The recent spate of dry weather in Brazil brought a little life to downtrodden coffee prices this month. Although prices have fallen back again, volatility is back in coffee. That means one of our favorite markets for selling options is back in play. But with volatility up, does that mean higher coffee prices as well? Should call sellers hold off and instead perhaps start positioning for a trend change? To best gauge how to sell options in this market, let’s take a look at the current fundamentals for guidance.
Fundamentals Still Ride on the Bear
Coffee’s recent price doldrums have as much to do with the global “risk off” vibe as they do with 5 consecutive years of ample Brazilian production. Brazil is by far the world’s largest producer and exporter of coffee. Thus developments in the Brazilian crop can have an outsized effect on prices.
But Brazil’s “new” coffee crop (2015-16) is currently in its infancy and is in the midst of its critical flowering stage. At the beginning of the production cycle, coffee trees develop tiny flowers that eventually drop off leaving a small “cherry.” This is what we eventually know as a coffee “bean.” How ever many flowers the trees gets determines how many beans we will eventually have.
Poor weather can mean less flowers. Thus weather in the flowering season is critical.
The new volatility and latest price rally has been primarily due to dry weather in Brazilian growing regions causing concerns over flowering.
But October weather rallies are not uncommon coffee. In fact, the increased volatility it brings could present opportunities to take advantage of the continuing, longer term bearish fundamentals in coffee. These include:
- Potential record 2016 Brazilian Production
- Burdensome Vietnamese and Columbian Production
- Seasonal Tendencies that favor bears
Understanding each is key to extracting premium from the coffee market.
1. Potential Record 2016 Production
Despite dry October weather, the USDA still projects 2015/16 Brazilian coffee production to top 50 million bags. Some early private estimates had some private estimates had the crop hitting a record 60 million bags. Although the recent round of dryness may have tempered that estimate, the year is young and the main growing season has yet to begin. The point is, with ample harvest the last 5 years and another projected for next year, the new crop can lose some yield and still come in more than adequate. Better irrigation, modern pruning techniques and development of new growing areas have served to make coffee production more consistent in Brazil. Bottom line: Unless the weather gets a whole lot worse, expect a big harvest from Brazil in 2016.
Brazil is expected to see another 50+ million bag harvest in 2016. (Note: 2014/15 crop has since been revised down to 45 million bags)
2. The Emergence of Vietnam and Revival of Columbia
In 1992, Vietnam produced just over 2 million bags of Coffee. In 2016, they’ll generate over 28 million bags. In the past 2 ½ decades, Vietnam has gone from a bit player in the coffee market to a global powerhouse. Now the second largest coffee producer in the world, Vietnam’s emergence has provided a cushion to shortfalls or fears about the Brazilian crop. Columbia’s reemergence as a player is a factor as well. Expected to produce 13 million bags of high quality Arabica in 2016, South America’s “other” coffee grower would boast the highest production year since 1996.
In the last 24 years, Vietnam has emerged as a global coffee powerhouse.
Columbian production has rebounded since newer coffee trees began to replace the trees lost to weather in 2008.
3. The Seasonal Play
Those getting “all bulled up” over dry weather reports from Brazil may want to take a bit of history into account. The fact is, weather is usually dry in Brazil from May thru October. There is usually some kind of dryness concern during flowering. And typically by November or December, ample (often excessive) summer rains begin to fall. Coffee trees have 2nd and 3rd flowerings where yields can often be “made up” from disappointments during October’s first. This is why September and October rallies often give way to weaker prices once seasonal rains arrive in November and December (See chart below.) If you’ve studied our book, you know that seasonal tendencies can play a big role in helping to select high probability options to sell.
Coffee prices have tended to weaken into November and December as the beginning of Brazilian Summer typically brings timely rains.
Conclusion and Strategy
The relentless 2015 downtrend in coffee was interrupted this month by a sudden, albeit limited rally in prices. This was due primarily to dryness in Brazilian growing regions during the pivotal flowering period for the 2016 crop. While markets could swing either way in the coming weeks based on Brazilian weather, volatility in coffee options has surged as a result. The public loves a weather story. The public likes to buy calls. This is what creates so many advantages for option sellers.
Despite recent dryness, long term fundamentals remain bearish. Without additional weather problems this year, Brazil could potentially produce a record coffee crop in 2016. In addition, Vietnam and Columbia are both expecting bumper crops with Columbia expecting its biggest harvest in 20 years.
Finally, seasonal tendencies favor weakening coffee prices into December as Brazil’s summer rainy season arrives.
For these reasons, OptionSellers.com would view an additional weather rallies in coffee prices over the next 30 days as opportunities for selling deep out of the money call options. Recent volatility has made strikes 50, 60 even 70% out of the money available.
We’ll be working to position client portfolios over the next 2-4 weeks in writing these call options.
For more information on managed option writing portfolios with OptionSellers.com, visit www.OptionSellers.com/Discovery to receive a free investor information pack. A limited amount of new account consultations are available monthly as well.
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James Cordier is the author of McGraw-Hills The Complete Guide to Option Selling, 1st, 2nd and 3rd Editions. He is also founder and president of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television, Fox News and CNBC. Mr. Cordier’s book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now.
