Date: 2024-10-13 Page is: DBtxt003.php txt00026466
CHOCOLATE
FAR FROM A PERFECT MARKET
Chocoholics Won’t Be the Only Victims of Cocoa’s Surge
When a market becomes disorderly, trading firms are at risk.
FAR FROM A PERFECT MARKET
Chocoholics Won’t Be the Only Victims of Cocoa’s Surge
When a market becomes disorderly, trading firms are at risk.
Chocolate is becoming scarily expensive.Photographer: Ruth Schwarzenholz/Getty Images AsiaPac
Original article: https://www.bloomberg.com/opinion/articles/2024-03-26/chocoholics-aren-t-the-only-victims-of-cocoa-s-surge
Peter Burgess COMMENTARY
About 30 years ago I did a variety of assignments for the World Bank around the world. some of these assignments were in connection with various agricultural markets including coffee and cacao.
As a university trained economist I knew something about the theory of markets ... but the theory of markets did not match with my real world experience of actual markets. The question was why such a divergence.
I did my World Bank work as a contracted consultant and not a staff member of the WB. This meant that the WB tsaff could ignore me with little repercussion.
Essentially my practical real world experience suggested that many of the important commodity markets including those for cacaoand coffee were being 'gamed' in a variety of ways not least by major international commonidty experts and advisors.
Onf the most blatant in my experience was an incident in Burundi where I worked on the eastablishment launching of a local coffee auction. Bottom line ... with the launching of an effective auction process, the exports prices for Burundi coffee instantly doubled. More than anything else this was explained by having a 'market' rather than a private price advice system delivered from London that had served as the 'price fixer' for decades!
I have not been in touch with markets in Africa for a long time ... but I am not particuarly optimistic that there has been much positive progress to improve things!
Peter Burgess
When a market becomes disorderly, trading firms are at risk.
Written by Javier Blas ... Javier Blas is a Bloomberg Opinion columnist covering energy and commodities. He is coauthor of “The World for Sale: Money, Power and the Traders Who Barter the Earth’s Resources.”
March 26, 2024 at 1:00 AM EDT ... Updated on March 26, 2024 at 7:13 AM EDT
In every sustained commodity price rally, there’s a moment when fundamentals — supply, demand, inventories — no longer matter. The cost of the molecules, whether in the form of energy or foodstuffs or metals, stops being a price and becomes just a number. The market ceases to be orderly and becomes unruly.
It’s clear that moment has arrived for cocoa. On Tuesday, cocoa futures in New York surged above the previously unthinkable $10,000 a metric ton. In dollar terms, they surged more than $1,000 over two days — equal to the trading range that in the past would have taken a year to witness.
Chocolate Crisis
Cocoa prices have surged more than 250% over the last year, surging to $10,000 per metric ton -- nearly double the record high set 46 years ago
Sources: Intercontinental Exchange Inc. and Bloomberg
The upshot was a brutal price rally that took cocoa to $6,000 a metric ton by February from $2,500 a year ago, surging above the 1977 record. Facing a massive deficit, the market was doing its work by sending prices high enough to curb consumption and restore the supply-and-demand equilibrium. Although in nominal terms cocoa prices are at a record level, in real terms — adjusted by inflation — prices remain below the peaks of the 1970s. The record high set back then equals to about $27,000 a ton in today’s money.
Historic shortfall
The cocoa market will suffer a large deficit in 2024 for the third consecutive crop season, the most pronounced shortfall in modern history
Source: Bloomberg and International Cocoa Organization
Note: 2024 is forecast based on interviews with cocoa traders
Since then, however, prices have risen vertically, setting fresh highs almost daily. Granted, the cocoa deficit is so large — three consecutive years of shortfalls, and potentially a fourth one coming — that sky-high prices are needed to curb consumption meaningfully. But the last few weeks of daily record highs have more to do with financial factors than fundamentals.
To understand what’s happening one needs to look at the plumbing of the market — and who’s bearish and who’s bullish. Why are some traders still maintaining short positions – that is, bearish bets – in cocoa futures even though every fundamental has pointed toward higher prices for several months? The reason is hedging. Cocoa traders holding a long position in the physical market — owning inventories of cocoa beans or semi-processed products such as cocoa liquor, butter and powder — typically offset that by taking the opposite position in the financial market. The hedge should work; in a rising market, like the current one, losses on the short positions are covered by gains on the value of the physical holdings. But as they wait for the financial contracts to mature — as long as several months — they need cash to meet margin calls on those losses on derivatives.
In a normal market, companies use cash reserves to meet those margin calls or borrow small amounts of money. But in a sustained bull run, like the one currently engulfing cocoa, the margin calls may overwhelm the capacity to pay of a company in otherwise sound financial health, forcing it to lift its hedges to avoid a cash crunch. In that scenario, the only option is to close out the short positions at whatever price the market demands. That’s why I said that at times, prices aren’t prices – just numbers. The alternative is to default.
The Who's Who of Cocoa Trading
Five global commodity trading houses dominate the market
Source: 'Large gaps in voluntary sustainability commitments covering the global cocoa trade', Global Environmental Change, Volume 81, July 2023
Disorderly markets can lead to trading firms struggling, and even collapsing. That’s what happened in the European electricity and natural-gas markets in 2022, forcing several European governments to offer taxpayer-funded credit lines to traders to meet margin calls. It also happened in the cotton market in 2008 and again in 2011, prompting the collapse of the historic trading house Paul Reinhart Inc.
In the cocoa market, I’m hearing chatter about a cash crunch as margin calls balloon. As with cotton, cocoa is a market dominated by a few large players and a handful of small-sized trading houses that may struggle to secure credit in a pinch. Regulators should pay close attention to the market with a view to helping anyone in difficulty before the issue metastasizes.
There’s a second problem. Currently, some cocoa traders face a mismatch between their physical long positions and their short financial positions. In industry parlance, they are over-hedged because they’ve sold futures worth more than they hold in actual products. The reason? The crop failure has reduced deliveries, with traders securing fewer beans and semi-processed products than they originally contracted for. Cocoa processing plants in Ivory Cost and Ghana, for example, have stopped working due to lack of supply, failing to deliver products they‘ve already sold. If delivered, some of those beans and products are being dispatched later than expected, so some traders have their financial hedges covering the wrong months. All those mismatches are forcing traders to buy back their hedges at inflated levels.
The magnitude of the margin calls and over-hedging is clear in the rapid decline of the aggregate number of outstanding contracts in the New York and London cocoa futures market. The so-called open interest has fallen by 35% over the last three months — the largest drop in such a small timeframe in at least three decades — as traders buy back their positions. Ultimately, it’s a self-sustaining problem; the higher cocoa prices rise, the bigger the the margins calls and the scale of over hedging. And as some traders buy back their positions, they push prices up further, creating the same problem for others.
Once prices become untethered from fundamentals, a bull market is almost impossible to stop — until something breaks. Brace for the current surge in cocoa to have wider ramifications than inflating the cost of your Easter egg.
More from this writer at Bloomberg Opinion:
- Oil Trading Is Rife With Bribes. Time It Cleaned Up: Javier Blas
- The Truth Behind the Coming Meltdown in Chocolate: Javier Blas
- You'll Have to Pay to Use the Highway. Blame EVs: Javier Blas
To contact the editor responsible for this story: Mark Gilbert at magilbert@bloomberg.net
Javier Blas is a Bloomberg Opinion columnist covering energy and commodities. He is coauthor of “The World for Sale: Money, Power and the Traders Who Ba
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