Coffee Corrects- A Risk-Reward Opportunity

Coffee is a volatile agricultural product that is a soft commodity sector member. Soft commodities trade on the futures market on the Intercontinental Exchange (ICE). In 2022, nearby coffee futures reached a peak of $2.6045 per pound, where they ran out of upside steam. The weather in Brazil and rising production costs pushed the Arabic bean’s price to the highest level since 2011. 

Nearby December coffee futures were around the $1.80 level on October 27, with the short-term trend pointing lower. However, the price has remained at the highest level since 2014. The iPath Series B Bloomberg Coffee Subindex Total Return ETN product (JO) tracks coffee futures prices higher and lower. 

Coffee falls from an eleven-year high

In early February 2022, nearby ICE coffee futures reached the highest price in eleven years at $2.6045 per pound. 

As the chart illustrates, the price turned lower in February, with coffee futures making lower highs and lower lows, reaching the most recent low of $1.7870 on October 27. Coffee corrected by 31.4%, and the trend remained bearish on October 27. 

The long-term chart remains constructive- The critical support level for coffee futures

While the short and medium-term trends are bearish in the coffee futures arena, the long-term chart continues to threaten a recovery and return to prices above $2 and perhaps a test of the early 2022 highs or even higher. 

The long-term chart dating back to the early 1970s shows coffee futures broke out above the critical technical resistance level at $1.76 per pound, the November 2016 high in July 2021. The technical level on the upside has become the support level to watch in the coffee futures market. Coffee futures at the $1.80 level remain above the crucial technical support price as of October 27, 2022, meaning there has yet to be a challenge to the long-term bullish trend.

Three reasons why coffee futures could continue to make higher highs

Three factors that could lift coffee futures and create a higher low to the $1.76 support level are:

• Inflation has lifted production prices of all commodities, and coffee is no exception. Elevated energy, labor, financing, and other input prices make producing each pound of Arabica beans more costly, putting upward pressure on prices. 
• As Brazil is the leading producer, and coffee futures trade in US dollar terms on the futures exchange, coffee is highly sensitive to the Brazilian real versus the US dollar exchange rate. While the dollar index has rallied to a two-decade high in 2022, the foreign currency exchange rate between the dollar and the real reflects an upside bias for the Brazilian currency. As the real appreciates versus the US dollar, production costs in Brazil rise as coffee is a labor-intensive crop and wages are in the local currency. 
• The weather conditions in Brazil are the most significant factor for the annual crop. A frost in 2021 pushed coffee prices to the highest price in a decade on the back of supply concerns. A weather event or a crop disease in 2022/2023 could launch coffee prices and push the short and medium-term trends back into a bullish path. 

Coffee futures have substantially corrected from the early 2022 high, but if the soft commodity makes a higher low above the $1.76 level, it could see a sudden and violent rally that takes coffee back above $2.00 and towards the February peak or higher. Coffee futures last traded above $3 per pound in 2011, and a move to that level or higher is not out of the question in the current environment where inflation continues to push agricultural commodity prices higher. 

JO is the coffee ETN product

The most direct route for a risk position in the coffee market is via the Arabica coffee futures and futures options that trade on the Intercontinental Exchange. Market participants looking for exposure to the coffee price without venturing into the futures arena can turn to the iPath Series B Bloomberg Coffee Subindex Total Return ETN product (JO), which does a reasonable job of tracking the soft commodity’s price higher and lower. 

At $50.45 per share on October 27, JO had $47.48 million in assets under management. The ETN trades an average of 14,468 shares daily and charges a 0.45% management fee. 

Nearby ICE coffee futures reached a low of 92.70 cents per pound in June 2020 and rose to $2.6045 in February 2022, rising 181%. 

The chart highlights that over the same period, the JO ETN rose from $29.20 to $70.55 per share or 142%. 

The recent decline to $1.7870 on October 27 took coffee futures 31.4% lower. JO fell to $50.00 the same day, a 29.1% decline from the February peak. While JO underperformed coffee on the upside, the ETN slightly outperformed the soft commodity futures on the downside. 

Coffee is a limited risk play from the long side at the $1.80 per pound level. A move below $1.70 per pound would negate the rationale for a long position. With 10 cents downside risk and the potential for a return to the $2.60 high, or n 80 cents profit, coffee futures offer risk-reward odds of 1:8 at the current price level. 

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