Hot cocoa may be cooling off

April 15, 2015 12:00 PM

February’s strong U.S. employment report gave the proverbial “all clear” to the U.S. economy and stoked speculation that interest rates are destined to increase as early as this summer. This added extra fuel to the ongoing rally in the U.S. dollar, whose continuing strength has been a macro force weighing on prices of many commodities.  

Cocoa has been one market to buck that trend. Why? Cocoa’s production is concentrated in the limited geographic area of Western Africa. Ghana and the Ivory Coast account for more than 60% of the world’s cocoa production. Get a handle on the crop in those two countries, and you’ve got a pretty good advantage on the cocoa market.

As recently as December, the mainstream cocoa trade was expecting a small cocoa production surplus for the 2014/15 crop year. Then the dry seasonal winds known as the Harmattan winds blew down from the Sahara. This year’s version was an extremely harsh one, blanketing much of West Africa’s cocoa growing regions in dust, blocking sunlight and lowering temperatures.

As a result, yields in both Ghana and the Ivory Coast are expected to be affected. Early estimates had the Ivory Coast losing 10%-15% of production, while Ghana could be off as much as 7.6% in 2015. The International Cocoa Organization (ICCO) last month revised estimates of a surplus to a global cocoa deficit of 17,000 tons in 2014/15. 

As a result, prices rallied by more than $300 per ton (10.8%) during the month of February (see “Cocoa defies dollar”).

It is never wise to attempt to pick tops or bottoms; however, futures traders may want to seek opportunities to short cocoa, as it could now be overpriced based on current fundamentals. 

There are a few reasons why. First, during market events such as the Harmattan winds, commodities markets tend to overshoot on the upside or downside as a “worst case scenario” is priced into the market during or immediately following that event. Then, as time passes and the true effects of the event are sorted out, the net result often ends up being less extreme than originally thought. The market must then backtrack to make up for its overshoot.

This is what commodity neophytes, and even some experienced traders, fail to understand. By the time you’re reading about a market “event” in the newspaper, chances are, it’s already been factored into the price. The speculators and fast buck chasers tend to get in at the end, driving the price above and beyond the level that fundamentals dictate. 

Cocoa could be in this situation. Conflicting estimates from the ICCO this week are casting fresh doubts on the severity of production losses on Ghana and the Ivory Coast. In addition, the mood from cocoa buyers in Ghana has indicated that there is still “room for some recovery” with seasonal rains about to set in. 

Also, in West Africa, cocoa beans ripen from October through April, bringing two crops. The “main” crop, sometimes accounting for 80% of total production, is harvested by the end of March. The “mid” crop, kind of a supplementary harvest, if you will, takes place in May. By the time the Harmattan winds blew down the dust, the main crop was already made. That means that any damage was likely done to the substantially smaller mid-crop, another reason early production losses could have been overestimated.

Another reason is seasonal: cocoa prices have historically tended to weaken into the heart of the March/May harvest.  This is, after all, the time that supplies will be higher than at any time during the year. As discussed above, the main West African cocoa harvest begins in March and is already underway. Thus, supplies are already heavy as the mid crop harvest begins in May. 

While there is no guarantee that it will happen this year, this has historically tended to act as a bearish force for prices during this time period. 

While prices could see some additional volatility over the near term as the true effects of 2015 weather are realized, the majority of damage is close to being priced in. A continuing strong dollar along with the factors above should eventually force prices into a consolidation phase, if not a push back towards January lows. 

Additional rallies in the coming weeks should be viewed as call selling opportunities. We like the September 3300 call, as it places your position comfortably above the September 2014 highs. However, we would wait for premiums to get a bit higher before pulling the trigger.

Aggressive traders can look to put on a short futures position or to sell call premium on the next rally. More conservative traders can look for a slightly bigger upswing to take higher premiums. Current volatility should make that possible on another test of last week’s highs.

About the Author

James Cordier is the founder of www.OptionsSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. He is the author of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).