Have you had your coffee yet?

30 Nov 2023

We already know that coffee beans have always been one of the most traded commodities in the world, specifically second, so why the sudden interest again?

Figure 1: Summary of World Coffee

In recent years, global consumption has increased at a higher rate than production due to pent-up demand. This rather large deficit in balance in the past two years puts the coffee market in an interesting spotlight. Nonetheless, arabica beans continue to be the more favored selection, with South America as the central production region, driven mainly by Brazil.

Gaining Access to This Market
Amongst various coffee derivatives, a coffee futures contract is the most common way to trade coffee. The 4/5 Arabica Coffee Futures (ICF) listed by Brasil, Bolsa, Balcão (B3) Exchange is an example of such contracts.

For those unfamiliar with futures contracts, it is a legal agreement to buy or sell a specified asset at a predetermined price for delivery at a specified time in the future. For the ICF contract, the asset is 100 bags of 60 kilograms filled with grade 4-25 or better Arabica coffee bean produced in Brazil that is meant to be delivered in the city of São Paulo, Brazil, or a B3 accredited warehouse.

The ICO’s Grading and Classification of Green Coffee states that “coffees of the highest altitudes are denser and larger in size than those produced at lower altitudes.” Loosely speaking, larger beans with higher density are better.

The grade indicators refer to the number of defects found in a 300g sample. To achieve a 4-25 grade, the coffee must be classified by B3 in accordance with its rules and regulations. This grading system is more specific to Brazil-produced beans. Other coffee-producing countries have other specifications and classifications.

The Trampoline Effect
Figure 2: Supply & Demand Factors

Historically, the ICF future prices resemble that of a trampoline, with major support lines at the 124.55 and 103.60 levels. Let us explore some of the factors that caused these jumps previously; bear in mind that consumption of Arabica beans has been steadily increasing since the 1990s.

S1: Poor weather conditions in South America in 2010
Brazil suffered from poor weather conditions and faced significant problems in meeting the expected crop yield. Large producers were also considering hoarding their stocks. The problem was further exacerbated by the backdrop of record low arabica stock levels since the 1960s.

S2: Drought in Brazil in 2014
Similarly, poor weather conditions caused uncertainty in crop production for the harvest year and pushed prices up.

S3: Drought and frost in Brazil 2021
The effects of drought followed by a severe wave of frost in Brazil wiped out its coffee production. This was accompanied by increased freight costs and shipment issues caused by Covid-19.

S4: Harvest Conditions
Evidently, weather conditions pose significant downside risks to the coffee supply. Moreover, occasional coffee leaf rust coupled with increasing demand has caused spikes in coffee prices.

USD and Coffee
Figure 3: ICF and DXY (Inverted)

As with many commodities, coffee tends to move inversely with USD. This is especially so since most coffee contracts, like the ICF, are priced in USD. When the dollar rises, coffee becomes more expensive in non-USD terms and can cause international demand to fall, and vice versa.

Figure 4: ICF and BRLUSD

This relationship becomes more apparent when compared to BRLUSD. Our thought process:

Local Brazilian producers and manufacturers traded these ICF contracts as a hedging tool. During the physical delivery of the beans, these market participants would then have to do a currency exchange. Consequently, the impact of BRLUSD rates would have a larger impact on them.

Similar Coffee Futures Contract
Figure 5: ICF and KC

The two contacts’ underlying assets - arabica beans - have similar grading standards. Consequently, macroeconomic factors are likely to have similar impacts on the two contract prices. The prices between the two contracts exhibit a very strong positive correlation. We can then create a spread with ICF – Coffee C (KC) Futures Contract.

Figure 6: ICF - KC

ICF is quoted USD per bag for a contract size of 100 60kg bags, while KC is quoted USD cents per pound for a contract size of 37,500 lbs. We can then create a spread with ICF1!/60-KC1!/0.4536/100, by converting both contracts to the same base units.

The spread setup indicates that KC generally trades at a premium compared to ICF. This could be attributed to several factors, a notable one being the higher liquidity preference investors tend to have for the KC contract, which might reflect a broader international preference. It is also worth noting that ICF requires Brazil-produced arabica beans, while KC comprises beans from other countries. This could explain the uncanny coincidence between the upside bias in spread movements (Figure 6) occurring in periods identified in Figure 2 – supply-side factors driven mainly from the Brazil side.

Putting into Practice
Enough has been said about coffee; you must be wondering how we then use this information to set up trades. Here are some ways for consideration.

Case Study 1: Directional Driven
By considering current macroeconomic factors on coffee, to express a “quieter” outlook on coffee, an investor could sell the ICF future contract (ICFH4).

At the present level of 206.00, with a stop-loss above 219.00 – a conservative resistant line – it brings us a hypothetical maximum loss of 219.00-206.00 = 13.00 points.

As shown in Figure 2, if ICF1! Reverts to major support line 124.55, a hypothetical gain of 206.00-124.55=81.45 points.

Each ICF futures contract represents 100 bags; the value of each point move is USD100.

However, as we approach the main harvest period for Brazil, May to Sep, it is of paramount importance for the investor to keep a watch for any potential hiccups that could negatively affect the harvest yield. Furthermore, this is likely to be a medium-term macro-driven strategy.

Case Study 2: Spread Driven
Regarding the ICF-KC spread currently trading at the upper bound, an investor with a bearish short-term view that the spread will trend downwards could sell ICF futures contract (ICFH4) and buy KC futures contracts (KCH4).

At the present level of 206.00 and 169.95 for ICFH4 and KCH4, respectively. Following the formula above, the spread will be at –0.31336 points.

Setting the resistance at the Fibonacci 50% ratio, we have a stop loss at -0.25, which brings us a hypothetical maximum loss of -0.25-(-0.31336) = 0.06336 points.

Setting the support at the Fibonacci 38.2% ratio, we set our take profit at -0.40, which brings us a hypothetical gain of -0.31336-(-0.40) = 0.08664 points.

The value of each point move in ICFH4 is USD100, while KCH4 is USD375.

Conclusion
There are various methods to create opportunities for investors, depending on how the investor would like to view the market or what other financial assets to pair up with coffee futures contracts. What we have covered in this article merely scrapes the tip of the iceberg, and we hope investors keep a creative mindset and explore other potential options.

Disclaimer:
The contents of this article are intended for information purposes only and do not constitute investment recommendations or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.