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Coffee price rally may be getting ahead of itself

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History doesn't repeat itself, but it rhymes, they say.

It looks there's some resonance going on between coffee and cotton markets.

When New York cotton futures soared to a peak above $2 a pound two years ago it sparked a wave of contract defaults, as suppliers pulled out of low-priced deals in favour of accepting far higher offers.

Now, with New York arabica coffee futures soaring above $2 a pound, on fears for the impact of dryness in Brazil on production, talk has started of the same kind of double dealing in the bean too.

Colombian traders, who buy from producers to sell to exporters, are said to be dishonouring contracts to supply at the low levels around at the turn of the year, and seeking higher prices.

Different cycle

The question for coffee investors is how closely the story of the bean's rally from here echoes the course of the cotton price spike.

The cotton precedent is sobering. Spot futures, after topping in March 2011, halved in four months.

Still, there are agronomic reasons to think that front coffee futures will take a different course. While cotton is an annual crop, meaning strong prices can instil a full and swift reaction from producers in beefed-up output, coffee trees take years to mature.

Besides, it looks like the Brazilian drought has already compromised next year's Brazilian crop too, hampering the growth of branches which will, around September, bear the flowers which will turn into cherries next year.

Wolthers Douque, a US-based coffee importer, believes Brazil's coffee production could fall again next year, pegging it at 40m-42m bags, compared with 47.7m bags expected for 2014.

Recovery ahead?

But that does not mean that elevated futures values will stick around for ever.

There is no reason, yet, to think that Brazil's output in 2016 – an "on" year in its cycle of higher and lower production years - will remain depressed, unless drought causes full-scale tree death.

And coffee growers are not powerless to raise output. They can influence yields through the likes of fertilizer rates and pruning programmes.

After all, current prices are well above output costs. Macquarie last year estimated Colombia as one of the highest-cost growing countries, with its coffee taking about 160 cents a pound to produce.

Now Colombian farmers' investment around the turn of the decade in rust-resistant trees, which should keep production growing and fill some of the void left by Brazil, is not looking such a lost cause.

Price too high?

All this puts a question mark over whether investors aren't attributing a too much risk premium to prices for 2016-17, for which futures have also soared above $2 a pound.

Indeed, these contracts were on Thursday offering a small premium to nearer-term lots. So rather than incentivising buyers to delay consumption, as typically happens when a supply squeeze is in view, they were encouraging immediate purchase.

That looks a step too far.

During cotton's rally, its distant contracts rose by only a fraction of the extent of the nearer-term lots. The ninth-in contract, for instance, topped out at less than half the price of the spot contract, rather than keeping ahead, as distant arabica coffee futures are doing.

At least this meant that the distant cotton lots had less far to fall when the crunch came.

By Mike Verdin

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