The driver of record cocoa prices (Financial Times subscription required) is a classic supply/demand story. It’s also a story of what happens to hedgers and traders when they get caught on the wrong side of a market.
On the supply side, inventories at exchange registered warehouses are at very low levels. The Ivory Coast, which supplies 40% of the world’s cocoa, had a poor crop. The trees are old and disease prone, and without new investment crop production will continue to fall. Consequently, many believe that cocoa demand will outstrip supply for the fifth straight year.
Now enter the hedgers. Hedgers usually sell futures against their crop. Cocoa processors also use hedges to lock in a certain profit. As contracts expire, they usually roll them over into the next forward month. With prices hitting new highs, hedgers must pay the difference to roll their contracts forward, especially if they put the hedge on early. With prices rising, industrial processors also bought call options, which gave them the right to buy cocoa at a given price.
The one thing to remember is that industrial processors must have the product at all costs to stay in business. This was their rationale for buying call options.
Next we have the speculators. Banks love to “sell” call options. In a normal market, options expire to zero. Banks then pocket the premium on their options. However, in a raging bull market, the options keep going up instead of down. This forced banks to hedge their trades by buying futures. Such a move further exacerbated price rises.
Spot cocoa in London hit a high of 2,500 pounds per ton; July cocoa on the futures market traded at 2,558 pounds per ton.
The July spot contract expires July 15. However, even taking into account excess speculation, the supply/demand fundamentals remain intact. Greater demand for chocolate will keep prices firm.