“Freeze Season” in Coffee is Opportunity for Call Sellers in 2017
With the 2017 Brazilian Harvest Wrapping up and a potentially record crop next year, a supply burden should keep prices in check into next year
If you’re a mainstream investor used to gauging P/E ratios or milling through bond yields, selling options on coffee futures may sound like launching a trip to the moon. “Soft” commodities are also sometimes referred to as “exotics” – most likely named by mainstream investors more comfortable with familiar assets such as gold.
But if you’re considering branching out into the diversified commodities markets, especially as an option seller, you don’t want to avoid these markets. For it is in these backwater food and fiber sectors, away from the glow of public spotlight, where fundamentally based opportunities often exist.
This month, we present just such a potential opportunity in the coffee market.
The Seasonal Coffee Cycle
Brazil is by far the world’s largest producer and exporter of coffee – in particular, the higher quality Arabica coffee used to satisfy the majority of the ICE Coffee futures contract. Thus, developments in the Brazilian crop are key to forecasting coffee prices.
Brazil is the world’s largest producer and exporter of coffee beans.
In Brazil and the southern hemisphere, coffee trees experience a bi-annual “on/off” cycle. This means the trees tend to produce more beans during “on” years and less beans during “off” years. Thus, every other year should theoretically produce a higher yielding crop. As an option seller, you should know if the year you are in is an “on” or “off” year.
In addition, the coffee growth cycle has three key seasons you should be aware of:
3 Key “Seasons” in the Coffee Growth Cycle (for option sellers)
Flowering: The coffee bean life cycle begins in October with flowering season. This is the most critical time for the upcoming crop. As the flowers drop off, they leave in place a “cherry.” This cherry is what ultimately turns into what we know as the coffee bean. Thus, the number of flowers will determine how big the upcoming crop will be. And the weather will help determine how many flowers form on the trees. As October is typically the beginning of rainy season, it often coincides perfectly with flower formation. However, if rains are late in coming, worry and thus, prices can increase. It is not uncommon to see a weather premium building into prices during flowering season. However, these can often be call selling opportunities as prices can decline sharply when the rainy season begins and flowering is complete.
Growing Season: November through March is the Brazilian growing season. During this period, weather can sometimes be a factor. But in Brazil, its typically warm and wet. This time is typically reserved for analyzing the true size of the upcoming crop and keeping an eye on its health.
The Brazilian coffee bean harvest can start in March and last all the way through September.
The Harvest: In March, the Brazilian coffee harvest typically begins and can last all the way through the next flowering season. Harvest season also overlaps the Brazilian winter which is June-September. This can also be a time for weather concerns as a harsh freeze can hinder or damage the harvest and/or hurt tree development for the upcoming flowering (more on this in the next segment).
Knowing the seasons and the seasonal price tendencies for coffee can help you better identify the best option selling opportunities.
Buy it all for a Freeze?
It used to be that coffee traders got excited about “going long” coffee ahead of the Brazilian winter. A series of high profile freezes in the 1990’s and early 2000’s made this an annual event. Coffee prices often rallied even without any weather threat at all, simply off of public participation in the annual chance to “strike it rich.” If a freeze decimated the coffee crop, the holders of futures contracts would made a bundle. But Brazilian coffee farmers grew weary of spinning the annual roulette wheel. Beginning in the mid-2000’s, replacement trees planted to supplant early frost losses were planted further north, closer to the equator in warmer climates. With up to 30% of Brazilian production moved all but out of harm’s way, the “freeze” phenomenon became less of a factor.
Seasonal tendencies show that despite potential for freeze, mid-winter (Brazilian winter is June-Sept) can often be a good time for selling calls in the coffee market. A secondary opportunity can also occur during flowering season in the Brazilian Spring (October).
That doesn’t mean it went away entirely. Cold weather talk can still bring out the buyers in coffee market. It is our opinion, in fact, that weather buyers were a primary driver of the recent 26% price surge in the coffee market. But the chances of a Brazilian hard freeze causing significant damage to the coffee crop have dropped substantially in just the last 10 years. Thus, weather rallies during the Brazilian winter often be excellent call writing opportunities in coffee.
2017 Fundamentals – Thorn in the Bull’s Side
Coffee bulls made quite the big deal about 2017’s “off” year in the Brazilian production cycle. Yet estimates for the 2017 Brazilian harvest range between 49-51 million bags of coffee. This is the largest “off” year harvest on record and only 4-6 million bags shy of last year’s record 55 million bag harvest.
That’s not the bull’s biggest challenge, however. As of August 1st, the 2017 Brazilian harvest was 80% complete – vs. 76% last year. As harvest nears completion, the focus will begin turning towards next year’s crop. By most accounts, it’s expected to be a whopper.
While the numbers will come more into focus after flowering, early estimates put the 2018 Brazilian coffee harvest at 58-62 million bags. This due to an “on” year in production, in addition to a fair degree of pruning done to trees this year. This can help trees bear more fruit in the next.
If the forecast are realized, 2018 would be an all-time record for Brazilian coffee production.
Lastly, US Green Coffee warehouse stocks are now at all time record levels – largely overshadowing the bulls argument of a 2017 global coffee deficit.
Conclusion and Strategy
The bulls continue to tout the “lower” 2017 Brazilian coffee production and a 2017 global coffee deficit as reasons to buy the market. Let them.
2018 is shaping up to be an oversupplied year for coffee. In addition to a potential record crop out of Brazil, Vietnam, the world’s second largest producer, is expected to harvest 10% more coffee next year than it did this last.
With seasonal factors now also appearing to shift in the bear’s favor, and call premiums elevated after the July/August rally, we feel the time is nigh to consider layering on short coffee call positions for early 2018 expirations.
March 2018 Coffee
Selling the March 2.00 Coffee Call Options
While we’ll be staggering a series of strikes and strategies for managed clients, self-directed traders can consider the March 2.00 call on further rallies this month. Target premiums of $400-$500 per option. Should no such rally occur, traders can consider moving out to the May contract where the same strike currently offers premium in excess of $550.
It would likely take an unforeseen and substantial weather event to eventually push coffee prices to 2:00 per pound. With the end of Brazilian winter approaching, the chances of such an event decrease daily. Risk of loss, of course, is still present in any trade and thus, risk parameters should always be adhered to.
However, current margin requirement to premium ratio projects a 43% return per option should the options expire worthless. That’s getting paid pretty well to bet against the improbable.
James Cordier is author of McGraw-Hill’s The Complete Guide to Option Selling, 3rd Edition. For more information on managed option selling accounts with James Cordier and OptionSellers.com, visit www.OptionSellers.com/Discovery for a Free Information Kit. There is no obligation (Recommended minimum $1 MM US opening deposit.)