Thursday, January 28, 2016


The cocoa market has a soft spot in my heart. It was the first commodity I ever concentrated on, and I have continued to follow it all these years. My first real job in commodities was as cocoa analyst for MARS Inc., the privately help candy company. BTW, MARS was a truly excellent company and probably still is. The big reason for this was (is?) guidance from a really smart family that takes a multi-generational outlook. I doubt if they will ever IPO, but if they do, I'm in.

Anyway, there are a few structural issues in cocoa that make it somewhat unique:

- Cocoa is a tree and it takes 6 -8 years from the time prices provide incentive for an increase in plantings until you start getting substantial production from the new trees. Say one to two years for the plantings to occur and another five or so for the trees to mature. Once the tree has matured cash costs for harvesting are very low. So cocoa can and does have multi-year cycles, like oil.

- Cocoa fundamentals are exquisitely researched by the major participants in the industry. The large candy companies have staffs continuously examining the trees in the major growing regions. They see even minor effects of weather or disease quickly. Some of the large trade houses also do this research, but on a smaller scale.

- Cocoa speculators are generally technical. This makes sense; it's more difficult and costly to get fundamental info than in say, corn or soybeans. So technicals are all they have. This mostly means they follow trends.

Let's start with the long run position of cocoa using the ten-years graphs. Click here for an explanation.

Interestingly, cocoa has the highest r-squared on this graph of all the commodities in my universe, over 90%! I've backtested it, and you can actually do pretty well in cocoa using this alone. The ten year outlook is still bearish. Let's go a little deeper.

I'm not going to spend any time on current year's supply/demand because as I said, the major players know far more about that than I ever could. So I'll concentrate on the longer term and then discuss tactics. This "time arbitrage" is where Commodity Strategists have their edge.

The bullish case in cocoa can be summed up like this: Demand in emerging markets will increase as their populations adopt a middle-class western diet. Meanwhile cocoa production in the traditional area of west Africa will stagnate as old farmers retire, and their sons move to the cities.

I don't find this argument persuasive. First, as I said in my post of 10/21/15, I don't believe that most EM residents will ever move to a western diet. This is even more true for cocoa since chocolate is a cold weather food. Even in the US or EU consumption strongly dips in the summer. Second, the current productivity of cocoa trees is extremely low. Most African cocoa is grown by "smallholders" who cannot or will not adapt current farming techniques. Yields per acre on commercial plantations are much higher. Also, the African farms mostly use older cocoa varieties that yield much less than newer ones (although they do have better taste). As an example of what can be done with yields on a modern plantation, see United Cocoa.

My view is that cocoa is still historically overpriced, and that there is no "this time is different" case to be made. So I want to be short. Now let's look at tactics.

As noted in the beginning, cocoa speculators are largely trend followers. I once backtested a simple strategy using the CFTC's Commitments of Traders report. The strategy simply waited until the managed money went long (short) by a certain amount. The system did the opposite. It was a net positive strategy, although the drawdowns were too large to actually trade. Here's a graph of the COT over time from

My backtest found that the key statistic is the position of Large Speculators (CTAs). That is the green line in the middle panel. You can see that these specs got maximum long slightly after the peak in prices in early December. You can also see that they are now largely washed out, down to about the lowest long level they have been on the chart. On this basis, now would not be a good time to initiate a short position in cocoa. In fact, now is probably a good time to cover shorts.

So is this a good time to actually go long? I wouldn't. As a Commodity Strategist, I am only playing this from the short side. Nonetheless, the combination of the spec washout and the appearance of heavy manufacture buying at this price back in early 2015, is tantalizing. If you want to do it, you could probably buy here with a 2,700 stop.

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