Short-Term Supply Squeeze Is Call Writing Opportunity in Coffee

The market was reacting to fears of a short-term supply crunch due primarily to Vietnam's reduced 05/06 coffee crop. Vietnam is the world's second largest producer of coffee behind Brazil. Output in 2005/2006 was off 21% in Vietnam due to a lingering drought in several key growing regions. As we near the end of the crop year, the industry is running low on Robusta beans and the market is adjusting accordingly.

While the LIFFE contract trades Robusta coffee beans, there is another coffee futures contract traded in New York. The New York Board of Trade (NYBOT) coffee contract is for Arabica coffee beans. While the LIFFE and NYBOT contracts are sisters, they do not always move in tandem. Yet, they share a lose correlation that can often present opportunities for traders familiar with the fundamentals of each.

Arabica and Robusta coffees can serve as substitute goods for each other in some circumstances, meaning a shortage in one can often mean increased demand for the other. However, this interchanging of coffee beans can only go so far. Thus, the reason for separate contracts. Robusta coffee is generally considered a lower quality bean and is used primarily to make instant coffee and/or packaged coffee drinks. Arabica coffee is a milder, less bitter bean and comes in varying degrees of quality. It is the most popular bean for drip coffee makers and gourmet varieties.

Vietnam produces primarily Robusta coffee while Brazil produces primarily the Arabica variety. Thus, changes in the crop size in one of these countries can affect one contract much more than the other. Which brings us to our opportunity.

LIFFE futures rallied over 30 cents (26%) over the last 2 weeks due to the reduced supply out of Vietnam. NYBOT coffee futures experienced a "sympathy rally," managing to rise about 15% during the same time period. Yet, there is no supply squeeze in Arabica coffee. Brazil is in the midst of harvesting a 43 million bag coffee crop which, if realized, would make it the third largest Brazilian harvest on record. With the harvest nearly 65% complete as of this week, there is a very high probability that this harvest estimate will be realized, if not exceeded.

And while supplies are indeed growing tight for Robusta beans, Vietnam begins harvesting new crop Robusta beans in October. This 2006/2007 harvest is expected to be a bumper crop, producing up to 14.5 million bags of coffee - 26% higher than last year's total.

In summary, while near-term Robusta supplies are tight, there is a lot of coffee that is about to be dumped on the market soon. The market has done its job in pricing in near-term supplies for Robusta beans. Yet, we feel the rally in the NYBOT contract is fundamentally unjustified and that futures are now overpriced. Brazilian farmers are going to have to start marketing all of this coffee soon and that means roasters will have plenty of options when it comes to suppliers. This generally would lead to price competition and thus, you guessed it, lower prices.

With Robusta prices now substantially above than their July lows, it is possible that the shortfall in supplies have been priced into the market. Sometime soon, traders will start focusing on the upcoming crop which will make the back months in LIFFE futures look expensive if they remain at current levels.

We think the combination of adequate near-term supply of Arabica coffee and the specter of increased Robusta supply on the horizon will pressure both contracts in the coming weeks. The NYBOT contract, however, will probably have the most difficulty staging a sustained rally which makes it the better candidate for selling call premium.

Bulls are talking about dry weather in Brazil and its potential impact on the flowering of the upcoming Brazilian crop. However, July and August are typically dry in Brazil and there remains plenty of time for adequate rains to fall. In addition, any type of drought conditions over the next 60 days would only be impacting the development of next year's crop and any supply shortfalls would not be felt until well into 2007.

The remaining 2006 NYBOT coffee contracts look like excellent candidates for call selling strategies at this time. Last week's rally produced some much needed volatility, which means attractive premiums available at strikes more than 50% out of the money.

We will look to write coffee calls in the October-December NYBOT contracts for client portfolios and expect prices to fluctuate in a 10-15 cent range while the market begins to digest fresh Brazilian supply coming to market.

If you would like more information about selling options in the coffee market or building a portfolio based on the option selling approach, please feel free to call or visit us on the web.