This article was written by David Shabotinsky, a Financial Analyst at I Know First, and enrolled at an undergraduate Finance program at the Interdisciplinary Center, Herzliya.

Coffee Industry Analysis

“The exchangeable value of all commodities rises as the difficulties of their production increase.” – David Ricardo

Summary:

Types of Coffee in the market today and how it is traded as a highly demanded commodity

Global demand trend

Negative global supply shock increasing price per pound of both types of coffee beans

I Know First maintains a bullish mid-term outlook on coffee traded as a commodity

Coffee Market Background & Key Player

Since 1457 in Constantinople (Rome), where the modern day coffee shop was founded, people around the world have enjoyed drinking a daily ‘Morning Joe’, or coffee as a beverage. Though coffee beans were originally developed and grown in Ethiopia for thousands of years, today the main producers of Coffee beans can be found in Brazil followed by Vietnam. Today, investors are able to achieve ample exposure in the coffee markets and are not simply restricted to trading it as a futures contract.

(Source: International Coffee Organization)

I Know First offers its subscribers exposure in the world of Coffee through its forecasts. It currently forecasts iPath Bloomberg Coffee SubTR ETN (JO), an ETN designed to provide investors with exposure to the Dow Jones-UBS Coffee Subindex Total ReturnService Mark. The Dow Jones-UBS Coffee Subindex Total ReturnService Mark (the “Index”) reflects the returns that are potentially available through an unleveraged investment in the futures contracts on coffee.

However, many investors opt to choose to buy and sell futures, betting on volatility in the price movements of coffee. Essentially, a trader is able to secure coffee beans a specific price, for a specific time frame, relative to its spot price. When trading on a coffee exchange, such as Brazilian Mercantile and Futures Exchange (BM&F) and/or Intercontinental Exchange (ICE), the trader secures the price of the contract by multiplying 37,500 pounds (general expected quantity) times the price per pound of coffee.

In the market there are two main types of coffee beans produced for consumption. They are Arabica and Robusta beans. The former is considered tastier on average, thus commands a price premium in the market. While the latter is more bitter but with a 50% higher concentration of coffee. Brazil is the top producer in Arabica coffee, while Vietnam producers the most Robusta coffee. While Brazil is able to command a lead in exporting coffee has there is a higher demand for Arabica, it is still susceptible to competition from other countries that focus more on Robusta coffee (not grown in Brazil). Though coffee bean production is on a rise has droughts in both countries are nearing an end, with more rainfall, consumption is still outstripping demand. As described in the diagrams below, consumption was greater than output by approximately 3.3 million 60kg bags of coffee beans. The main indicators of coffee that affect price levels are systematic risks that relate to the crops, demand, and roasters/coffee importers. Today, the supply or output has been a decline, while roasters such as Starbucks and Nestle have been attempting further expand their global coffee operations. Currently, demand has outpaced production levels for the past two years as of September 30th, 2016. Since this will likely affect the bottom-line for many coffee roasters and producers, i.e. Starbucks, a price increase in your daily cup of ‘joe’ may occur in the foreseeable future.

(Source: International Coffee Organization)

Negative Global Supply Shock

The global population of over seven billion people (and growing) means that coffee consumption will continue to rise with an ever growing world population. This is especially the case in emerging economies and China which has seen a large growth coffee shops this past year. For example, Starbucks has 2,300 stores all over China and plans to expand to 5000 by 2021. Large supply concerns in the world’s largest exporters of Coffee beans can cause a negative supply shock to dramatically skyrocket coffee prices since demand won’t falter. Brazil which has experienced heavy drought levels over the past two-year has put greatly hurt their coffee crops has threatened to hurt global output for Arabica beans, and drought conditions in Vietnam have resulted in an 11% decline in the Robusta crop. These systematic risks come at a crucial time for coffee bean crops, as it’s the flowering season where the actual yield is produced for the beans. Furthermore, many investors are carefully watching which direction the Brazilian economy will take under the new administration there.

Additionally, a higher demand is seen with Arabica coffee beans causing a further increase in its premium of about 9.7%. This come as Vietnam expects Robusta supplies to drop further drop 20% and countries in the EU and Britain increasing their consumption level. For December futures, Arabica traded at up 4.3% at about $1.645 per pound.

As a result of these macro implications for Coffee producers, Robusta coffee climbed to two-year high last week, trading at $2,126 per ton from ICE Robusta coffee futures. Though it is hovering around the $2,000 range, continuous supply concerns with an ever-growing consumption have caused investors to expect further price increases. Though Arabica coffee has seen impressive gains throughout this year as well Robusta has clearly outperformed its peer, as a many investors have expectations for a deficit to occur in the coming months. The International Coffee Organization currently predicts a deficit of 3.3 million 60kg bags of coffee for 2015/2016, meaning a tighter supply is expected.

I Know First Coffee Forecast

Though I Know First algorithm’s forecasts a bullish price movement for a mid-term outlook, in the long term coffee prices will likely begin declining from new heights as supply and demand will stabilize to reach an equilibrium level. The reason is because the main effects on the current price spike are the negative supply shock occurring at the moment. However, analysts are expecting an end to the current drought levels as well a better political situation emerging in Brazil’s new government.

Conclusion

Though the top two coffee producers are currently experiencing troubles with coffee production, the market should reach equilibrium as this problem has been persisting for quite some time now. Additionally, if coffee roasters/sellers such as Starbucks feel that this problem will persist in the foreseeable future, they may well decide to raise the price of their coffee, as to not drastically affect their margins. Over the next few months we recommend investors undertake this opportunity in the coffee market, while being more cautious over a longer period.