expect these large price swings that often widely decouple from the fundamental story over the short-term. The higher ratio of open interest to average daily trading volume creates this set-up with fewer market making liquidity providers vs. grain or energy markets where realized price volatility and speculation embedded volatility leverage is lower.     

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We hosted a call with renowned coffee specialist Judy Ganes, founder and CEO of J. Ganes Consulting service for agricultural softs. A link to the replay of that call is included below:

Coffee Outlook in 2015 and Beyond

The takeaway was that regardless of how the weather turns on the margin during the harvesting period in OCT-DEC, irreversible damage is much more threatening than consensus expectations:

  • For the first time we are looking at a two-year production deficit vs. a normalized year-on, year-off production cycle:
    • Late winter frost last year: Brazilian November-December mild frost lowered crop quality
    • Severe Drought: Drought and lack of moisture in tree root system from January-March during the vegetative period
    • Heavy Rainfall: Late timing of heavy rainfall knocked flowers off trees, reducing the available volume for harvest (CURRENT CATALYST)
    • Brazil WILL NOT produce enough volume in 2015-2016 to meet the global market demand for Arabica coffee
    • Aggregate demand next year is expected to be around 34 million bags. However due to a current stock deficit and severe crop damage, Brazil’s production yield will be just 27 million bags in 2015
    • Not enough capacity from other countries to cover the expected crop shortage of premium Arabica coffee in Brazil
    • How High Can Prices Go? $2.75-$4.00/LB. There will likely be a spike in prices for Arabica and a higher basis for other grades of coffee.

See the following links for our restaurants team’s bearish thesis on Starbuck’s which will be supported by a worse than expected Brazilian crop:

SBUX Best Ideas: Short Call

New Best Idea: Short SBUX   

Ben Ryan

Analyst