October
25, 2012
While many commodities
are prone to sharp fluctuations in demand, coffee demand has consistently
increased for decades. That demand paradigm might have a steep increase
in the coming years as China, India and other emerging countries are introduced
to the marketing power of the West.
Rising Global Demand
Global demand for
coffee is expected to grow by an annual rate of 2-3 percent for the next
decade. Meanwhile, coffee production has had a difficult time keeping up
with demand in recent years. The International Coffee Organization (ICO)
recently announced that they will launch a marketing campaign to promote coffee
in emerging countries. This should help increase demand and lay the
groundwork for acquiring new and loyal coffee drinkers into the future.
Demand for coffee is
fairly inelastic in the major consuming countries. This provides a
major insulation from economic and political crisis around the world. As
an added benefit, coffee demand could increase further if the global economy
has an upturn.
The emerging economies
have provided some of the best growth rates for coffee consumption and they are
expected to account for a large portion of the growth in the next decade.
Barclays Capital forecasts China demand to grow at a rate of almost 40 percent
a year from 2011 to 2015.
You don’t have to look
any further than Starbucks for proof of this. They expect China to become
their largest market outside the U.S., where stores are planned to increase
from 600 to 1,500 by the year 2015. Their operating margin in China/Asia
is 34.6 percent versus 21.8 percent for America. With that profitability,
it is likely that Starbucks will continue opening stores in China at a
relentless pace.
Similar efforts are
seen in India and other Asian countries as coffee shops are penetrating the
stronghold of tea as the customary beverage. McDonalds, Dunkin Donuts and
local coffee chains are introducing a whole new world to drinking coffee.
Not only are people drinking coffee at the coffee shops, but automatic coffee
makers are also being promoted heavily in the emerging countries. People
can consume their coffee on a daily basis from the comfort of their own home or
office - just like in America.
Will Supply Keep Pace?
The demand side of
coffee looks solid for the near future, but no market analysis would be
complete without looking at the supply side. Coffee producers will
have to keep up with the rising demand. The majority of Arabica coffee
beans, which are traded on the ICE Futures contract in the U.S., are produced
in Brazil. Colombia is the second largest producer of Arabica.
These areas are prone to the South American weather problems, which can bring
excessive rains and sometimes freezing temperatures.
There will be little
margin for error in the coming growing seasons if the coffee supply is to keep
pace with demand. We have seen these problems in the last few years for
Colombia. Coffee production dropped some 25 percent due to poor weather
and disease problems. The country is still struggling to get back to
normal production levels. During this period, prices reached record
levels above $3.00 a pound.
Rising input costs
could be a major obstacle in preventing a large increase in production.
Coffee producers are facing rising costs of petroleum, transportation, labor
and fertilizer. These costs make it risky and expensive to expand
production. A prolonged downturn in prices or a poor crop year could
devastate growers.
Coffee at Half Price
Coffee prices have
fallen about 50 percent from the high, which presents an attractive opportunity
in a market that is in a long-term uptrend. Brazil recently had a large
harvest, which helped depress prices. After the recent harvest, many
coffee producers are holding on to their supplies with the market at these low
prices. This is a good indicator that they feel prices have moved too far
to the downside and higher prices are ahead.
In order for the
market to move much lower from these depressed levels, coffee production is
going to have to outpace demand by a sizeable margin. That seems unlikely
considering rising demand and prevalent weather problems throughout history for
coffee. When you adding rising production costs and coffee prices cut in half,
it seems unlikely coffee growers have a major incentive to rapidly increase
production in the near future. The quality of Arabica coffee beans
has also been an issue in recent years. Not only do they have to produce
a large quantity, but the quality also has to be there.
Trading Opportunity
The coffee market has
the fundamentals that we like to see in our option selling approach. The
fundamentals over the next few quarters and even years should support steady to
higher prices. We don’t believe prices will move substantially lower from
these levels, which works well when selling puts well below the market
price. This type of position will show a profit at expiration if prices
remain the same, move slightly lower or the market rises. This type of
trading strategy helps put the odds in our favor.