Last week on November 30th, the coffee market rallied 14.5c or almost 9%, in a single day. To put this in context, this is the largest single day move since the Frost in Brazil in July of 2021 and in a market where 10c is considered a very large, outlier day. Just a few days later, the market fell 8c, bringing us back nearly to where we had started the rally.
For my part, I was surprised by the 14c rally and because it was so surprising, I think it is worth examining. The short answer to why coffee rallied 14c is pretty clear: the certified inventory dropped by 60k bags, or 22% of the total inventory in just 2 days. However, there is more to the story here and there is much uncertainty in the future, which is what we will examine in this article.
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Background:
I'm a fundamental analyst, meaning that I believe that supply and demand is the key driver to prices in the coffee market, and the certified inventory is the official supply of the Arabica futures market. The "certs" (as the certified inventory are affectionately known) have been declining since mid-2021 as the world struggled with high freight rates, shipment delays and high differential prices. This combination made consuming certified inventory attractive and the trend persisted with only a small period of stock build in the beginning of 2022.
The normal reaction to a stock decline would be bullish and this was the defacto relationship between certified stocks and coffee prices for many years. However, the 2021-2023 years were not normal. By mid 2021, the world was reeling from covid and reduced demand and the certified inventory was chock-full of semi-washed Brazilian coffee (+2 million bags) after the massive 2020/2021 crop.
In July of 2021, Brazil was hit with the worst frost this century, and possibly the worst since the 1970s and 80s. This massive frost plus prior drought damage decimated the largest producer of coffee in the world. For Arabica prices, the impact was immediate and incredibly bullish. The market rallied 40c in just a few days, and the market didn't really stop rallying until highs were reached around 260s, making this one of the top 10 coffee market rallies of the last 50 years. However, the effect on supply was not entirely straightforward.
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Frosts don't impact the present supply, but rather the future supply. A frost kills the coffee tree's potential for the coming crop, one year forward. So in essence, when the market rallied following the Jul 2021 Brazil frost, the market was pricing in a shortage of coffee one year forward.
This forward orientation is not unique to coffee frosts, Brazil's biannual cycle of having one big crop and one smaller crop (on and off-cycle) allows the coffee industry to have some inclination of forward supply. This is why one of my most useful mantras has been, "coffee is forward looking". In other words, coffee isn't concerned with the present, we have priced that in long ago, the market is concerned with pricing in the future.
As the market rallied up to 260 then, the market was pricing in a 2-year deficit in coffee that would end only in 2023.
The Present:
In 2022 and 2023, even though we were in the midst of a deficit, the market had priced this in back in 2021, and during 22 and 23 we were now looking to the future.
Brazil had a poor crop in 22/23 (as expected from the frost) but 23/24 was looking to be a meaningful improvement, and now, in December of 2023, the world is looking forward to the 24/25 crop. This crop is by most indications looking to be in very good shape, with many tradehouses forecasting a record crop. In addition, there were indications that the 23/24 crop has now been completely harvested, the warehouses in Brazil are full and we believe that this crop was actually better than originally expected.
Meanwhile, certified inventory had not really stopped in its steady decline. Although freight prices had returned to normal levels, differentials were very high in the beginning of 2023 and consumers turned to the stocks for consumption as an alternative.
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Demand languished in general and combined with relatively high futures prices, differentials were rapidly declining. We followed closely the calculation of tenderable parity to see when it would be economical to deliver new coffees to the exchange. By our calculations, we were not yet at the magic level, but we were getting close, and aggressive blending methods might have made it profitable.
For months, I have been telling my clients to anticipate new coffees coming to the certified inventory. We had a surplus this year and the combined supply of the 23/24 Brazil crop plus the October crops would bring in much needed supply.
Indeed, we finally started to see new coffees submitted to the exchange for grading in November of 2023. These were new origins in new ports not seen in the exchange before. With the market being "forward looking", we and others were optimistic that the trend was shifting toward greater supplies of certified coffee.
Moreover, the market had encountered a much-maligned phenomenon, the "re-cert" and this was coming to an end. Certified coffees were being decertified from the exchange and then resubmitted to avoid aging penalties. In some cases, there was suspicion that large amounts of coffees that were decertified were then resubmitted as pending stocks several weeks later. In essence, some of the certified consumption was not actually "real."
The exchange listened to complaints about this and decided to actively prohibit recertifying previously certified coffee, and the deadline was given as November 30th. In the run-up to this deadline, we considered it very likely that anyone who had the ability to de-certify coffee would do so by the deadline, with some people suggesting that we might see large quantities in the last few days as an attempt to influence the market.
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As the market approached the deadline of Nov 30th, we watched to see if any "re-certs" would appear on the exchange. They did not. In fact, the opposite happened and large quantities of coffee were de-certified on the last day that re-certs were available. In other words, someone decertified a bunch of coffee that they knew they would not be able to re-certify...this coffee was intended for consumption.
At this point, certified inventory was at critically low levels but the market had largely grown complacent. Cert stocks had been at multi-decade lows for months now and forward looking coffee was focused on how the market would soon be out of danger. However, in the present things just got a lot scarier.
When the market has 2 million bags sitting in exchange approved warehouse, decertifying a few dozen k bags is no big deal. However, when there is only 300k bags of coffee, and the market consumes 60k in 2 days, that is a very big deal. If this rate continued, the certs would hit zero in less than 2 weeks.
Meanwhile, technical analysts and trend followers really liked the look of coffee. I saw multiple trend followers discussing how the market was turning bullish, and for our own part we noted to our clients the 20 vs 200 SMA cross which signals a long term trend shift and is a buy signal to trend followers.
Any shorts in the market who were optimistic on the direction of prices based on the pending stocks would have placed their stops above the recent highs from mid-November. Any trend followers looking for a buy signal would have placed their entry points for the breakout above these highs.
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Then on November 30th, all of these factors happened at once and the market rallied and didn't look back for nearly 15c.
Going forward:
Looking forward the market is in a peculiar place. By most traders calculations coffee is in a transition where we are coming out of 2 years of deficit and moving into 2 years of surplus. This is an unambiguously bearish future, but we do have a pesky problem of the present.
In the present the certified inventory is at critically low levels and the market is essentially at the mercy of just a few actors. Any one large trader house or roaster that decertifies coffee at this point will have an outsized impact on the market. While I'm sure that the exchange will be paying close attention to anyone who chooses to decertify coffee, if a commercial justification is made then in theory, any owner of coffee can consume their own certified inventory.
On the other hand we have new coffees submitted for grading in a steady trickle. The market has averaged 1.7k bags a day since the pendings have started. Just the other day we saw 7.1k bags passing inspection (72% pass rate) which likely facilitated the 8c sell off.
While it seems likely that the increase in certified inventory will continue, the short-term inventory levels are a difficult scenario to predict.
People in general are predictable as a group. We know that for every 1 million people, roughly 50% will be male and 50% will be female. We can make all kinds of statistical assumptions about their behavior. However, a small group of specific people are a lot harder to predict. Without knowing exactly who owns the coffee and what their positions and commercial needs are, its rather difficult to determine how they will behave. This sets the market up for volatility in the short term as the market waits to see whether more coffee will be consumed or how quickly new coffees are submitted for grading, and in what volumes.
Looking further out into the future it actually becomes easier to predict. If the market is inverted, and the market is in surplus and differentials continue to fall then we will see coffees graded and added to the exchange. If this trend continues sufficiently then calendar spreads will return to contango and the futures market will fall. When the futures market falls the specs and trend followers will return to the short side and we will have our bear market.
We still need to get through this interim period of tightness before we can get to our bear market though and there is much uncertainty over how this will play out in the short term. I still believe in the value of my old mantra, that coffee is forward looking. However there is another old cliche that is applicable here, in the market, timing is everything.
Coming back to the 14c rally, this mantra failed in that occasion, or at least the market was looking at a future that was much closer than one year forward.
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