One of the key components that I use, when trying to ascertain fair value of #coffeefutures is the #certifiedinventory, and the outlook is...not so good.
We have been seeing one of the largest cert draws in the history of #coffee and we recently passed an important milestone the 1 million bag threshold. Coffee is now below the 1 million bag level for the second time in just a couple of months, and unfortunately this trend looks set to continue.
In this article, I will show why I think the certified inventory levels are so important for coffee, what are the dynamics at play, provide my forecast for what stocks will be and then finally explain what I think this means for coffee prices.
Why Cert Stocks Matter
We believe that coffee is priced by #supply and #demand, and the cert stocks are one of the most important indications of supply.
S&D as a driver of price has broad support in the academic literature going back to Adam Smith, but it is unfortunately not super straightforward in the real world. Supply and demand exist across multiple time frames, and so to use supply and demand to come up with a price value, we need to add more specificity. We will see shortly how certs are an important component of this.
My preferred method for assessing the value of coffee, is with a price model based on a stocks-to-use ratio. Stocks represent the current supply, and demand represents expected annual demand. Many roasters refer to this as weeks of consumption but it is functionally the same thing (stocks / weekly demand). This is widely used across the commodity world as a way of assessing and forecasting price.
The problem in coffee is that there is no universally available information on global stock levels. This is where cert stocks come in.
Certified stocks represent the globally available supply of coffee, that can be exchanged for futures. This is fungible with non-certified coffee though so we also need some indication of non-certified stock levels. For this we can use the #GCA stocks (more on the GCA stocks here).
We can construct a stocks-to-use ratio using certified inventory and #GCAstocks and this will provide us with a reasonable proxy of both certified and non-certified coffee.
As you can see from the above graphic, stocks to use ratios are at historic lows and this is the reason that prices are at very high levels.
Cert Stock Dynamics
To understand how to forecast certified inventory we have to understand the economics of why coffee is certified in the first place. The primary reason that coffee is certified, is because the owner of the coffee believes that they can sell it on the futures market for more than they can sell it in the physical market.
There is also a secondary reason, where the owner of the coffee may certify the coffee in order to secure financing. However, this is less of a driver of new certified inventory and more of a reason that certified inventory might be maintained.
The whole purpose of certified inventory is that it can be exchanged for a future. The fact that certified coffee can be exchanged for a future is essential for a well-ordered futures market because it is what makes futures reflect the actual price of coffee. However, the differentiation of various types of washed Arabicas means that it is not always economically viable to exchange certified inventory for coffee.
To understand why, we have to understand the Physical Coffee Prices. (see more on this here: Physical Coffee Prices).
Physical coffee prices are often priced as #differentials. The "differential" refers to the premium that specific origins are traded over the future market.
The futures market represents the value of a basket of washed arabica coffees. Theoretically, pricing a coffee differentially enables the buyer and seller to trade the coffee on its distinct merits.
In practical terms, this means that the seller of a specific coffee receives the futures market price, plus a premium or discount based on the supply and demand of that particular coffee.
When differentials are very high, it incentivizes sellers to sell coffee in the physical market where they will receive a large premium rather than exchange it for a future. When differentials are very low, it incentivizes selling coffee on the futures market and delivering against a future since they don't have to receive a discount.
Similarly, when differentials are very high, it incentivizes buyers to buy futures and accept delivery of certified inventory rather than pay the premium for the coffee in the physical market.
This is the scenario we find ourselves in now. High differentials are incentivizing draw down in certified inventory.
Where will Cert Stocks Go From Here
My view is that certs will continue to draw down at a fairly high rate and that this will continue until we see differentials improve in #Arabicas. We are unlikely to see differentials improve until we see some productive harvests from the #milds and washed #Brazils.
A lot of this will depend on #weather.
#Brazil is poised to have a healthy crop in 2023, one year forward and this would be the powerhouse of new certified coffee. However, there are still some very big unknowns as to the 2023 crop. We have already experienced significant dryness over the last several months, and the forecast for the next few months looks like it could be dry as well.
We also are not finished with #frost season yet, and any additional frosts after last year would be a major catastrophe for the 2023 Brazil crop.
#Honduras would be the next major source of potential washed coffees that could be certified. They are the largest producer of washed #Milds after #Colombia and their differentials are usually the first to be low enough to be economically viable.
It is still early to say about next year's crop, as it is still 4 months away. For now, we have to assume that the crop will do at least ok. The flowering was very good and rainfall for the last 90 days has been good during the critical period of blooming and cherry growth. However, the next few months looks drier in the long-range forecast which is not great.
Colombia is often too expensive to tender to the exchange and we do not see that changing in the near future. Especially if we see a repeat of excess rainfall there.
Therefore, we believe that the earliest that we will see new coffees tendered to the exchange will be the next crop out of Honduras in Oct-Dec timeframe and even that may be too soon.
What is the Impact on Price?
The general impact of lower stocks on price would be higher prices. The dynamic would be one of the lowest certified inventories in memory. The lowest inventory since the year 2000 is 897k, and that was on 1/4/2000.
As you can see from the below chart, the impact of low inventory on prices is significant and repeatable. It is not the only factor, but it is a major factor.
We can see that right now, we are undoubtedly in a period of low inventory and high prices. The only question is, where will stocks go from here?
In the short term, we have to assume that stocks will go lower. However, going forward, there is a famous saying in commodities: "the cure for high prices is high prices."
The historic high prices in coffee will be stimulating global coffee production and we all know that eventually the bear market is coming. The only question is, will that bear market come in a couple months, or a couple years...that looks like a small difference in a long-term chart but will make a big difference to all of us in the coffee industry.
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