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Coffee speculators have never been more short the commodity; are they about to get burned?

After enjoying a bit of a resurgence in recent years, most of the commodity complex has had a rough go of it over the past several months. And needless to say, the poor price action has taken its toll on investor sentiment. Perhaps no market provides a better example of such dour circumstances as does the coffee market.

As today’s Chart Of The Day illustrates, the price of coffee (as represented by the S&P GSCI Coffee Index) just traded at its lowest level in the index’s (albeit brief) history. Significantly, the price also undercut its previous lows from 2007, 2008-2009 and 2013. And on the sentiment front, the data matches price’s gloomy performance. According to the CFTC, Speculators in coffee futures have adopted their largest net-short position in the history of the contract -- by far.

So are coffee prices due for a bounce? In other words -- are these traders due for a wake-up call? In a Premium Post at The Lyons Share, we share our analysis of coffee prices and our interpretation of the CFTC data as well some other compelling indicators related to the coffee market. And we look at how traders might take advantage of the present, unprecedented circumstances.

If you’re interested in the “all-access” version of our charts and research, please check out our new site, The Lyons Share. You can follow our investment process and posture every day — including insights into what we’re looking to buy and sell and when. FYI, our Pre-FALL Sale (25% OFF) is going on now  so it’s a great time to sign up! Thanks for reading!

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Down over 20% just since election day, coffee prices may presently be testing a key level of support.

The out-sized moves set in motion on election day in many of the major financial markets certainly represent the biggest investment story of the back half of 2016. It was an under-the-radar market, however, that we chose as our Chart Of The Day that day. At the time, coffee prices were on a tear. As represented by the S&P GSCI Coffee Index, coffee was up more than 60% off of its January lows and up over 20% just in the month leading up to election day. Despite coffee’s red-hot run, we noted a few reasons why the “Buzz Could Wear Off” in an election day post (actually posted in the wee hours on election night):

“...despite the fact that we are staunch believers in the concept of relative strength (i.e., sticking with the up-trending markets), there are circumstances currently that make us suspect of continual upside in coffee over the near-term. One is the fact that prices are hitting the 5-year Down trendline (on a linear scale) stemming from the highs in 2011 and connecting the tops in 2014, demonstrated here by the S&P GSCI Coffee Index. Additionally, there is potential price resistance just above via Fibonacci Retracements stemming from the 2011 and 2014 highs.”

...another factor...may be a...substantial headwind should some selling commence. According to the CFTC, Commercial Hedgers in coffee futures are holding their largest net short position in the history of the contract. The concern is that these Hedgers most often represent the “smart money” once positioning gets to an extreme. Thus, this record net short position indicates a potential negative for coffee prices, should they begin to reverse lower.

As it turns out, these concerns were warranted as coffee prices actually topped out on election day. Since then, it hasn’t been pretty. In just 7 weeks, the GSCI Coffee Index has dropped more than 23%. The good news, however, for coffee bulls is that prices are now hitting an area containing a cluster of potential support levels.

At around 104 currently, the GSCI Coffee Index is testing the Up trendline stemming from its January low and connecting the February-March and May-June lows. Also residing at the same level is the key 61.8% Fibonacci Retracement of the January to November rally. Lastly, the 500-day simple moving average is presently sitting in the same vicinity.

One continuing concern is the level of Hedger shorts in coffee futures. While they have covered over half of their record net-short position from early November, they are still holding a sizable net-short position. It may not represent the potential headwind that it did in early November, but it is still far from a tail wind for coffee prices.

That said, while we don’t prefer to catch falling knives, the confluence of technical levels at current prices should be good enough for a temporary bounce at least -- even if momentum from the recent drop eventually exerts more downside pressure.

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More from Dana Lyons, JLFMI and My401kPro.

The rally in coffee prices could soon be facing some headwinds.

This year has been a favorable one for many commodities. Included among them is coffee with prices up some 50% for the year and hitting 20-month highs. Despite this, and despite the fact that we are staunch believers in the concept of relative strength (i.e., sticking with the up-trending markets), there are circumstances currently that make us suspect of continual upside in coffee over the near-term. One is the fact that prices are hitting the 5-year Down trendline (on a linear scale) stemming from the highs in 2011 and connecting the tops in 2014, demonstrated here by the S&P GSCI Coffee Index. Additionally, there is potential price resistance just above via Fibonacci Retracements stemming from the 2011 and 2014 highs.

This potential price resistance may be enough to halt the coffee rally temporarily, even if it does not derail it longer-term. However, there is another factor that may be a more substantial headwind should some selling commence. According to the CFTC, Commercial Hedgers in coffee futures are holding their largest net short position in the history of the contract. The concern is that these Hedgers most often represent the “smart money” once positioning gets to an extreme. Thus, this record net short position indicates a potential negative for coffee prices, should they begin to reverse lower.

Now these factors don’t guarantee an end to the coffee rally. If prices spike right through the chart resistance, the potential headwind represented by an unwind of futures positioning won’t likely be triggered yet. However, we do have a recent, almost carbon copy, example of a similar situation in natural gas prices.

Just 3 weeks ago, nat gas was running up against its own 8-year Down trendline with a near-record Commercial Hedger net short position. As we have updated recently on Twitter and Stocktwits (@JLyonsFundMgmt), nat gas has lost nearly 25% in just the 3 weeks since. Circumstances in the coffee market could put a similar chill on the coffee rally.

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More from Dana Lyons, JLFMI and My401kPro.

As featured in the Commodity Trader’s Almanac 2013, coffee typically tends to start a seasonal bottoming process before distributors begin buying ahead of anticipated demand in the upcoming cold winter months. This is the time to cover the best seasonal trade short position from May. It is also a time to look for a short-term trade opportunity on the long side. Traders can look to enter a new long position on or about August 18 and hold this position until about September 5. The trade usually ends right around Labor Day, but coffee prices can continue to head higher as illustrated by the yellow shading in the one-year seasonal pattern below. This trade has worked 26 times in the last 40 years, for a success rate of 65.0%. After posting a gain every year from 1986 to 1997, this trade has had a spotty record of late, successful in just eight of the last 16 years. 

Coffee has increased in popularity on an international scale in the last few decades. Most consumption has been from the United States, parts of Europe, and Canada. Many Europeans have switched from tea to coffee and with the introduction in late 2005 of Starbucks coffee in Europe and in Asia. Demand is improving, especially for higher grade and quality coffee. With increasing global consumption habits, if there are threats of supply disruptions or production declines for higher grade coffee, the futures market can be prone to extreme price moves. One such move was earlier this year when coffee surged nearly 100% in about three months due to drought conditions in the major producing areas in Brazil. These conditions have not completely eased and production and quality are projected to suffer this year and possibly even beyond which should set a floor under coffee prices for some time to come.