Cocoa prices have recently jumped on the global commodity markets to levels not seen since the late 1970s, sending shockwaves throughout the cocoa processing industry.
Prices for September-delivered cocoa peaked at £2,465 a tonne on 19 July, the highest level for a second-month contract in 32 years. Cocoa prices are now around 25% higher than their peak in June 2008, a year that saw food commodity prices increase dramatically across the world.
Prices in July rocket
Cocoa’s recent price hike was triggered by Armajaro, a London-based hedge fund specialising in commodity trading, purchasing around 250,000 tonnes of cocoa. This transaction – worth around £650 million – amounts to around 25% of total cocoa stocks available in Western Europe, according to estimates from the International Cocoa Organisation (ICCO).
Industry reports suggest that the operation was masterminded by Armajaro’s co-founder Anthony Ward, who has a well-known history in cocoa trading. In 2002, Mr Ward bought cocoa beans worth almost £300 million and sold them for a US$19.3 million profit, according to reports at the time.
Members of NYSE Liffe, the London International Financial Futures Exchange, are demanding a review of rules governing speculative positions in the cocoa market following a letter of complaint from traders who claim that price manipulation is bringing the London market into “disrepute”.
Sixteen European trading organisations have written to Liffe to say they were “shocked with what is happening on the London cocoa market”, claiming it was harming producers and consumers. The signatories, including the Association of the German Confectionery Industry, accuse the market of lacking transparency and control.
Output constrained by structural production weakness
Beyond the stir caused by events in mid-July, the large increase in cocoa prices in the midst of ongoing economic uncertainty continues to puzzle most industry insiders. Research suggests that these price fluctuations can be explained by two factors of a very different nature.
Firstly, and from a production perspective, cocoa crops have struggled to keep up with current and past demand. One of the reasons for this is the heavy dependency on cocoa from the Ivory Coast, which accounts for around 40% of global output. Cocoa farming in the Ivory Coast is suffering from chronic underinvestment and high taxes, with many farmers switching to the more lucrative trade in rubber. Furthermore, industry insiders point out that Ivorian cocoa trees, planted more than 25 years ago, have already passed their peak of productivity and, without new planting, production in the country will likely drop each year, tightening the global market as demand rebounds alongside economic recovery.
Overall, global cocoa production is predicted to grow by a mere 3% over the 2009/2010 season, according to ICCO sources. Meanwhile, total demand for chocolate confectionery is forecast to remain stagnant in 2010 and grow by 2% in retail volume in 2011, according to Euromonitor International’s projections.
Despite this relatively low growth, the stronger performance of cocoa-intensive dark chocolate formats in categories such as boxed assortments and tablets is predicted to put further strain on global demand for cocoa beans.
During 2010, end-of-season global cocoa stocks are estimated to fall by 4%, according to ICCO’s estimates, a drop set to take place in the midst of stagnant chocolate confectionery sales. The stronger consumer demand for chocolate expected in 2011 is therefore unlikely to improve the current cocoa stock/industry needs ratio.
Speculation banks on uncertainty
A further factor behind the volatility in cocoa prices is speculation. Research suggests that, after the tightening of fiscal and financial rules, hedge funds are turning to food commodities to make a quick profit.
Speculative movements have been linked to traders taking advantage of historically low interest rates and weak US$ exchange rates, which has allowed them to borrow ‘cheap dollars’ to fund short-term positions on cocoa beans. As expectations with regard to future economic recovery gathered momentum in the second half of 2009 and first half of 2010, so too did the probability of stronger demand for chocolate, which pushed up cocoa prices.
As such, traders are finding themselves in an advantageous position to sell their cocoa at a premium price in the futures market, and make a profit which could be used to borrow again, and re-start the whole process. Furthermore, the structural constraints on cocoa production have led to increased uncertainty in the category’s ability to meet future demand requirements.
The fact that most cocoa production is concentrated in developing countries, which are prone to political turmoil and/or oftentimes suffer from poor central planning, makes the upgrading of plantations quite unlikely in the medium term. As a result, rumours about poor harvests or the effects of natural catastrophes on crops unnerve chocolate manufacturers almost instantly. In turn, it is in this business environment that hedge funds have quickly spotted a weakness on which they can easily cash in.
According to ICCO projections, global output for cocoa beans is predicted to increase by 6% in volume terms over the 2010/2011 season. It is important to bear in mind, however, that these projections are subject to regular revisions and remain heavily dependent on weather patterns. That said, they do provide a reasonable benchmark on which medium-term price trends can be based.
Assuming this 6% benchmark to be correct, cocoa bean availability worldwide would increase by around 215,000 tonnes in 2011. According to Euromonitor International’s projections, total global volume sales of chocolate confectionery are predicted to grow by 143,000 tonnes in 2011. This would mean that, provided ICCO’s projections are accurate, production should not only meet actual demand for chocolate production but also allow cocoa suppliers to increase their stocks.
Conversely, small variations on this 6% output projection could lead to supply shortages. In an intermediate case scenario where production increases by 3% rather than 6% during 2010/2011, for instance, the increase in cocoa output would be around 40,000 tonnes lower than the increase in projected demand.
Stagnation in production would increase the shortfall between consumer demand for chocolate confectionery and cocoa supply to 140,000 tonnes. This might force chocolate manufacturers to draw on existing cocoa stocks in order to meet demand.
Overall, and given an intermediate output scenario, it is fairly plausible that prices should not increase beyond the 1-3% mark. Even in this intermediate scenario, however, nervousness about supply shortfalls might push chocolate manufacturers to increase their cocoa stocks. In turn, this could push up prices from the predicted 1-3% to around 5-6%. If speculation adds to real demand-driven price fluctuations, the increase in prices might well double or triple and reach marks close to 12-20% in 2011.
In view of the uncertainty set to pervade in the cocoa market during 2010 and 2011, chocolate manufacturers should be wary of short-term supply agreements, as they may factor in speculative movements that do not simply reflect real fluctuations in industry demand.
Linking official cocoa production projections to retail forecasts for chocolate confectionery may prove more accurate in predicting commodity price movements over the medium term.
Furthermore, ‘seeking refuge’ in market niches might prove an effective strategy in reducing exposure to speculation. Fairtrade-sourced chocolate is one example. Euromonitor International estimates this market to be worth around US$300 million (2009) at global level.
The production of fairtrade chocolate, which is subject to strict certification procedures, requires close contact between chocolate manufacturers and cocoa farming communities. Additionally, its production involves fixing a ‘fair price’ for the crop output beforehand, regardless of the final output volume.
This ‘fair price’ is not strictly related to short-term market fluctuations but to welfare standards that allow farmers a fair living based on the use of sustainable resources. From a chocolate manufacturer’s perspective, fairtrade chocolate allows for tighter control of volumes, product quality, delivery lead times and price from its cocoa suppliers.
Despite its relatively small market size and associated costs, steady retail sales growth for fairtrade chocolate amidst continued economic uncertainty might offer confectioners a valuable tool to reduce their exposure to increasingly volatile commodity markets.