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The Economist noted last week that “a shortage of premium Arabica beans from Colombia (the world’s second largest producer behind Brazil) and Central America has sent coffee prices shooting up by 25% since the beginning of this year, and traders expect wholesale coffee prices to increase further before the arrival of the new Brazilian crop later this year.”  Bloomberg reported yesterday that “persistent wet weather in Colombia may hamper a recovery from last year’s 33-year production low by depriving plants of sunlight,” according to Jorge Lozano, head of the National Association of Coffee Exporters.  Meanwhile, inventories of arabica coffee in warehouses monitored by ICE Futures U.S. have dropped to the lowest level since May 2000.  Yet Sudakshina Unnikrishnan, a commodities analyst with Barclays, maintains that the price spikes in Arabica and Robusta coffee are not linked to underlying supply and demand issues.  “There is no fundamental reason for coffee prices to have increased so much in recent weeks,” she said back in June.  “Although global inventories have come off over the last few years for the 2010-2011 marketing year we are expecting Brazilian production to be very high.”

Kudos to Tom Lydon for returning my gaze back to coffee, which along with cocoa, is one heck of a tasty commodity to track.

Lydon cites Bloomberg’s Claire Leow, who reported on Tuesday that world coffee consumption may outstrip production by as much as 8 million bags in 2009-10 because of the smaller crop in Brazil, the world’s top grower:

Prices of the mild-tasting arabica coffee used by Starbucks Corp. jumped 6.1 percent yesterday, the biggest gain in almost three years as Brazil’s Agriculture Minister Reinhold Stephanes said output may drop as much as 22 percent next year to as low as 36 million bags. Prices of the bitter-tasting robusta used in espresso and instant coffee by Nestle SA climbed 4.3 percent.

Interestingly, coffee has outperformed commodity indexes since prices plunged at the end of June.  Arabica has dropped 29 percent in New York, for example, compared with a 61 percent slump in the S&P’s GSCI index of 24 raw materials.  Leow’s report mentions, by the way, the other two coffee exporters of note–Colombia and Vietnam:

Colombia was expected to produce 12.5 million bags, “but rains may have reduced that by 200,000 to 500,000 bags.  Good management practices will keep the crop at between 12 million and 16 million bags in coming years, said [Nestor Osorio, International Coffee Organization Executive Director].

“Vietnam isn’t losing very much because the industry is still young and the trees have strong yields,” he said, estimating the current crop at 21 million bags. Output in the next three years may stabilize at 18-20 million bags, he said.

Finally, the  iPath Dow Jones AIG Coffee TR Sub-Index ETN (NYSEArca: JO) is down 24.8% since inception.  It, along with the other soft commodity funds from the iPath family, is arguably a prudent play, especially if you buy into the Jim Rogers’ secular commodity hype that reasons that the world is only getting bigger, and demand can only outpace supply in the long run.

Interesting tidbits while we’re still on the subject of the coffee trade, and especially its rise in Asia which has all kind of global macro bells going off in my head (or is that just a caffeine high?)

This article from Business Daily (BD) Africa is dated roughly a year ago, but still seems highly apropos given my last post on the expected rise in both global demand for coffee, and also the contract prices of coffee futures. Highlighted points include:

  • China, famous for its ancient tea traditions, is following the rapid development already seen in Japan. An old tea-drinking nation, China’s rich neighbor has become the world’s third biggest importer of coffee in just 40 years.
  • China’s consumption–estimated at between 30,000 and 40,000 tons for the mainland–is still less than a tenth of the demand in Japan, according to the International Coffee Organization. However, coffee consumption is growing by 10-15% per year, a rate of growth surpassed only by Russia.
  • Coffee shops are popping up across China. The biggest chain, Taiwan’s UBC, now has around 1,100 stores on the mainland, including 300 that opened last year. Second is Starbucks, which has more than 250 stores in mainland China and predicts that the nation will become its second biggest market outside of North America.
  • Despite coffee’s increased market share, African coffee growers have a fairly low presence in China. As of summer 2007, Uganda was the only African coffee producer with its own distribution chain. Yet all coffee growing nations desperately need to boost their exports to China to help adjust the trade imbalance.
  • Two factors may explain African coffee’s lack of market share: one is marketing, or the lack thereof, especially when compared with South American and specifically Colombian brands; the second is the cheapness and competitiveness of the Chinese marketplace. “China is still a cheap market,” says Ji Ming, director of the China Coffee Association, and higher quality, higher priced beans from say, Kenya or Ethiopia, may not seem so attractive, especially when compared with Vietnamese or Ugandan grown robusta.
  • However, most analysts are convinced that a combination of both local distribution and better promotion could help African arabica growers garner more market share. “We’re confident that with a little more promotion our exports will really increase,” claims Melaku Legesse, head of trade at the Ethiopian embassy in Beijing. “The big brands are now starting to influence Chinese buyers on quality issues and our name is getting better known.”
  • African arabica growers, however, will have to compete with the domestic Yunnan Arabica, which supplies all of the beans for the China-based Nescafe factory that opened in 1992. Roasters in Europe and Japan are increasingly buying Chinese Arabica too. And roasters within China are buying more local coffee in order to avoid the high tariffs on imported product.

Within various frontier markets in Africa are two “soft” commodities beloved by many: coffee and chocolate. We will touch on chocolate (and specifically the Ivory Coast, which accounts for 40% of its world trade) later.

With coffee, like other agricultural commodities, there is a cyclical aspect to pricing. It is also subject to supply and demand pressures. And in particular, as we’ve seen the past few years, prices are somewhat at the mercy of the dollar. Ethiopia and Kenya in particular are receiving increased attention and recognition for the superiority of their crop, especially in relation to the lower quality fare found in Latin America and Vietnam. Economist recently wrote, for instance, that “altitude, climate, soil and genetic diversity give East Africa an inherent advantage in quality. With lower-grade Latin American coffee dominating the market, there is scope for the best coffees from Ethiopia, Kenya, Tanzania and Rwanda to establish themselves.”

Ethiopia is the largest African producer, with coffee sales last year of $425m (representing 36% of export earnings). When studying coffee, it’s important to first distinguish between arabica coffees–a species of coffee indigenous to Ethiopia and Yemen, believed to be the first species of coffee to be cultivated, and considered to produce better coffee than the other major commercially grown coffee species–and coffea canephora, or robusta (here, an arabica fan contrasts the two). Arabica contains less caffeine than any other commercially cultivated species of coffee. Robusta is cheaper to produce, however, and still has a place as filler in instant coffees and also some espresso blends. In recent years Vietnam, which only produces robusta, has surpassed Brazil, India and Indonesia to become the world’s single largest robusta exporter.

But investors should be mainly keyed in on the arabica brand of bean. Conceptually, I’m long arabica for a variety of reasons. For starters, as Economist notes, “coffee prices are the highest they have been for a decade. As consumers in India and China develop a taste for the drink, prices are likely to keep rising. Meanwhile something new is happening in developed markets. Europeans, Americans and Japanese are switching to higher-quality coffee. Discerning consumers now demand authenticity: they want stories about where their coffee beans come from. So the best coffees will increasingly be differentiated, like fine wines and spirits, and sold at previously unthinkable prices.” One only has to look at China by itself to begin to quantify this drastically increased expected demand. For instance, if China increased its current per-capita coffee consumption from about 200 grams to the same levels as in Japan (about 2.3 kilograms), then coffee consumption in China would be almost 3000 million kilograms (compared to about 100 or 200 million kilograms for most Western countries). At present, China is consuming around 45,000 tons of coffee/year, and is growing at a rate of 10% to 15% annually.

Second, I believe in the positive effects that I expect will result from the agreement signed last year between Starbucks, the world’s biggest coffee chain, and the Ethiopian government. You will remember that Starbucks was initially against the government’s plan to trademark the names of three local coffee varieties–Harar, Yegarcheffe, and Sidamo—the bread and butter varieties, so to speak, of Ethiopian coffee, and widely recognized as among the finest beans overall in the entire world. Starbucks argued that if it had to license trademarks, then certain legal complexities could be introduced whereby it might be deterred from buying trademarked beans in the first place, thus hurting Ethiopian farmers with distressed sales. But the government stood its ground. Trademarking regional varieties would establish them as brand names and enable farmers to demand higher prices. With the agreement in place, Ethiopia quickly licensed its brands to 70 suppliers worldwide, including Starbucks. So much for that deterrence? The firm announced last year that it planned to double its imports of coffee from East Africa through 2009, and that it also planed to build a farmer support center staffed by a team of experts in soil management and fieldcrop production to help farmers increase their capacity to produce high-value coffee. It has also spent over $1m on microfinance to East African farmers. Thus, the general industry consensus is that the agreement will be a net positive for farmers. Economist concluded its analysis by quoting Rick Peyser of Green Mountain Coffee Roasters, an American supplier which counts Yegarcheffe among its premium coffees: “[Peyser says that] it will be only a matter of time before the trademarks start to improve the lives of farmers. Ethiopia is now planning to extend the trademark approach into new areas, such as traditional medicines and certain types of teff, the country’s usefully gluten-free staple cereal crop. But coffee, an unparalleled genetic resource, with over 5,000 varieties, will remain the biggest earner.”

How to play East African, arabica coffee? You could invest into companies like Starbucks, which has taken a beating recently due to a slumping U.S. economy (but is also primed to capitalize on increased global sales, especially in China and East Asia). But Starbucks itself does not provide direct access to the coffee market; rather, it must hedge its purchases like anyone esle, and also account for rising costs in other aspects of its production. Another option could be commodity-specific ETFs, which sometimes feature coffee among their listings. However, coffee is not likely to play very prominent role in its holdings.

I believe the play is two-fold. Starbucks will theoretically suffer (as it has historically) if commodity prices continue to rise (see graph), even though it buys most of its coffee based on contract and not the open market.

Theoretically, though, dollar bulls could hedge all at once against the dollar’s further fall (especially when interest rates eventually do rise again), the coffee commodity’s continued rise, and also take advantage of increased global demand in Asia, by getting in while Starbucks is still in a rather depressed market state. Jason Simpkins notes, for instance, that “even though East African nations are among the world’s biggest coffee exporters, China’s accelerating market has proved elusive to African growers.” But now, with Starbucks on the scene, in addition to purchasing African coffee beans, offering micro-financing loans to farmers, and providing social development programs, “it will also be distributing brands of coffee licensed by African nations to its 400 coffee shops in mainland China.” Thus, over the next few years, “[while] East African nations will continue to push for their own avenues of global distribution, they will also continue in their efforts to boost the price of their unique coffee beans in any way they can. In the meantime, Starbucks [will] become a very powerful agent for African coffee production, particularly in China, the world’s fastest growing coffee market.”

However, there may be no better play than to buy directly into the coffee market through futures contracts and specifically through ICEthe Intercontintal Exchange, which operates global commodity and financial products marketplaces, including the world’s leading electronic energy markets and soft commodity exchange. A coffee futures contract is a standardized, binding agreement to make or take delivery of a specified quantity and grade of a commodity at an established point in the future at an agreed upon price. A contract buyer is obligated to take delivery of coffee according to contract terms at a specified date, while sellers are obligated to make delivery. Buyers are considered to be “long” and sellers “short” the coffee futures contract.

JGW

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