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Is the Incredible Run in Coffee ETFs Finally Over?

Zacks Equity Research

Coffee ETFs have been on a tear this year having returned more than 60% so far in the time frame. Though the commodity had an awful run last year losing about 20% thanks to a supply glut, uneven demand and investors’ appetite for stock markets as well as an unfavorable harvest condition in Brazil – a key coffee producing region – put the commodity on investors’ radar screens.

Though the rally in coffee prices, which started off in early 2014, began to buck the trend from mid March on an easing drought condition in Brazil, the crop again caught investors’ sights in late July. Two coffee ETNs, namely Dow Jones-UBS Coffee ETN (JO) and Pure Beta Coffee ETN (CAFE), added about 14% each (read: 5 ETFs Up At Least 10% in the First Half of 2014).

Reduced crop yield in Brazil and United States Department of Agriculture’s (USDA) forecast for a lower global production and an increased demand pushed up the coffee price during that phase. Let’s discuss the drivers in detail:  

Drivers of Performance

First, Brazilian farmers are finding the weather too harsh to produce the required level of next year’s crops. Also, the outbreak of coffee leaf rust affected several coffee producing nations. The latest epidemic in Central America appears to be the most severe in 38 years. Notably, the rust ravaged as much as 74% of coffee growing in El Salvador.

USDA predicted that global coffee production for 2014/15 season will slip by 1.5 million bags from the preceding year. Brazil’s Arabica variety is forecast to fall for a second successive year.
A protracted drought and high temperatures in major Arabica producing areas dented the crop. In other parts of the world, Indonesia’s production is projected to fall 600,000 bags to 8.9 million thanks to weather concerns, per the USDA.
In fact, Agrimoney noted that Citigroup reduced its forecast for coffee output to 41.75 million bags from 44.25 million bags projected earlier and that the Arabica coffee market is poised for a prolonged bull run.   
Only supply bottlenecks are not an issue. Reno Gazette Journal noted USDA’s forecast for record global coffee demand this year. To add to this, consumption is rising at a swift pace in major producing nations like Brazil, Vietnam and Colombia.  Other major coffee consuming regions – the European Union and the U.S. – are also expected to record marginal rise in imports (as per USDA).

Market Impact
Thanks to these fundamentals, S&P GSCI Coffee index has seen a 5.7% gain in the last five trading sessions (as on August 4, 2014). However, drivers like USDA’s forecast and Brazil’s concern seemed to be very short-lived as coffee prices again started to lose steam from August 4, 2014. Both JO and CAFE retreated more than 5% in the week ended August 4th.

Causes of Concern
Undoubtedly, there will be a certain downward drift in the production scenario but we believe that will not be sufficient to evade the oversupply condition. Secondly, the recent slump in the Brazilian Real against the greenback will likely make imports expensive and exports cheap, posing a major threat to coffee prices (read: Stumbling Start to June for Agricultural Commodity ETFs).
The Fed’s decision to exit the QE era this year will likely strengthen the U.S. dollar. As a result, a weaker real allows exporting countries to sell in higher amounts which in turn increase availability in the market but at the same time weigh upon prices. Moreover, European growth has begun to exhibit a sluggish trend lately which raised questions over the sustainability of the demand picture.
Russian Ban Comes as a Boon
By now, the World has come to know about the Russian ban on food imports from regions including North America, some European nations and Australia in a move to hit back the sanctions imposed on it by the West over Ukrainian issues. As per sources, Russia will now turn to various Latin American nations for its food requirements. Amid such a situation, Brazil’s should get an increased export opportunity for many of its crops.
Bottom Line
Both ETNs— JO and CAFE – possess a Zacks ETF Rank #5 (Strong Sell). Investors should also note that the relative strength index of the duo is presently hovering around 50–51 indicating that the funds are yet to reach the overbought territory, though not far behind the threshold mark (read: Don't Be Fooled by the Coffee ETF's Surge).
We believe that all good news out of coffee beans is presently reflected at the current level. Still, investors looking for some entry points in this volatile space should closely follow the weatherman first in Brazil, Indonesia and Vietnam, and the pace of global recovery later.

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