Over-reaction to Brazil drought and possible El Niño could send Arabica prices lower, says ETFS analyst Nitesh Shah

ETF Securities research analyst Nitesh Shah sees a possible adjustment in coffee prices, as investors react to further weather data.

Drought-induced rally has probably gone too far

The front month Arabica coffee future price has risen 55% since the beginning of this year in reaction to the worst drought in Brazil in decades. Brazil produces 45% of global Arabica. However, rain has resumed in key growing areas which should relieve stress. Coffee bushes are more resilient than widely assumed and accelerated pruning activity in the past season should have helped make the bushes more resilient than previously.

According to the Brazilian National Agricultural Supply Company (Conab) it is too early to assess the damage to the crop and increased rain can partially reverse some of the damage.

Coffee stocks are currently at a three-year high. The hoarding of coffee stock by farmers during the period in which prices hit a seven-year low (prior to the drought) should abate. Increased sales at current levels should place downward pressure on prices.

El Niño weather pattern likely to assist Arabica coffee supply

The US National Oceanic and Atmospheric Administration’s models indicate the possibility that an El Niño weather pattern will begin during the northern hemisphere’s summer. El Niño’s are associated with warmer weather in Brazil and Colombia (which together make more than 55% of global Arabica production). That would reduce the risk of damage to coffee from frost.

At the same time an El Niño’s will likely bring drier weather in Mexico and Central America (which together make more than 20% of global Arabica production). That would supress the impact of moisture-loving rust fungus. Rust fungus has reduced output from this region in the past few years and so any reversal of its effect will provide farmers a welcome reprieve.

An El Nino would also create drought conditions in India, Vietnam and Indonesia, which will likely be supply-negative. However, these countries combined only produce 5% of global supply of the Arabica variety.

Price is vulnerable to a fall in investor optimism

Net speculative long positioning in Arabica coffee futures has risen to over one standard deviation above its 5-year mean (from being net short only 4 weeks ago). Investors trimming long positions could be a catalyst for further price correction.

Price correction likely to follow

ETF Securities believe that prices have over-reacted to the news of drought. With weather conditions changing and the potential for an El-Niño weather event to boost supply in coming months, they expect prices to decline back to recent support levels around 1.55 per pound


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