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Hard Times In Soft Commodity ETFs

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Thanks to an improved economic outlook, many commodity ETFs have put up solid performances so far this year. Broad products tracking commodities in multiple sectors have been buoyed by high returns in the oil, base metal, and some precious metals as well. Due to the strength of these sectors, many of the most popular commodity ETFs have pretty much matched broad stock indexes to start 2012.

Yet while the broad space has had a solid start, it hasn’t been universal by any means. In fact, the soft commodity space—a group that includes products such as coffee, cocoa, sugar, and cotton—has been pretty weak in comparison so far this year (see Three Commodity ETFs That Have Not Surged).

Generally speaking, this weakness has been a result of broad oversupply trends in each of the major soft commodities. This oversupply situation tends to impact soft commodities—and grains—more than in the other sectors of the commodity world. After all, you rarely (if ever) hear about an oversupply of gold or oil.

Thanks to this, production trends and political developments can have an outsized impact on products in this space. Unfortunately for investors, pretty much all the softs have seen at least some of this over the past few months, ensuring that the weakness stretches across the broad soft sector and that it isn’t just one or two commodities that are slumping in the segment (see Is USCI The Best Commodity ETF?).

Given the weakness in the space, especially in light of broad commodity strength, investors might want to take a closer look at the broad soft commodity space for investment. Products in this corner of the market could be poised for a rebound if they continue to underperform other corners of the commodity world heading into the second quarter.

Yet, before looking at the space, investors should note that the situations impacting each product have been quite unique. As a result, it seems as though investors should familiarize themselves with some of the key trends in the market before considering a play on the beaten down sector:  

Cotton- (BAL - Free Report) ,

Cotton prices have been heavily impacted by political events, especially from the major producing nation of India. The country recently imposed a ban on all cotton exports which helped to boost prices, but after only a few weeks, the country partially lifted the rule.

Thanks to this shift, prices are once again tumbling for cotton and are now approaching their 52 week low, currently trading around the 90 cents per pound mark. This represents a decent slump from the 2012 high of just under $1/lb. while it also appears as though traders have already forgotten about the Indian export issue (read Should Investors Consider Commodity Country ETFs?).

Given the ongoing shift towards alternative fabric components and the gross oversupply of the market, the outlook still looks pretty bearish for cotton in the near term. In fact, the USDA projects that close to 123.64 million 480 pound bales will be produced this year while demand looks to be just 108.72 million bales, suggesting that the production situation is certainly favoring the bears for the time being.

Coffee- (JO - Free Report) ,

Coffee prices have been decimated by worries over a strong Brazilian harvest this year. Not only is the harvest expected to be good in the key producing country, but it also is expected to be in good condition too. This could offset some concerns over a weak crop in other nations, specifically in the case of Colombia.

Beyond Brazil, Vietnamese production is also expected to surge this year. The country is already the biggest producer of robusta beans and exported roughly 180,000 metric tons during February. This represents a nearly 25% increase from the year ago period.

Given the strength in production from these two major producers, coffee prices could continue to have trouble this year as well. Prices have already dropped by about 20% so far in 2012, plunging from around 22.5 cents per pound at the beginning of the period to current levels around 18 cents a pound. This is even worse when investors look from a longer term perspective as prices were roughly 30 cents a pound at this time last year.

Cocoa- (NIB - Free Report) ,

Cocoa is an interesting commodity because more so than others on the list, politics can drive the prices of the product. Cocoa’s main production location centers on Western Africa, including some unstable governments in the region. This is especially true in the case of the Ivory Coast as the country continues to have problems maintaining stability.

However, predictions on the global supply and demand picture continue to be rather cloudy to say the least. Some analysts expect a deficit of close to 100,000 tons for this growing season, a level that is close to 30,000 tons higher than predictions just a month ago.

Yet, there isn’t exactly agreement about this as some analysts are looking in the opposite direction for the supply trend. One closely followed analyst—it was unclear who in particular—sees a large surplus for the market, a trend that could push prices even lower if it comes to fruition this year (see Cocoa ETFs Surge On Supply Worries).

As a result of this, cocoa prices have been quite choppy in recent trading. Prices fell from about $2,900/ton to just over $2,000/ton at the start of the year. Since then, however, prices have oscillated between the $2,000 pound level and $2,500, a rather wide range in this short time period.

Given the uncertainty over the situation in the cocoa market, one has to assume that prices will remain rocky heading into the second quarter of the year. If the prediction on a surplus ends up coming true, one has to expect another slump in prices although one has to wonder how likely this is given the large number of analysts who are forecasting a deficit instead.

Sugar- (SGG - Free Report) , , (CANE - Free Report)

Sugar has been one of the few soft commodities that has held up so far in 2012. The product has been buoyed by strong fuel demand in Brazil as ethanol and reports of low stocks in the EU. These trends have helped to keep prices relatively range bound in 2012 while the EU developments have especially had an influence lately.

However, on the bearish side there are still a few reasons why the market could drop in this sweet commodity. Brazilian production in the key center-south region is expected to rise sharply as production is expected to hit 33.88 million tons for the 2012-2013 growing season. This represents a nearly 9% increase from the current year, suggesting that prices could trend lower if demand isn’t able to keep up (see Inside The Forgotten Energy ETFs).

Thanks to this uncertainty, the prospect of weaker stocks due to weather in Brazil, and the EU situation, prices have actually been up in sugar this year. Contracts were trading around 23 cents a pound and are now hovering around the 25 cent mark, a decent increase especially when compared to the other soft commodities in the time frame.

Broad Soft Commodity ETNs

For investors who are looking for a broad approach to the soft sector, there are currently two choices available, both from iPath. The two notes, the iPath Dow Jones-UBS Softs ETN (JJS - Free Report) and the Pure Beta Softs ETN , both target three commodity contracts; sugar, cotton, and coffee.

The products are quite similar—both collateralize their investments and have a 0.75% expense ratio—but there are some key differences between the ETNs and how their pick their investments.

JJS just invests in the next futures contract, rolling into the next to expire one each month. This is in sharp contrast to GRWN which applies a more methodical approach. The note looks to cycle into the contract that is most representative of the returns for the commodity in question. This approach could cut down on contango and may also make returns more in line with spot price performance (see Inside The FlexShares Natural Resource ETF).  

While this may be a selling point for GRWN over JJS, investors should note that volume is very low for both products. JJS sees volume of about 5,000 shares a day an average bid ask spread of 0.2%. Meanwhile, GRWN sees volume of about 1,700 shares a day and its bid ask spread comes in at 0.54% on average. Thanks to this, investors could see higher total costs when investing in GRWN, suggesting that JJS could be cheaper overall.

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