As Adam Smith, the pen name of George Goodman, put it ‘When there is no game, don’t play’. In his commentary of the Wall Street of the 60s, Goodman went into commodities trading when equities became a little too risky. His brief foray into that market has been copied by the new traders of the 21st century; algorithms. Commodities markets have become the next frontier for algorithmic trading, and they are already having an impact.
The advantage of the commodities market, trading in goods such as coffee, cocoa, sugar or even things such as vanilla, is that the risks involved are separated, mostly, from the rest of the financial sector. People are always going to need their cup of coffee in the morning, despite what the stock market is doing. However, there are fears from more traditional commodities brokers that the sudden influx of money and new technology is divorcing the market from the basic assumptions of supply and demand.
The price of cocoa in New York recently shot up to over $3,000 per ton. Seeing this as a lack of supply, importers brought over beans that would normally be destined for other markets. It was not a dearth of cocoa which caused the spike in price, 20% above where it was trading before the run, but rather speculation fueled by the new algorithms in the market. These computer-controlled trades are also increasing intraday volatility, as they do not hold their positions for long. This is having a knock-on effect on companies who actually process and sell these raw materials onto consumers. They have experienced a reduction in their ability to hedge in the new market environments, which may lead to increased price volatility for the end consumer.
This may be good in the short term for coffee-lovers. Brazil is expecting a bumper crop this year. The crop is sold in 60kg bags, and last year Brazil produced around 46m bags. The 2018 crop is forecasted to be as high as 65m. Prices have dropped from late 2016, when they reached $1.80 per pound, by around 50% to approximately $1.20 a pound. If the bumper crop does materialise this could fall even further. Many funds involved in commodities contracts have shorted coffee in expectation of a fall in prices. While wholesale coffee may be coming down in price, a latte at your local Starbucks is likely to cost the same. Actual coffee beans only account for around 20% of the cost of running a coffee shop, and any savings are likely to be passed on to investors.
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