Coffee Prices Starting To Perk-Up?

Fundamentals

Coffee traders had some excitement last week, as the most active May futures made a new contract low early in the week, followed by a stunning nearly 9-cent move on Thursday. Like most commodities in 2009, Coffee prices have been weak, primarily due to the slowdown in the world economy.

However, if one were to look in a vacuum, Coffee fundamentals appear fairly friendly, with some estimates calling for a production deficit in the 2009/10 growing season. Brazil, the world’s leading coffee producer, is expected to produce approximately 37.9 million bags this season, which is down sharply from the 46 million bags produced in the 2008-09 season. Arabica Coffee production is cyclical, as the coffee bushes tend to produce a smaller crop every other year.

Current cash market prices in Columbia are well above the ICE futures prices, as tight current supplies have forced buyers to pay a premium to obtain high grade supplies.

Despite these seemingly positive fundamentals, large non-commercial traders continue to hold a net-short position in Coffee, according to the most recent Commitment of Traders report. As of March 10th , large non-commercial traders were net short 3,872 contracts, a decrease of 524 contracts from the previous week.

However, this data does not include the activity during the sharp rally in Coffee prices on 3/12, and next week’s data may show further short-covering by large speculative traders. Those who have traded Coffee futures in the past know that the market can turn quite volatile, especially during the summer months, when the South American winter is at its peak. Freezing temperatures can cause considerable damage to Coffee bushes, and in many years, traders build in a weather premium into futures prices going into May.

Given the potential for volatile trade, many Coffee traders like to purchase options to help define their position risk. However, Coffee options tend to be rather expensive, as option sellers want to receive a greater premium to compensate for high volatility in the Coffee market.

One strategy used by some traders is to buy Coffee bull spreads.

This strategy involves buying a lower strike call and selling a higher strike call in the same contract month. The calls sold help to lessen the total amount of option premium paid in exchange for limiting the potential upside of the trade.

For example, a September Coffee 130 call had a settlement price of 9.59, or nearly $3,600, with September Coffee trading at 115.60. A trader bullish Coffee through the South American winter could purchase a September 130 call and sell a September 160 call for about 4.50 points, or about $1700. The trader would receive the maximum gain of 25.50 points if September Coffee was trading above 160.00 at the time of the option expiration in August. If Coffee prices were to fall below 130.00 at option expiration, the trader would lose the entire premium paid.

Technicals

Looking at the daily chart for May Coffee, we notice prices hovering just above the widely watched 20-day moving average. Many short-term momentum traders look for a daily, or even a weekly close above this MA as a potential buy signal. The 14-day RSI has moved to a more neutral reading of 48.70. One should also notice that the 14-day RSI failed to make a new low reading when the contract lows were made last week. This may have set the stage for Thursday’s sharp price spike. The next price resistance for May Coffee is seen at the 2/26 highs of 114.95, with support seen around the 105.00 area.

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