Will Coffee ETFs Continue to Brew Returns in Q2?

Coffee has made an impressive comeback after a steep fall last year. A supply glut, uneven demand and investors’ appetite for stock markets over commodities resulted in a 20% decline in the price of the commodity last year. This was, in fact, the third year of decline in a row, with the commodity plunging about 88% in the time period.

Most investors thought that the trend would spill over into 2014 thanks to higher inventories which were thought to hit the 5-year high at June 2014 and the sluggish currency of Brazil – the world’s biggest producer and exporter of the commodity (read: Slump in Coffee ETF Continues).

However, proving many investors and analysts wrong, Coffee prices were on a tear since the start of 2014 due to inclement weather in Brazil which put a lid on production. Coffee prices as measured by the ICE futures contract shot up 58% to $1.78 a pound in the first quarter of this year. The worst drought in Brazil sparked fears of shrinking supplies.

This sudden supply crunch situation made coffee exchange traded products like iPath Dow Jones-UBS Coffee Total Return Sub-Index ETN (JO) and iPath Pure Beta Coffee ETN (CAFE) which were the top performers in the first quarter of 2014. JO and CAFE gave investors great returns of about 60% and 56%, respectively (read: Coffee ETFs Soar on Brazil Drought Concerns).

How About Coffee in Q2?

The enormous rally, however, continued until the middle of March which compelled many to believe that coffee is finally nearing a pull back. Drought condition in Brazil – the main driver of coffee’s incredible run-up last quarter – is easing now. Building hopes for rainfall are putting pressure on coffee prices. In the last 10-day period, JO and CAFE lost about 9% and 8% (as of April 2, 2014).

Despite a 10% drop in Brazil’s production this year, research firm Society Generale is still forecasting a coffee-supply surplus with production likely to surpass demand by 1.5 million bags. Several analysts share the view as they still see plenty of untapped supplies to meet future demand (read: Don't Be Fooled by the Coffee ETF's Surge).

However, hopes have still not died for coffee as a coffee market analyst believes that production is less likely to return to the historic high level as too much rain in Indonesia has ruined most of its Robusta crop.

Also, the world's highest Robusta coffee producer, Vietnam, saw the driest three months in a decade. Though April marks the start of the rainy season, it is expected to be drier than usual, resulting in a supply shortfall.

Coming to Arabica variety – the one Brazil is famous for – supply is highly dependent on weather. One analyst believes that coffee prices could rise to $3 a pound if April is drier than normal or if the crop flowers prematurely. Clearly heightened volatility is due for the beans and could deal a blow to low-income or cautious investors.

Last month, another analyst commented that Brazil’s output may slump to as low as 40 million bags from 47.7 million this season. There other drivers in place as well. The leaf rust disease lowered production yields in the last two years in Central America, adding to further concerns. Yet another analyst stated that global demand might supersede production by 6.5 million bags, compared with a surplus of 4.3 million a year earlier.

Another reason that could help Brazilian coffee price is the strengthening of the currency, the real. The ETF covering the Brazilian currency – WisdomTree Brazilian Real Fund (BZF) – gained about 6.65% this year recovering part of last year’s massive loss.

Notably, a weaker currency allows exporting countries to sell higher which in turn increases availability in the market but at the same time create pressure on prices. Should the real hold steady in the near term, coffee prices will gain some footing.

Market Impact

Having said this, we would like to note that investing in coffee in the days ahead needs a high risk appetite, if any investor is at all bullish on its future course and would like to play the recent subdued status as a buying opportunity.

While futures are definitely an option, some investors might want to take an exchange-traded product route by putting their dollars into JO or CAFE. Both the exchange traded products gained 3.24% and 3.20% in the past week but lost 5.62% and 4.84% in the past month (read: Breakfast Turning Dearer: 3 ETFs to Pick).

Bottom Line

Both the funds have a Zacks ETF Rank of 3 (Hold). Investors should also note that the relative strength index of the duo is presently hovering around 43-44 indicating that the funds have slipped almost into the oversold territory.

This gives another cue to make some profits out of the funds, if weather in Brazil fails to spur optimism. Thus, investors seeking to earn some dollars from this volatile corner should closely follow the weatherman first in Brazil, and then in Indonesia and Vietnam, for clues on Coffee’s future.

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