How to Trade Soft Commodities
What are Soft Commodities?
Soft Commodities, unlike Hard Commodities such as metals, are consumables. That is, they are used as raw materials, or as ingredients in the production of food and textiles which are then usually eaten and or worn. Soft Commodities are often seen as "trade-oriented markets" rather than investment markets. However, that distinction is being broken down by the use of CFDs (cash-settled, non-deliverable contracts). That allows traders and speculators to trade the underlying price changes in Soft Commodities without having to concern themselves about making or taking delivery of the underlying items.
The Commodities themselves are produced and traded on a global basis and are woven into the fabric of our daily lives. One only has to think about a humble cup of coffee to realise how ubiquitous the Soft Commodities are. But it would be a mistake to think that because they are commonplace, that they are uninteresting or static in nature. In this article, we will take a look at commonly traded Soft Commodities and the drivers for price change within them.
The chart below shows what percentage of US consumers (by age group) had consumed a cup coffee that day. Survey dates 9th to 23rd of Jan 2017.
As we noted above, coffee is one of the most widely consumed commodities in the world. Hundreds of millions of us will start our day with a cup or two of our favourite blend, and the coffee shop has become a so-called "third place" (not work, not home) in which we often conduct both our business and social lives. As we can see on the map below, coffee is cultivated across the tropical regions of the globe, in Southern and Latin America, East Africa, South East Asia and Australasia.
Brazil, Vietnam and Columbia are the world's largest producers, and the Dutch are among the world's largest coffee consumers when ranked on a per capita basis. This is because Soft Commodities are grown and harvested rather than extracted, as is the case with Oil or Gold.
Factors influencing Coffee Prices
Climate, meteorology and the health of the crop all play their part in determining the underlying price. Coffee is no exception to this, and in fact, favourable weather conditions in Brazil have helped to drive prices lower, as the market anticipates a bumper harvest in 2018. Brazil can supply up to a third of the world's coffee. So the size of the country’s harvest is a very material factor on the supply side. Coffee plants can tolerate cold weather but are highly vulnerable to frost. Out of the major producers, only Brazil tends to experience temperatures cool enough for frost to form. White frosts can prevent flowering, but so-called black frosts can kill a coffee plant, which must then replanted. It can take three or four years for the new plant to come into production. As we can see from the table below the temperatures in Sao Paulo (in the south-east of Brazil), do not typically fall that low. However, it can and does happen (if infrequently) in June and July, during or just after the harvest, that takes place then.
Coffee demand has been reducing in recent years with the USA, Japan and the EU importing less Coffee. Data from the trade body, the ICO, suggests that in the period between October 2016 and October 2017, global coffee imports fell -3.2%. Intuitively a weaker US Dollar should be positive for Coffee prices/demand, as this should reduce costs for Coffee buyers transacting in currencies, other than USD. However, in recent times, the opposite seems to have been true in that coffee prices have moved in the same direction as the trade-weighted or Dollar index, as is shown in the chart below.
Sugar is a global commodity. It is produced in 130 countries and traded across North and South America, Southern and Eastern Asia, as well as Europe and Russia. Sugar can be derived from two distinct sources, which are cultivated in both tropical and cooler temperate climbs. Sugar Beat grows in the cooler temperatures of Europe and Russia while Sugarcane favours the tropical climates of Brazil, India and China. Brazil is the world's largest producer of Sugar; it's annual production of 38.99 million metric tonnes being around 2.5 times that of the EU states combined. According to 2016 data from the International Sugar Organization. Sugarcane accounts for around 80% of global sugar production and Brazil account for a quarter of the total combined annual, global production of sugar.
Sugar is used as a food ingredient and sweetener, but also in animal feeds and more recently as a fuel source, in alternative / renewable energy production. The countries with the biggest sweet tooth are India, the EU, China and Brazil (all four are notable producers as well).
Brazil was an early adopter of Bioethanol fuels derived from Sugarcane, and the use of Ethanol as a fossil fuel substitute was ramped up in the country after the oil shocks of the mid-1970s. By the mid-1980s approximately 75% of all new cars produced in Brazil had biofuel compatible engines. More recently, Ethanol has been used as an additive to traditional gasoline. But the Brazilian experiment is often held up as an example of a sustainable, alternative energy source at scale. Because Sugarcane grows in tropical climbs, it is subject to the extremes of the climate in these regions, including the torrential rains and strong winds of tropical storms and hurricanes. However, the El Nino weather phenomenon that originates in the Pacific can also cause rains to fail over South America and the Caribbean, which can directly affect sugarcane crops.
Global Sugar demand had been picking up over the last seven years, but a slight dip is predicted for 2017/18, according to data from Statista shown below.
Sugar prices have fallen by some -18% during 2018 (as of the time of writing) thanks to the expectation of a surplus of supply both this year and into 2019. That reminds us that the price formation process (not just for Sugar) is, at heart, a balancing act between the key forces of supply and demand. As such, commodity markets are always trying to discount or price in future events and crop sizes.
The third of our ingestible commodities is Cocoa, the basic ingredient, along with Sugar, in some of our most favourite treats such as chocolate. However, the Cocoa plant and its beans are also used in a wide variety of other industrial processes including the production of alcoholic and soft drinks as well as cosmetics and soap. There are three major production areas of Cocoa across the globe. The largest is centred around West Africa, including Cameroon, the Ivory Coast and Ghana. Cocoa is also grown in South America, in both Ecuador and Brazil, and across the Indonesian archipelago and Papua New Guinea. African producers account for approximately 75% of the annual crop according to the International Cocoa Organisation. Cocoa prices have been rising in 2018 and dramatically outperforming other agricultural commodities which have mainly been trending lower. We can see this in the chart below that plots Cocoa against a basket of other commodities.
Trading Orange Juice
A western breakfast staple, Orange Juice production is centred around Brazil, the United States, the EU and China. The commodity is most synonymous with Florida, and indeed it is the state’s official beverage. Once again it is Brazil that provides the vast majority of the world's Orange Juice production, as we can see in the graphic below that maps 2017 production.
Orange Juice has the reputation of being the most climate-sensitive of the soft commodities, and the origin of the orange itself has recently been traced back to the Himalayas, and to approximately 6 to 8 million years ago. Rather ironically it's now thought that ancestors of modern oranges were propagated across the globe by climate change that took place around that time. As with the Coffee crop in Brazil, the Orange crop in Florida is sensitive to the effects of frost. Particularly, if temperatures stay at or below zero degrees for four hours or more.
Even though Florida is in the southern United States and extends into the warm waters of the Gulf of Mexico and the Caribbean Sea. The state can be subject to wintry conditions, as recent polar vortexes over the northern United States have shown. Moreover, because of its geographic location Florida finds itself in the heart of hurricane territory. The US hurricane season runs from June through to November. And we need to look no further than October 2017 for an example of the effect that a major storm, making landfall in Florida, can have, Hurricane Irma wreaked havoc with the crop in 2017 cutting production by 21% and the total orange harvest was predicted to register a 71 year low, according to Bloomberg data.
The US had not been struck by any major Hurricanes for a decade, before 2017. But that year saw three of the most devastating storms, ever recorded, make landfall in the USA. Forecasts for the 2018 hurricane season, published by Colorado State University, predict fourteen named storms for 2018. Three of which are thought likely to become full-blown hurricanes. Of course, these are just forecasts, and even if proven correct, they say nothing about the path that any hurricanes might travel along. But if we look back at the price chart of Orange Juice for the last year, we can clearly see the price rising through September and October before it peaked in late November.
Pestilence is also a threat to citrus farmers, and Florida's growers are currently battling against so-called greening, a bacterial infection that can fatally damage Orange trees, which is spread by the invasive Asian Citrus Psyllid, a sap-sucking insect, against which there is no readily available defence. So the next time you have a glass of orange juice or see a news item about storms in the Gulf Mexico, why not think about all of the above and what it may mean for OJ prices.
Another crop often associated with the Southern United States, Cotton is thought to have been harvested and perhaps primitively cultivated by humans as far back as 6000 BC.
Today Cotton is grown in many countries including China, India, the USA and Brazil (it would seem you can grow almost anything in Brazil) and Central Asia. In recent times, India has eclipsed China to become the world's biggest Cotton producer. While the majority of Cotton production finds its way into textile and clothing manufacturing it is also used in the production of paper, animal feeds, specialist oils and the manufacture of pharmaceuticals, rubber and plastics. It has even used to make bank notes.
Cotton production by country worldwide in 2016/2017 (in 1,000 metric tons)
Cotton has had to weather its own peaks and troughs as synthetic fibres rose to prominence in the post-war period. The balance between supply and demand for cotton is closer to equilibrium than in many other commodities. It might sound as though there would be little reason for prices to change, under those circumstances. But actually, the balance between these two drivers is quite a fine one, and therefore Cotton prices are highly sensitive to changes in and forecasts of crop sizes. Recently, Cotton prices have risen because of fears about reduced production in India. Those fears are down to the effects that a cotton parasite, the pink bollworm, may have on the final production figures. This illustrates an intrinsic relationship that applies to all cultivated commodities. Which is that price will usually move in the opposite or inverse direction to the size of the crop or harvest.