That morning cup of Joe gets the world moving. An estimated 83% of Americans drink coffee and the population of coffee drinkers is increasing. The United States spends approximately $4 billion each year importing coffee, with nearly a third of it coming from Brazil.
The supply of coffee has been plentiful … until recently.
Like most commodities, coffee’s worst enemy is the weather. Many coffee producers are going to struggle this year under the combined impact of a strong El Niño and “la roya.” But a bad year for coffee could be a good year for investors …
Tropical weather patterns began to shift late last year ahead of El Niño. Four of the top five coffee producing nations are in a drought and the fifth will face it late this summer.
In fact, coffee prices have climbed sharply since early January as it became clear that drought had ravaged Brazilian coffee. The coffee crop from Brazil is expected to fall 20% — that’s equivalent to about 40 billion cups.
The situation doesn’t look much better for the other major coffee-growing countries. Indonesia has been suffering through a drought, while drought conditions have just started to settle in for Colombia and Vietnam.
Ethiopia, the world’s fifth largest grower, has been profiting from Brazil’s woes because their weather has been great for growing coffee. But their fortune will change in August, as El Niño reduces their rainfall to about half of normal.
And then there’s “la roya.”
Central America accounts for about 9% of the world’s supply of coffee. The weather has been hot, allowing “la roya,” or coffee rust, to spread. Coffee rust is a fungus that infests the leaves of the coffee plant. The fungus spreads quickly in the hot weather, withering trees and sharply slashing production.
The weapons of choice to battle coffee rust: spraying coffee plants with fungicide and cooler temperatures. Spraying costs money — money that small growers don’t have or are forced to borrow. The alternative — cooler temperatures — will arrive in August as part of the El Niño cycle. Even so, it will take months to years for coffee plants to recover.
Any way you slice it, coffee bean production levels will be low as El Niño brings drought throughout growing regions while at the same time aiding the spread of la roya.
The price of coffee has been fluctuating as traders respond to weather forecasts that are prematurely calling for rain to return to Brazil. (This is the same group of forecasters that predicted each blast from this winter’s polar vortex would be the last one. They made that prediction at least eight times until they finally got it right in March.)
Rain will return to Brazil in July just as Colombia and Central America dive deep into drought. Brazil’s rain usually comes back with a vengeance, increasing the risk for flooding and landslides, which will cause even more damage to the coffee plants.
Coffee will be in short supply for another two years before the weather becomes favorable again.
Playing the Commodities With Some Extra Kick
The largest roasters are part of much larger, diversified companies such as Nestlé and Procter & Gamble (NYSE: PG), making it impossible to justify trading either one on the price of coffee alone.
Chasing coffee shops can be a trip down the rabbit hole because there are so many other variables in that space and coffee is a high-margin item. The markup on a $2 coffee is about 500%!
The largest players, Starbucks (NASDAQ: SBUX) and Dunkin Brands Group (NASDAQ: DNKN), for example, leverage long-term contracts for coffee. Starbucks has its 2014 supply and 40% of its fiscal 2015 supply under contract, locking in a price so that it isn’t vulnerable to market fluctuations. Dunkin has coffee contracted through the end of the year. You won’t see the price of coffee increase at Dunkin until the fourth quarter, according to its analyst’s call.
An exchange-traded note (ETN) is an excellent way to play the rising price of coffee without having to worry about all the extra noise you might encounter with the roasters and the suppliers. I recommended the iPath DJ-UBS Coffee Subindex Total Return ETN (NYSEARCA: JO) in February and it’s jumped 11% in less than three months. And it’s not done rising. The dry conditions created by El Niño will keep coffee production levels down, forcing the price of coffee higher during the near term. JO is a simple yet effective way to capture any coffee price gains.
Editor, Weather Trader