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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Cocoa prices: The top 10 most important drivers

1) Concentrated production: Two thirds of the world production of cocoa comes from West Africa with Ivory Coast the biggest world producer. This means that price is chiefly driven by supply issues in cocoa’s major producers. Any hint that supply may be worse or better than expected can have a disproportionate impact on the price of cocoa.

2) The weather: The right mix of rain and sunshine, at the right time, is needed for cocoa pods to mature properly. Climate disturbance at any phase of the growth process (from flowering to the maturing of the pods) can have a direct impact on crops by yielding shrunken or rotten pods. For example, long periods of dry weather are not conducive to cocoa bean growth.

Cocoa traders need to be on the watch for winds from the Sahara desert that typically bring dry weather and coolness to the largest producing countries from December to February.  Known as the Harmattan winds, strong dusty winds can dry out pods and damage crops.

3) Disease: Fungi and various diseases can also reduce output by reducing the yield from cocoa plantations. The most damaging disease is known as ‘Black Rod’ which was estimated to have resulted in the loss of almost half a million tonnes of cocoa in 2010. Its not just diseases afflicting the cocoa pods that can affect supply. The Ebola outbreak in 2014 forced farmers and their families to flee cocoa plantations in Sierra Leone while international buyers of cocoa refused to visit the producing areas.

4) Geopolitics: The major cocoa growers are accustomed to geopolitical uncertainty. When previous economic booms have led to bust, unrest has typically followed. As with many other countries that rely on commodities as a major part of their export revenue, the Ivory Coast has been plagued by corruption and unrest in the battle for power. Although citizens may be placated when times are good, as soon as the economic tide turns the population can turn if they do not feel that they are getting a good deal compared with those in power.

5) Infrastructure: The biggest producers of cocoa do not exactly have world class infrastructure. Something as seemingly benign as unexpected rain in December has proven to be a significant bottleneck in Ivory Cost. When crumbling roads are unadapted for trucking in the rain, transportation becomes costlier, and additional costs are shifted onto the commodity.

6) Consumer tastes: The trend towards dark chocolate (particularly in light of potential health benefits) has helped drive demand. Dark chocolate requires a higher cocoa content than milk chocolate. Meanwhile, chocolate has become increasingly popular in many emerging economies, adding to demand for cocoa.

7) Farmers: The price paid to cocoa farmers is set by the industry regulator. If farmers incomes are cut (perhaps due to a decline in the price of cocoa) then they are less likely to invest in new trees and are likely to cut back on fertiliser and other important inputs that ensure high quality cocoa beans. All of which means that both near-term and future supply prospects are lower. Lower incomes for farmers also raises the risk of civil unrest.

8) Flowering cycle:  It takes cocoa trees 3-5 years to yield a crop. But before that significant investment needs to take place by the farmer to clear and prepare the land for planting. The long lead time between decision to expand supply and the eventual harvest, combined with the risks (many of which are described above) 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.

9) Currency movements: Cocoa is typically priced in British pounds while the London cocoa futures contract long been used as the global benchmark for the pricing of physical cocoa. Since consumption of cocoa centred in continental Europe, and a large part of the cocoa processing industry based in the Netherlands and Germany a drop in the Pound versus the Euro increases demand for cocoa since it is now relatively cheaper to import cocoa for processing into chocolate.

10) Stocks: As with other commodities high stock levels may indicate that demand for cocoa is weak, putting downward pressure on the price. Cocoa is perishable however, and depending on how it is stored the quality (and the value) of the stocks may quickly deteriorate.

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What lessons does rhodium have for commodity investors?

All investors should occasionally look to the past to guide their views on what could happen in the future. For as they saying goes history doesnt repeat itself, but it often rhymes. Almost ten years ago the eyes of many commodity investors were focused on a little known precious metal called rhodium. What are the similarities to the present day surge in cobalt prices and can investors learn anything from that episode and others like it?

Rhodium is similar to cobalt in that it has a very small, very concentrated supply base. Around 80% of rhodium supply comes from South Africa, while around two-thirds of cobalt comes from the DRC. Much like cobalt, the supply of rhodium is also an indirect supply – the precious metal being a byproduct of platinum and nickel mining. That means that supply doesnt typically respond in the same way to high prices. Since the economics of the mine is governed by the value of the predominant metal rather than the byproduct supply tends to only respond after a big step up in prices. The relatively low prices for both nickel and platinum at the present time do not bode well for cobalt supply.

Like cobalt which is predominantly used in batteries, the demand for rhodium is also very concentrated. Eighty percent of rhodium is consumed in autocatalysts, with the remainder in chemicals, glass and the electricals industry. Meanwhile, in the same way that Tesla and other companies are keen to get their hands on as cobalt now amid supply risks in its main producing country, the same was true for rhodium in the eary 2000’s. From a $440 low in January 2004, prices ballooned near 23-fold to more than $10,000 over five years as industrial users hoarded the metal amid concern that South African mine supply would fall.

You could argue that the straw that broke the camels back for rhodium prices was the start of the global financial crisis. With car manufacturers holding large stocks of rhodium procurement decisions resulted in large swings in prices. Indeed, it is rumoured that the decision by one car manufacturer in the US to offload its rhodium stocks in 2008 set off the subsequent price collapse. Due to the ultra small nature of the cobalt market the same thing could happen there if one or more manufacturer becomes a forced seller for whatever reason.

The financial crisis was the final straw for rhodium, but it can be argued the crash would have come soon enough as car manufacturers were substituting with other materials. As the price of rhodium soared car manufacturers looked to cheaper alternative metals and reducing the amount of precious metals that they needed to use in catalytic converters. Could the same happen for cobalt? A complete shift away from high-energy batteries looks hypothetical at this stage with all high energy batteries currently requiring cobalt. However, there has been recently efforts to produce other types of battery chemistries that do not require cobalt. Tesla has reportedly also been trying to remove cobalt from the equation and add nickel instead. So far attempts for substituting cobalt resulted in a loss in product performance. But nothing is set in stone.

At least until recently there was little way that retail investors could gain exposure to rhodium directly. At the moment the only way for investors to gain exposure to cobalt is by investing in a company that mines it (e.g. eCobalt Solutions). There have been rumours that some financial institutions who have built up large stocks of cobalt are looking to create a product that would allow retail investors to ‘gain exposure’ directly. This should, in the same way that the launch of the rhodium ETF as a sign that some are trying to take some profit.

The rhodium market has seen several price spikes. The most recent being a major rally in the early 1990’s, a smaller one around the millennium and then the enormous 2004-08 boom. The cobalt market is no different. The last major spike in cobalt prices occurred in 2006/07 when prices surged from around $30 per tonne to over $110 per tonne.

One major factor that characterises rhodium, cobalt and a range of other minor metals is the short time in which prices spike and then fall back to earth, quite often right back where they started. How long do minor metal super-cycles typically last? Not very long is the answer. Prices typically increase sharply for 1-3 years before prices crash, often back to where they started 6-12 months later. What does that imply for cobalt? Well, cobalt’s rally is still relatively young by these standards, but come the end of this year it may start to look a little weathered.

Investors take note. By the end of 2008 the price of rhodium had declined by 88% to $1250 per oz. Remember miners are often (but not always a very good one) a leveraged bet on the underlying commodity. Trying to pick the peak in the price of rhodium will probably be just as difficult with cobalt. But by the time that happens the share price of a cobalt miner may have already gone in reverse.

Ride the narrative for as long as you dare.

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