Deep Out of the Money Calls Present High Yield Prospects in Cocoa
Reduced West African Yields are Driving an Attractive Inflation of Call Premiums in Cocoa. Here is How Investors can Benefit Now
A relentless rally in Cocoa prices is driving previously unavailable call strikes to attractive premium levels this month.
Cocoa prices have rallied over 30% since their December lows, largely the result of reduced expectations for West African yields.
Cocoa pods in the Ivory Coast. West Africa begins in 2018 Main Crop Cocoa Harvest this month.
But high prices cure high prices. And although reduced African yields are real, particularly in the cocoa laden Ivory Coast, their effects on the overall global cocoa supply appear to be somewhat minimal. At the very least, we do not believe they justify a 30% price increase. In fact, it is now our opinion that distant calls are overpriced and ripe pickings for call sellers.
70% of the world’s cocoa beans come from four West African countries: Ivory Coast, Ghana, Nigeria and Cameroon . The December – February time period is typically “dry season” in west Africa. However, this year’s season was particular harsh, with hotter and drier conditions more prevalent than usual. The fear has been that the weather will hinder yields.
These weather fears have been driving the cocoa price rally since December.
But will this create an actual supply shortage? We think not.
As we approach the month of April, seasonal rains have arrived in West Africa, potentially rescuing some of the more afflicted areas.
More importantly however, is the old axiom of buy the rumor, sell the fact. While a weather event unfolds, it is often the uncertainty, rather than actual yield loss that is driving prices.
While much has been made of the Ivory Coast production “shortfall,” global production is only expected to be off by 2.3% this year over last.
As dry season ends and we approach harvest, some real numbers are beginning to appear.
A recent poll by Reuters of the 13 largest cocoa exporters reveals the
following: Production estimates for the October-March “Main Crop” total 1.320 million tonnes, down 8.8% from last
year’s record 1.5 million tonne harvest.
It’s less supply, but not significantly so, especially after a record year.
Weather concerns have been more directed at the smaller April-September “Mid Crop” which also produced a record 520,000 tonne harvest last year.
But the arrival of March rains will likely have a broader impact on Mid-Crop development. In fact, producer concern over the mid-crop has waned substantially.
Price vs. Supply – The Case for Overpriced Cocoa
So what is keeping prices up? Largely the large spec position in Cocoa right now. Funds follow trends and trends are fed by fund and spec buying. Thus, trends can sometime sustain themselves for awhile, even after the fundamentals driving them fade – or become priced in. But eventually, the fundamentals catch up.
According to the ICO, global production is only expected to be off by 2.3% this year, despite concerns over West African weather.
We believe Cocoa is reaching that point now. While much has been made of the Ivory Coast production “shortfall,” global production is only expected to be off by 2.3% this year over last . Global Ending stocks are expected to climb by. Thus, the rumor and the actual fact appear to be two different things.
These can be lucrative opportunities for call sellers.
Conclusion and Strategy
Cocoa prices have seen a substantial rally in the past 12 weeks as dry weather brought concerns of reduced West African yields. However, with the rainy season now arriving in these areas, concern over this year’s Mid-crop is waning. While yields are still expected lower, the drop in production is not extreme. Global production is down only slightly. And with large stocks to begin the year, ending stocks will actually increase.
Whether the rally ends now or continues on for a spell, it is unlikely the market can steam substantially higher given the raw numbers and reduced uncertainty for 2018 production.
Selling calls above the $3000 per tonne area appears to be a high probability route to significant premium.
We will be positioning our managed portfolios this month in the cocoa market as opportunities arise across a spectrum of strikes and strategies.
December 2018 Cocoa
Selling the December Cocoa $3200 call options.
Self-directed traders can consider selling the December Cocoa $3,200 calls for premiums of $500 or better . Current margin requirement for these options is approximately $1,100 each.
For more information on managed commodity option selling portfolios with James Cordier and OptionSellers.com, visit www.OptionSellers.com/Discovery for a Free Investor Information Pack. (Recommended opening deposit US $1 MM)