Cocoa Prices Are Low, But Should You Invest?

October 13, 2017

Cocoa Prices Are Low, But Should You Invest?

  • Cocoa prices are at multi-year lows.
  • I’ll analyze the supply and demand situation to see if there might be profit opportunities.
  • A cocoa ETF isn’t the only way to profit form cocoa.



Introduction

Investing in commodities is relatively easy compared to other stocks.

As an example, to profitably invest in Apple (NASDAQ: AAPL), you should be able to estimate iPhone sales for the next few years. What’s difficult is that there are a myriad of factors that influence iPhone sales.

But when investing in commodities, all you need to look at is whether there will be more demand than supply or vice versa.

Where demand for some commodities is pretty easy to estimate, there aren’t that many factors that impact how much chocolate you’ll eat next year, and you’ll likely consume a similar quantity you ate last year.

On the supply side, it all depends on the weather. Good weather and healthy crops increase supply, while bad weather lowers supplies and pushes prices up or down accordingly.

Under the assumption that the weather and planting activities will always find a balance, it’s possible to invest profitably in cyclical price movements.

In today’s article, we’ll discuss cocoa as it’s now at multi-year lows.

Figure 1: Cocoa price in history. Source: Trading Economics.

The current cocoa price is $2,045 per metric ton (MT), down from the $3,000 level in the period between 2014 and 2016.

In 2013, there was a crash and the last time prices were below $2,000 was prior to 2008. If I go back to 1970, prices were around $1,000, and then again at the beginning of the 1990s. So at $2,000, cocoa prices are below the level that would cover for global inflation and could provide an excellent trading opportunity while also creating a commodity hedge for your portfolio.

Let’s check the cocoa supply and demand forces to see what’s going on there.

Cocoa Supply & Demand

If the price of a commodity drops suddenly, it usually means that there is oversupply. A look at what the International Cocoa Organization (ICO) has to say shows exactly that.

Figure 2: Cocoa supply, grindings, and stocks. Source: ICO.



So the ICO has forecasted increased production of 18.1% for this year and higher stocks as there was a clear indication of a surplus of 382,000 MT.

Additionally, cocoa bean arrivals to ports in Côte d’Ivoire reached 1.966 million tons as September 3, 2017, up by almost 35% (508,000 tons) compared with the 1.458 million tons recorded for the same period of the previous season.

The ICO has discussing the weather where favorable weather conditions are reported to be boding well for the upcoming main crop in most of the West African region. Should the positive weather conditions prevail, then expectations are that there may be a second consecutive global surplus of cocoa beans in the next cocoa year.

So it’s clear that there is, and will be, plenty of cocoa for a while. Therefore, some expect cocoa prices to fall significantly below $2,000 per ton which makes investing in cocoa now, just because it is at multi year lows, a very risky trade. You can’t fight nature, nevertheless, there are always ways to profit.

Profiting From The Cocoa Price Slump

The first way to profit from continuous oversupply is to short cocoa ETFs that track the price of cocoa through future contracts, the NIB (iPath Dow Jones-UBS Cocoa ETN) and the CHOC (iPath Pure Beta Cocoa ETN).

Figure 3: The cocoa ETF looks cheap but could go lower. Source: Bloomberg.



However, as cocoa, like any other commodity, is a cyclical, many farmers will probably cultivate fewer trees for next crop which, in combination with bad weather conditions, could lead to a deficit for next year. Thus, if you keep an eye on cocoa, you could make a profit.

The indirect way of profiting is to look at stocks that use lots of cocoa as their margins will probably increase. An example of such a stock is Hershey (NYSE: HSY) where, depending on the price, cocoa makes between 10% and 15% of cost of goods sold. However, the stock is already pretty expensive, so it might be an idea to keep as a pair trade for when cocoa prices rise, short HSY/long cocoa.

The Swiss Chocoladefabriken Lindt & Spruengli AG is even more expensive with a PE ratio of 38 and a dividend yield of 1.28%. The world’s leading manufacturer of chocolate and cocoa products, Barry Callebaut, is also expensive with a PE ratio over 30. Nevertheless, improving margins could make these stocks go even higher, and in the current market, anything is possible.

Conclusion

Just because something looks cheap, it doesn’t mean it’s a good investment. Investing requires a lot of research which mostly ends with a “no, thank you,” if you hold yourself to a low risk, high reward strategy.

Perhaps it’ll be better to look at coffee for food commodity exposure as prices are also very volatile, but have clearer long-term cyclical trends. Keep reading Investiv Daily as I’ll share my research on coffee soon.