The mocha hedge: Long planting cycles point to moribund soft commodity prices

The price of sugar, cocoa, coffee and orange juice have all suffered large declines over the past 6-8 months in the order of 30%-40%. Investor sentiment is poor and in the case of sugar at a record low with funds net short for the first time. The sharp price falls and poor investor sentiment has many investors anticipating a sharp reversal of fortune. But what does history suggest should happen this time?

The key to understanding the market for soft commodities such as these is the production outlook. The risk with soft commodities is that production is concentrated in particular regions of the world. Two thirds of the world production of cocoa comes from West Africa with Ivory Coast the biggest producer. Meanwhile Brazil dominates sugar and coffee and to a lesser extent orange juice supply. The impact of this concentrated production is that any disruption to supply can often have an disproportionate impact on prices.

The difference between soft commodities such as coffee and cocoa compared with grains like corn and wheat are their long agricultural supply cycle. The agricultural supply cycle describes the process of activities relating to the growth and harvest of the crop. These include loosening the soil, seeding, watering and harvesting etc.

It takes cocoa trees 3-5 years to yield a crop. In the case of coffee it will take approximately 3-4 years,depending on the variety for the newly planted coffee trees to bear fruit. An orange tree grafted onto rootstock may take three years to begin producing, while a tree grown from seed can take up to 15 years. Sugar cane has the shortest cycle of all the softs – the typical cycle from planting to harvest takes about 12-18 months.

This means that farmers price expectations (i.e. whether they expect high or low prices to continue sometimes 3-5 years in the future) are vitally important in determining future supply and prices. Coming so soon after a period of high prices, farmers are unlikely to have hit rock bottom in their expectations just yet.

The long lead time between decision to expand supply and the eventual harvest, combined with the risks (disease, weather, exchange rate and conflict) means that supply does not expand quickly enough to respond to higher prices and / or signs of higher demand. This can result in a boom-bust market where farmers only feel confident enough to expand right at the top of the market.

These long production lead times are reflected in the chart patterns too with periods of high prices often 3-5 years apart, inter-spaced as they are with periods of volatile, but ultimately lower prices.

History suggests that investors positioned for prices to rebound significantly based on the notion that just because poor sentiment is likely to reverse this means prices will too are likely to be left disappointed.

Related article: Cocoa prices: The top 10 most important drivers

Related article: Sugar prices: The top 10 most important drivers

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