Cocoa

It has not been a good day. I wrote the following piece on cocoa and almost traded; but then I gave in to the argument that it might be better to wait until after the expected weekend rains. I thought to myself in the pool at lunch time that this was a bad argument — but when I got back to the office, the market was up almost 6%. “I’ll just wait until things are a bit clearer” is a terrible, terrible argument. The time to trade is when the market gives you a chance.

I spent some time yesterday looking at cocoa. The basic story is as follows. The price of cocoa has fallen in the past year on account of strong production. The reason for the strong production is one of my favourite subjects, La Nina, which brought appropriately wet weather to Ivory Coast, by far the largest producer, last year. La Nina has persisted, and December arrivals of cocoa recorded in Ivory Coast were up on the year before, according to the International Cocoa Organisation (ICO). However, Ivory Coast has not had decent rain for some months, and is now suffering under a particularly harsh manifestation of a Saharan wind called the harmattan. Both factors are likely to cause crop damage, both to the main crop, which is still being harvested (Oct-Mar), and to the mid crop, harvested between May and August. What is more, last season’s low prices left some farmers short of money to buy pesticides and other chemicals to protect this year’s crop. While the cocoa crop is notoriously difficult to estimate, there are anecdotal reports of crop damage and, according to Reuters, industry players have already downgraded their crop forecasts from 1.2-1.3m tonnes to 1m tonnes, down from around 1.5m tonnes last season (and more if one includes likely smuggling during the export ban).

Turning to stocks and demand, stocks are likely to be high after last season’s strong production, although data are only available from the ICO with a year’s delay. Bloomberg quotes Barry Callebaut as saying that stocks are relatively high. On the other hand, that is presumably already in the price after months of price falls. On the demand side, Bloomberg reports that US grindings were up YOY in Q4. European grindings increased in Q4, but less than expected, after a 14% jump in Q3; nonetheless, grindings are still up and demand may not suffer excessively in a recession, demand for cocoa-based products likely being less income elastic than for other discretionary purchase (even the poor buy chocolate). In any case, demand is unlikely to collapse before the March cocoa future expires.

I do not know how the cocoa crop is going to turn out, and I do not have anyone on the ground; but I can read a Reuters article (http://bit.ly/wSvZvR) written by someone who has been to Ivory Coast, and hear the same anecdotes that he heard. These suggest that the risks to the main crop are on the downside. Cocoa prices jumped 15% on 9-10 Jan on a combination of crop-damage fears and the nationwide strike in Nigeria (which could have restricted Nigerian cocoa exports), having touched their lowest point since the autumn of 2008. Prices and have since been stable despite an end to Nigeria’s strike on 16 Jan, and the most reasonable interpretation of this is to see the strike as the catalyst for crop-damage fears to come to the fore. It strikes me that the market had priced in a lot of downside before its recent spike and that with the latest newsflow, the risks to prices lie on the upside. What is more, I have a stop level: before 9 Jan the main crop seemed to be progressing well; after 9 Jan, things were not so sure; therefore it would be inconsistent if the price of March cocoa were to fall back to its 8 Jan level; hence it would make sense to go long if I can get in with a stop at the level of 8 Jan or below.

A risk in the trade is that the Nigerian strike was more significant than I am giving it credit for, and the price is just taking time to fall back to its pre-strike level. There is also a risk that the harmattan could give way to rain that would revitalise the crop. Rain is forecast to begin on 28 Jan and to abate on 31 Jan, according to several weather-forecasting internet sites that provide two-week forecasts, and I wonder whether it would be wise to wait to see how much actually falls. Perhaps the forecasts are the reason why the market is not rallying at present.

European Bailout Funds

According a spokesman for Angela Merkel, the idea of abandoning a total lending cap on the combined EFSF and ESM during the period when they will be running concurrently — a year from mid-2012 — is “under discussion”. This is in line with my expectation that the European Union will continue to edge towards fiscal transfers — something I have been talking about since the summer. This measure would increase the available lending capacity in 2012 from EUR 500bn to EUR 750bn. Together with the EUR 150bn pledged by Eurozone central banks for the IMF, this means that the EU’s effective lending capacity may have increased by EUR 400bn in the past couple of months (assuming that both measures actually happen). This is happening without fanfare, but it is nonetheless significant. The ECB thinks the way to end its transfers to the periphery is for governments to take over with fiscal transfers; if a large-enough mechanism for this is put in place, the ECB may pull back, precipitating a temporary crisis while countries are forced into a position where they have to ask for bailouts from the fiscal institutions.

Data

Eurozone flash PMI 48.7 b.e. and rose.
Eurozone flash services PMI 50.5 b.e. and rose above 50.
German manufacturing disappointed, but German services and both French series showed expectation-beating expansion.
UK public sector net borrowing continues to fall on a 12-month rolling basis. It has done so consistently since the start of 2010.

Next 24 Hours

Japan trade balance
German Ifo
UK MPC minutes
UK prelim. GDP

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