Understanding the #SupplyandDemand (S&D) balance sheet is essential for any professional #trader, but can also be extremely daunting. For many #coffee and #commodity #traders and #analysts, we have a deep insecurity in our relationship to the fundamentals because of its complexity and the extent of the many unknowns.
Despite (or perhaps because of) the difficulty of mastering the #SnD, it is a prized skill in our profession and a key driver to price discovery in the #coffeemarket. The #fundamentals are not only prized because of the impact on the #coffeefutures market, but also because it helps us to plan our #trading decisions across different markets and origins.
For many of us in the physical #commoditymarkets, the fact that supply and demand drives price is a given. We observe it year after year.
If there is a massive #surplus (such as the #Brazil driven surplus of 20/21), this puts important context to any deficit that may come after. When #Ethiopia experiences a drought and a delayed #harvest, we see #differentials spike as #consumers and traders fear a shortage.
Therefore, having a clear and reliable view on crucial data, such as #production, #demand, #exports (and others) is critical for making informed decisions.
Our premium clients receive our global S&D as a service from us in our Fundamentals Report, and in this article, we will share details on this report (and others like it) and how you can use it inform your trading.
Even if you are not a subscriber, our intention is to provide some insight into how to think about Fundamentals and to use these essential reports.
The S&D Pyramid
Our first step in understanding S&D, is having a clear and easy to read format.
Having clear numbers and visualizations will not only help us to understand the impact of S&D on price and availability, but also enable us to spot errors quickly.
Supply and Demand numbers are often guesses, estimates and provisional numbers, so we never want to take any number as gospel, but the first step is understanding what the numbers are.
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The crux of delivering information quickly, and with depth, is for reports to be pyramid shaped.
We summarize the big picture right up front, but this summary is well supported by a cascading foundation of data.
The tip of the pyramid is the stocks-to-use ratio. This distills the entirety of Supply and Demand into a single number: stocks divided by annual use. A low S/U ratio is bullish prices and a high S/U ratio is bearish prices.
Comparing a S/U ratio to prices over time is the essential starting point for any trader wanting to make sense of whether current prices are under or overvalued.
Think of both prices and S/U ratios as reference points and observe where they cluster together. When prices were at $1 where were S/U ratios? Where were they at $3? Where are they now?
Just below the S/U ratio in importance, but still near the top, are two closely related concepts: Supply and Demand #Balance and #Inventory levels.
Balance is simply total supply #minus total #demand. This is actually where many traders think of the top of the pyramid, as it shows the market in #surplus or #deficit.
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However, the important context for interpreting a surplus or deficit is the inventory levels. A big deficit may not actually be very bullish if there is an existing over-abundance of inventory.
In our report, the first summary is divided into global production and consumption from the two main different types of coffee: Arabica (divided into Milds and Naturals) and Robusta. This provides a quick insight into how the global S&D has been developing (going back to 2016/2017), and what is likely to be the way forward.
A chart provides a visual interpretation of this. I like to use bars for production and lines for consumption to easily differentiate. Below the S&D charts, we include a bar chart of the balance. This is what many consider to be the crux of the fundamentals for any commodities trader: surpluses and deficits over time, along with their respective sizes.
Digging Deeper
Having a grasp of the top-level of global S&D is super important, and a great place to start in our understanding.
However, if you stop here you will be exposing yourself to a major vulnerability. If we don’t understand why a market is in surplus or deficit, then we won’t know what to watch or what conditions might indicate something important has changed.
Since this is coffee, there is a good chance the issue is Brazil. So here is a pro-tip. If someone asks what you think about the Fundamentals and you have no idea, just say “I think it's all going to come down to Brazil.” There is a good chance that you will be right. (Substitute #Vietnam if you’re talking #Robusta).
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In all seriousness, there is often one or two origins that are the problem area and by scanning production data by origin you can identify it pretty quickly. What you are looking for are patterns and deviations from normal.
Once you identify a pattern, you want to dig deeper. Talk to experts who trade that origin, or who work there.
I had a mentor once who said, “Fundamentals is a journey not a destination.” This is where the journey comes in, becoming an expert in the Fundamentals is a million small conversations about the nuances of production and demand all over the world. I’m a few hundred thousand short of a million conversations, so not sure that I qualify as an “expert” yet. However, it is something that I aspire to.
Production in Vietnam increasing every year? Why is the trend increasing? Is it planted area or productivity? Both? Why is Colombia stagnating in production? Digging deeper into these topics will introduce you to what are the indications that the trends will change. Either returning to “normal” or getting off track.
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Exports and Imports
While Production is the sexy number that everyone likes and wants to know. The exports and imports are important supporting information. For exporting countries, the exports are the confirmation of production.
Customs data is often more reliable than crop estimates, so looking at exports will often provide confirmation of whether crop estimates were right or wrong.
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Exports are also a solid indication of demand. Since someone has to have purchased the coffee for it to be exported, we can sometimes look at ebbs and flows in exports to indicate when demand is increasing or decreasing.
Keep in mind that exports are not 100% reliable either. Some countries have multiple sources that provide export data, and sometimes this information conflicts. When it does, we need to rely on a judgment call and experts in country to help make sense of the data.
Imports in exporting countries are also important for differentiating when origins are exporting coffee grown locally, or whether they are importing coffee for re-export. Subtracting imports from exports (net exports) will help to get a more accurate number to confirm production.
Imports are also useful for importing countries, not only for confirming demand, but also to imply exports from origins without reliable export data. If we are missing export data from a country, we can simply sum the imports from that country to derive what are called “mirrored exports.”
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Domestic Consumption
Domestic Consumption is one of the more elusive of the categories of Supply and Demand because there is so rarely accurate data for this. If we think of production as an algebra problem (Production = Stock change + Exports – Imports – Domestic Consumption) , then Domestic Consumption muddies this formula by adding a second variable.
Without reliable Domestic Consumption data two analysts can come up with completely different production estimates using the same customs data but assuming different Domestic Consumption. This is a perennial problem in coffee and one that leads to many interesting disagreements between friends (usually... sometimes a little bit less friendly).
A good starting point for Domestic Consumption is the data provided by the ICO, but this should be checked against population figures at the very least. Its also essential to check with friends from origin.
Individual Origins
Its beyond the scope of this article to go too deep into individual origins, but we wanted to briefly touch on it. For many of the largest origins, we often break down the individual coffee growing regions as if they were there own mini-origin. This helps to identify trends, but most importantly it also enables us to more accurately understand the impact of weather.
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Conclusion
Our Fundamentals Report is something that we have spent a long time in developing, both the format and the underlying data. We strive to provide accurate data that is easy to read.
We also think that we provide a service to our friends in the coffee industry, because we believe independence is important. Our research is created independently from banks, brokers and the trade. For our sources we use data from customs, our proprietary weather forecasts and also an independent network of small exporters, large farmers, independent analysts and traders.
We strongly believe that that independence has value. If nothing else, an independent source can confirm your own information and provide insight beyond what your in-house team thinks.
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Our report is constantly updated and published monthly to our subscribers, so they can observe changes over time. Additionally, every report goes along with a commentary discussing what has been adjusted and why.
The fundamentals are essential in our business. They help us to inform our trading decisions and to understand what is happening in the futures market.
We believe everyone has the power to understand and use this information in their own trading and their own business, with or without the help of professionals.
However, if you like our process, our goal is to assist you in your understanding of the fundamentals by doing the legwork for you and providing context with video and written commentary. if you think that is valuable too, then we invite you to evaluate our services for free.
Thanks for reading and we look forward to working with roasters, farmers and traders like you!
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