Coffee at 7-year highs as Brazilian crop is expected to fail

It would seem the world gets its kick start to the day only after we have had our first cup of coffee. What would we do without the caffeine rush? Starbucks has their earnings report today at the market close, but all eyes will be on the Brazilian weather forecasts for the remainder of the week.

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About 13 years ago a friend and business partner of mine investigated renting some retail space on a street in London to open a coffee shop. Just prior to this we had noticed that a local coffee chain had over-expanded and at the height of the Great Financial Crisis had been forced to close a couple of their coffee shops, which led me and others to think that there would be an opportunity to make our move into the coffee shop retail trade. Within the time we had explored what it would take, someone beat us to it and set up a coffee shop around the corner, which led my business partner and myself to ditch our idea thinking that the gap in the market had been filled.

Roll on a further 5 years and we were proven very, very wrong. Suddenly there were coffee shops on every street corner, competing for retail space with the likes of Tesco Metro and other retail chains. Then all the independent shops in the area, regardless of whether their core business was selling second-hand furniture, vintage clothing, hair salon, or cycling had a corner carved out for a coffee machine and pastry stall.

There was literally a coffee everywhere and no one seemed to be worse off for having it. The supply could not meet the demand. On the high street, café culture continues to boom, 80% of people who visit coffee shops do so at least once a week, whilst 16% of us visit daily

It felt as though the demise of the British pub correlated to the rise of the coffee shop, so maybe where people may have met for a couple of swift halves and a chat they had switched to a cappuccino or flat white. Maybe the caffeine was more addictive than the mix of cigarettes and alcohol which had been outlawed from public spaces like the pub. It could have been a fad but even though smoking is in decline and pubs have been under extreme pressure, the coffee continues to be drunk more and more.

In 2019, 95 million cups of coffee per day were consumed in the UK. Currently, there are 66.8 million adults living here, so on average, we drink nearly 1.5 cups of coffee a day. Personally, I probably have 3 but maybe I should reduce that. Globally, coffee is the second most drunk beverage, with only water being more widely drunk.

In 2020 the 3 largest coffee companies were Starbucks, Costa Coffee, and Tim Hortons. For those who have never heard of Tim Hortons, they are from Canada but have a global reach.

Starbucks was in the financial press today on the announcement that they in South Korea are selling a 17.5% stake in their Joint Venture to their local South Korean partner E-Mart inc. and the Singapore sovereign wealth fund GIC. They are also reporting for their fiscal Q3 2021 results at today’s market close and analysts are expecting good numbers. The company has reported better than expected earnings figures for the last four quarters with the latest revenues beat consensus too. The company’s net income margin fell in 2020 due to much higher operational expenses. The reopening of the restaurants, reduction in restrictions, and lower operational expenses are expected to improve the earnings in 2021.

The future however looks likely to be a bit more challenging for Starbucks and maybe the coffee industry. Over the last couple of months, there has been crop devastation in the areas of Brazil where Arabica coffee is grown. Starbucks proudly states that they only use 100% Arabica beans, “so you can enjoy the delicious, high quality these beans help to create”.

About 70% of Brazil’s arabica coffee is grown in the central Minas Gerais region, which is in the north of the southeast region of Brazil, which also contains the states of São Paulo, Rio de Janeiro, and Espírito Santo. It is Brazil’s fourth-largest state and has the second-largest population, exceeded only by that of São Paulo. Minas Gerais alone produces approximately 50% of Brazil's total coffee and has thrived since 1727 due to the ideal temperature, heavy rainfall, and a distinctive dry season, which has provided optimum growing conditions.

Climate change is influencing the coffee production of Brazil and the considerable changes in recent years have resulted in higher temperatures, long droughts interspersed by heavy rainfall, more resilient pests, and plant diseases. Recently though there have been wide-ranging frosts. Today Bloomberg ran a headline story which stated that a crop-killing frost is imminent for the Minas Gerais region adding to the previously damaging cold weather from last week.

Coffee futures have skyrocketed 26.70% in the last month and that is adding to the year-to-date run-up of 84.96% returns, but the ActiveTrader sentiment indicator shows that 79% of traders are shorting these prices.

Usually, when the retail sentiment gets to this extreme, I look for ways to fade them and to see if they get squeezed out of their position. I can only assume that the traders that are short believe the same will happen to coffee prices as it did to lumber. Where a supply shock sent the cost of lumber rocketing higher only to then have prices tumble on lack of demand and oversupply. The difference is there are forests of trees ready to be cut down should there be a supply shortage, and assuming the bottlenecks at ports free up soon, there should be a return to normalcy soon for most commodities. However, if you are reliant on an annual crop and the weather goes against you, there is nothing that can be done about this year’s crop if it fails. The demand will be left unfulfilled, and prices will increase at the consumer end.

Coffee producers can employ a short hedge to lock in a selling price for the coffee they produce while businesses that require coffee can utilize a long hedge to secure a purchase price for the commodity they need.

Following the managed money or going opposite to the producers’ hedges would appear to be a good passive way to follow the trend using the Commitment of Traders report over the long term. The recent data showed that producers added to their short hedges as coffee futures prices increased.

When there is a macroeconomic and fundamental reason for a trade, I find it is always best to go with the trend. Currently, that trend is for higher prices. Because coffee is a soft commodity in high demand, traders will have to keep an eye on the weather forecasts and crop yields. Which makes it a bit more involved than just buying on a moving average cross.

That said, I wouldn’t blindly buy at these elevated levels, any chance of a pullback should be considered a buying opportunity for now, as momentum is to the upside and so is the price action. A lot of the time momentum will lead to price. Whether the opportunity can come at the breakout level of 168.00, I don’t know, but if it did, the stops would most likely go below the next swing low as prices continued higher.