Fat Prophets are bullish on commodities. In essence our view boils down to two key arguments. First, is that there exists a tight balance between global production and demand. The ever growing requirements of the world's emerging nations are set to keep supplies, which are already tight in many cases, under continued pressure. Second is our belief that the US dollar is structurally weak. We view commodity exposure as a hedge against a freefalling greenback.
"... the real kick to total coffee consumption in our view, as with most other commodities, will come from emerging economies, particularly China and India"
We remain steadfast in these views. The drivers of current market volatility have done nothing to weaken our case.
Commodities stocks have suffered along with the rest of the market in recent weeks as concerns over a global credit crunch continue to grow. The initial catalyst for weakness was the 'sub-prime' crisis in the US, and the spill over implications for the broader housing market and economy.
We have recognized the ills in the US financial system for some time now. We do not believe the market's sudden realization of endemic weakness here precludes a continuation of a commodities super cycle.
Far from it. Whilst the US is a key contributor to global economic welfare, this is not where future incremental growth will emanate from. We believe that emerging economies are the real story. Massive, rapidly urbanizing, populations in China and India in particular will underwrite demand for a whole host of commodities for decades to come in our opinion.
In our view the market is missing the point, and once the dust settles will wake up and smell the coffee. And speaking of the bean...
We believe that soft commodities are an equally attractive way to play what we see as a secular boom. Specifically, coffee is looking very attractive currently.
Supply and demand fundamentals continue to support higher coffee prices in the years ahead. The International Coffee Organization estimates that global demand is set to reach 120 million bags (60 kilograms) in 2007/8. Consumption is growing at a particularly healthy rate in producing countries. Brazil and India for example have seen demand grow by 6 and 5 percent respectively in the past 12 months.
Meanwhile, the global crop for next year is set to come in at just 112 million bags. So after stepping up to the mark this year, the industry is facing a supply deficit of around 8 million bags in the coming 12 months.
Brazil, the world's largest producer, is behind the slump. After producing 42.5 million bags last year, poor weather will see the upcoming crop fall by up to 10 million bags.
Clearly the shortfall should drive prices as processors are forced to dig into their stockpiles. Until now inventories have been building up, which in our view explains the weakness in prices for the more common Arabica variety in the past 12 months.
Longer term, we expect climate change to also have an increasing impact on prices. For instance, Uganda (producer of 2.5 million bags last year) believes a temperature change of 2.5 degrees Celsius could wipe out the entire domestic coffee industry. And the danger of this is very real. The United Nations has said global warming could lift temperatures by up to 4 degrees Celsius.
Meanwhile increasing efforts by producing countries to more carefully control supplies could place a floor under prices even as they ratchet up. The industry had a painful experience from 1997-2003 when over supply contributed to a sharp drop in world prices. We are certain that lessons have been learned.
Mind there may be little need to control prices on the downside. Geometric increases in the world's population, along with the bean's addictive nature will ensure as much.
However, the real kick to total coffee consumption in our view, as with most other commodities, will come from emerging economies, particularly China and India. A growing middle class and the adoption of more Westernized consumption habits will underpin this demand.
And with a burgeoning population the size of China for example, even a small switch towards Western beverage choices will have a substantial impact on requirements. Germany which imports around 1.5 million bags a month, consumes 50 times the amount of coffee on a per capita basis.
So fundamentally there are compelling reasons for coffee prices to go higher. Then there's the US Dollar. Should our expectation of further sustained dollar weakness eventuate, coffee prices (denominated in greenbacks) should appreciate as growers demand more in return for their beans.
Now, what about the charts? Let's take a look at the NYBOT Front Month Futures Contract on coffee.
Here the outlook for coffee remains strong in our view. For more than two years, prices in the coffee futures market have been consolidating within an ever narrowing range. As suggested by the converging lines of resistance and support, the pattern that has formed over this period is known as a triangle.
Triangles typically form as a temporary pause within a longer-term trend. When they form in an upward trend, a breakout through the upper edge of the triangle signals a release of pent up demand, which often drives prices sharply higher. This was seen at the end of 2006 when a November break above initial trendline resistance saw prices rise a further 10 percent by the end of the year.
In the subsequent eight-months, the original triangle pattern has been expanded while maintaining the same lower edge support line. In our opinion, the larger pattern is now a stronger and more significant pattern. This increases the expectation that the eventual breakout and extension of the upward trend will be substantial.
In the near-term, we anticipate a continuation of the rally away from May's test of triangle support at $101.10. Such a move will target resistance provided by the upper edge of the triangle, currently in the region of $127.50. A sustained break above here would signal a revival of broader upward momentum. In our opinion, a continuation above $129.75 would target the March 2005 high of $137 with gains toward $200 achievable in time.
We firmly believe this is one soft commodities play that is ready to charge. So come on, wake up and smell the proverbial, before the rest of the market does.