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Will Cocoa ETFs Taste Bitter or Sweet Ahead?

Zacks Equity Research

Cocoa has been one of the high-potential commodities since the start of the year with prices hovering around the three-year high level. Surging global demand for chocolate, increased consumption in Asian nations specifically China and supply crunch thanks to the political unrest and inclement weather in major producing regions – Ivory Coast and Ghana – took Cocoa prices and related exchange traded products to the highs. Also, an epidemic of fungal disease in Brazil hurt the crop yield last year.

However, the soft commodity recently bucked the trend as an American nation Ecuador is expected to produce record amount of cocoa this season surpassing the previous topper among American countries Brazil. Ecuador’s output will likely increase 9% in 2014 helped by government aid and easing concerns of the El Nino weather (as noted by Bloomberg).

Thanks to a benign weather forecast and the resultant growth in output, cocoa prices – that jumped about 19% to $3,216 per ton so far this year – are estimated by Bloomberg analysts to slip to $2,992 a ton in 2015 (read: 3 Agricultural Commodity ETFs Slumping in July).

The International Cocoa Organization recently commented that cocoa farmers will globally harvest 10% more crops this year resulting in a record 4.345 million metric tons of production in the current season, ending September 30 (as noted by Wall Street Journal).  With this number, output will likely exceed demand by 40,000 tons against the previous projection of a 75,000-ton shortfall.

What Lies Ahead?

While the output outlook appears decent, demand outlook looks robust and should result in a favorable pricing condition in our view. In fact, despite increased production in Ecuador, the president of Ecuador’s National Cocoa Exporters Association – Ontaneda – expects cocoa prices to shoot up to $3,400 by the year-end reflecting the swelling Chinese demand.

Notably, emerging nations are playing an important role lately in driving cocoa prices higher. Resurgence in middle class population and rising purchase power are allowing these nations to indulge in luxury food items like chocolate – which is made of cocoa. Ontaneda expects a 100,000-ton supply shortage this year and a deficiency of about 800,000 tons by 2020.

We also believe that cocoa prices will remain firm in the days to come. China slowdown, deflationary worries in Europe – one of major consumers of chocolate – and relaxation in production hurdles are unlikely to weigh upon the strong pricing trend of cocoa, at least in the near term. The production scenario needs to be more stable to outperform the present demand profile and register a declining pricing trail.

However, given the spike in prices in the year-to-date frame, the future momentum in cocoa prices could face a slowdown. After a gain of over 30% in the last one year, Cocoa exchange traded products might have got an overvalued status and we have looked at both of these ETNs in greater detail below:

iPath Pure Beta Cocoa ETN (CHOC)

This note looks to track the performance of the Barclays Cocoa Pure Beta Total Return Index. Unlike many commodity indexes, this one can roll into one of a number of futures contracts with varying expiration dates, as selected by using the Barclays Pure Beta Series 2 Methodology.

This approach might result in less contango. This can be an important factor, as month-to-month shifts in contracts can eat away returns during an unfavorable market situation. The fund is a bit unpopular in the space as evident by its AUM of $10 million. The product charges 75 bps in fees.
The ETN gained 29.0% over the last one-year period – the highest among any other agriculture-based products. CHOC has a Zacks ETF Rank #2 (Buy) with a High risk outlook (read: Invest in Cocoa with These Top Ranked ETFs).

iPath Dow Jones-UBS Cocoa Subindex Total Return ETN (NIB)

This ETN seeks to match the performance of the Dow Jones-UBS Cocoa Subindex Total Return. The index delivers returns through an unleveraged investment in the futures contracts on cocoa and currently consists of one futures contract. The product normally utilizes front month contracts to gain exposure (see: all the agricultural ETFs here).

The fund is also unpopular and has attracted just $23.0 million in assets this year. The product charges 75 bps in fees per year and trades in a small volume of nearly 20,000 shares on average daily basis. This increases the trading cost in the form of a wide bid/ask spread.

The ETN added about 28% in the last one year. NIB too has a Zacks ETF Rank #2 with a High risk outlook.

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Read the analyst report on NIB

Read the analyst report on CHOC

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