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Don't Be Fooled by the Coffee ETF's Surge

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The commodity markets saw a choppy 2013, with soft commodities – coffee in particular – lacking luster. A supply glut resulted in a 20% decline in the price of the commodity last year. This is, in fact, the third consecutive year of negative performance from coffee.
However, toward the beginning of last month, the robusta variety of coffee saw some strength. The upside can be partially attributed to the seasonal demand pattern, wherein the cold December month usually gives coffee prices a boost.
The rise in coffee prices also led popular coffee exchange-traded products Dow Jones-UBS Coffee ETN and Pure Beta Coffee ETN to clock unexpected marginal positive returns last month (read: 3 Commodity ETFs to Watch in 2014).
However, the real reason for the price rise was blamed on a supply shortage. Vietnamese farmers had deliberately held back supplies to lift the rock bottom coffee prices. The artificial supply shortfall increased the demand for the Arabica variety of coffee.
Are the recent higher prices sustainable? 
Experts believe that Brazil, the biggest producer and exporter of the premium Arabica beans on earth, will post another record year of production in 2014 due to solid crop conditions. Extensive rainfall forecast in some parts of Brazil over the next few days is expected to make the texture of soil ideal for coffee plantation.
Moreover, harvest in Colombia, the second-biggest Arabica producer after Brazil, is also expected to be quite strong.
The U.S. Department of Agriculture forecasts that the global production, including the robusta variety will surpass coffee demand during the 2013–2014 season by 6.04 million bags (read: Coffee ETFs: More Weakness Ahead?).
This will push inventories to a five-year high, with global coffee stockpiles set to rise by 7.5% to 36.3 million bags. This expected bumper Brazilian coffee production could lower prices.
The real culprit
The cause for this present oversupply condition can be traced back to a price rally in 2011, which encouraged producers to plant more. As the coffee plant needs a few years to grow and currently we are in the midst of the 2011 plantation, the supple glut is expected to continue at least through 2014.
Other factors
Not only is bumper production a key factor for the lackluster outlook for coffee prices, the sluggish consumption pattern is also to be blamed. Global coffee consumption in 2013–2014 is expected to rise only moderately to 141.9 million bags from 141.6 million bags during 2011–2012.
The moderate rise in the global coffee consumption can be attributed to lackluster consumption patterns in EU – the largest coffee consumer – and the U.S. However, consumption in the BRIC nations is expected to rise moderately.
The depreciation of the Brazilian Real is also considered as a factor impacting coffee prices. A weaker currency allows exporting countries to sell higher amounts which in turn increase availability in the market but at the same time weigh upon prices.             
ETF impact
The demand, supply and the currency effect which also played a dampening role on coffee prices during 2013, resulted in a downslide in JO and CAFE ETFs.
Both the ETFs fell more than 30% in the last one year. In fact, JO delivered a massive negative return of 65.70% in the last three years (read: 3 Commodity ETFs Surging Higher).
Easing of supply concerns from Vietnam led to a 4.6% fall in JO and 3.7% fall in CAFE in the last one week.
Bottom Line
As this sluggish trend is unlikely to reverse before mid-2014, we caution investors who still are long on coffee instead of shorting the product. As such, both JO and CAFE currently carry a Zacks ETF Rank of 5 or ‘Strong Sell’, indicating that the funds might face significant bearishness in the months ahead.

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