In my decade of investing, I've often found that the most intriguing opportunities arise not from the flashy headlines of tech innovations or corporate mergers, but from the quieter corners of the market. Today, I'd like to discuss one such opportunity that has been percolating in my mind: the global coffee market.

Listen to this article as a podcast:

audio-thumbnail
Coffee Crisis Brewing Trouble
0:00
/677.12

The Supply Crunch: A Tale of Two Giants

At the heart of the current coffee market turmoil lies a severe supply shortage from the world's two largest producers: Vietnam and Brazil. These two nations have long been the cornerstone of global coffee production, accounting for over half of the world's supply. However, events this year have dramatically altered this landscape.

Vietnam, which produces around a third of the world's robusta beans (primarily used for instant coffee and espresso blends), has been hit by a double whammy of climatic extremes. A prolonged drought followed by weeks of heavy rain has devastated the country's coffee belt. This has come at a critical time, just before the October / November harvest.

According to Trinh Duc Minh, chairman of the Buon Ma Thuot Coffee Association in Vietnam's largest coffee-growing province, Dak Lak, the harvest is expected to be cut by 10% to 15% this season. The impact is twofold: not only are the trees producing fewer beans, but the beans themselves are smaller. This reduction in both quantity and quality is a significant blow to global supply.

Meanwhile, in Brazil, dry weather has severely impacted the arabica crop. The damage to coffee trees has resulted in smaller beans, further exacerbating the global supply shortage. This one-two punch from the world's leading producers has sent shockwaves through the coffee market.

The Demand Shift: A New Era of Coffee Consumption

While supply constraints are tightening, we're simultaneously witnessing a seismic shift in global coffee demand patterns. The growing popularity of instant and grab-and-go coffee drinks has spurred a more than doubling of robusta prices over the past year. This trend is particularly noteworthy as it represents a fundamental change in consumer behavior, not just a temporary blip.

What's more, emerging markets, particularly China, are developing a taste for coffee. This burgeoning demand promises to keep supplies tight for the foreseeable future. It's a classic case of an inelastic demand curve meeting a constrained supply – a recipe for sustained price increases.

The Price Implications: A Bitter Pill for Consumers

The ramifications of these supply and demand dynamics are already being felt throughout the coffee industry. Major players like JM Smucker Co., whose brands include Folgers and Café Bustelo, have implemented price hikes. Even smaller, specialty coffee shops are being forced to raise prices, often for the first time in years.

Patrick Grzelewski, director of coffee for the eight-location Variety chain in New York City, summed up the situation succinctly: "When it comes to price hikes, we've always triple second-guessed ourselves before we pulled the trigger. But it's just not something anyone can avoid anymore."

This sentiment is echoed across the industry. From the corner coffee shop to international chains like Starbucks, the era of cheap coffee appears to be coming to an end.

The Long-Term Outlook: Climate Change and Sustainability

As we look to the future, it's clear that the challenges facing the coffee industry extend far beyond short-term weather disruptions. Climate change poses an existential threat to coffee production. Both robusta and arabica beans face significant climate risks, although robusta is generally more tolerant to heat and disease.

This reality is prompting a reevaluation of the industry's approach to sustainability. There's a growing recognition that coffee traders and roasters have long been underpaying farmers, a trend that some buyers are now trying to reverse. Higher profits for growers are essential to incentivize continued coffee production and to allow for reinvestment in making trees more resilient to disease and climate risks.

Diversification: A Potential Solution?

In response to these challenges, the coffee industry is increasingly looking to diversify its supply chain. Investments are being made in smaller producing countries, from Cuba to Rwanda. Companies like Illycaffe, Volcafe, Starbucks, Lavazza, and Nespresso are all expanding their sourcing to include a wider range of origins.

While this diversification is unlikely to significantly reduce prices in the short term – smaller producers often lack the economies of scale of Brazil and Vietnam – it does represent a potential long-term solution to the industry's supply challenges. Moreover, it aligns with growing consumer interest in specialty coffees from diverse origins.

The Investment Opportunity: Riding the Coffee Wave

Given this backdrop, I've identified what I believe to be an attractive investment opportunity in the coffee market. My chosen vehicle is the WisdomTree Coffee Exchange Traded Commodity (ETC), trading on the London Stock Exchange under the ticker symbol COFF.

It's important to note that this product does not hold physical coffee beans but instead provides investors with total return exposure to Coffee futures contracts. As with any investment, particularly in commodities, there are risks that investors must consider and understand.

My approach to this investment is not a simple buy-and-hold strategy. Instead, I prefer to trade COFF as it grinds its way upwards. Specifically, I buy when it touches its EMA 21 (represented by the white line on the chart) and when the Relative Strength Index (RSI) is close to 50. I then sell and take profits when the price extends itself and I see the RSI cross 70. As you can see from the chart above, the current price of COFF is overextended on the RSI, so I am not a buyer at the current price.

This strategy is based on my understanding of the cyclical nature of crop production and weather patterns. When a crop has "missed the harvest" it's unlikely that a sudden supply will appear in the market. Given the current state of global coffee production, I believe this trade has the potential to be profitable for at least the next year.

As with any investment, it's crucial to have a clear exit strategy. In this case, I'll be closely monitoring news about coffee crops. Once I start to see positive news about coffee production hitting the wires, I'll take my foot off the pedal on this trade. But until then, "Brew, Baby, Brew".