Is a Rally Brewing in Coffee Futures?

Today's Idea

Coffee futures are notorious for volatility; especially should a weather event occur that could potentially harm production out of Brazil, which is the world's largest Coffee producer. Some traders who are expecting an upside breakout in Coffee prices may wish to explore the purchase of a bull call spread in Coffee futures options. For example, with September Coffee trading at 270.55, the September Coffee 285 calls and sell the September Coffee 295 calls could be purchased for about 3.30 points, or $1,237.50 per spread, not including commissions. The premium paid would be the maximum potential risk on the trade, with a potential profit of $3,750.00 minus the premium paid realized at option expiration in August should September Coffee be trading above 295.00.

Fundamentals

The bull market in Coffee futures has begun to cool a bit, with prices of the September contract consolidation just below the 275.00 area. The rally in early may above the key 300.00 level was triggered by concerns that Coffee production in Brazil would fall sharply, as this is the "down" year in the bi-annual cycle for Arabica production. In addition, the market had started to price-in a "weather" premium going into the South American winter. Current strong demand for Coffee has kept prices high, and concerns that high quality Coffee would be in short supply this year have kept the market from seeing a weakness in prices, even during the recent commodity-wide sell-offs the past couple of weeks. However, Coffee bears have received some supportive news, with the International Coffee Organization (ICO) projection that Coffee production will fall by a meager 3 million bags this coming marketing year, despite a nearly 10% decline in production expected out of Brazil. Increases are expected out of Vietnam, with the ICO expecting the new-crop harvest to total 19.5 million bags this year, vs. 8.5 million bags for the 2010-11 crop year. Many traders will turn their attention to the weather forecasts for any chances of a crop-damaging frost or freeze . In addition, the key Coffee growing region of Minas Gerais could use some rainfall in the coming days, to help the maturing Coffee beans fill out. Should any detrimental weather affect the crop, we could see prices move sharply higher, as many traders will likely be forced to trim their crop estimates.

Technical Notes

Looking at the daily chart for September Coffee, we notice prices forming a consolidation pattern after the nearly 55-cent decline seen from the early May high. Prices have recently begun to trade back near the 20-day moving average, and the 14-day RSI has moved back to a neutral reading of 50.17. Many traders will be keying on the direction of the eventual breakout of the recent consolidation phase as a signal of the probable direction of the next major price move. Support is seen at the June 2nd low of 256.95, with resistance found at the May 18th high of 277.65.

Mike Zarembski, Senior Commodity Analyst