The coming cocoa correction

November 19, 2010: 3:56 PM ET

An improving political climate in the Ivory Coast could result in a cocoa production boom. Combine this with slowing economic growth in the U.S. and Europe and the commodity looks downright expensive.

By Daryl Jones, Hedgeye

cocoaCocoa futures aren't looking so sweet these days.

We're short cocoa, mainly because of the potential for an improving political situation in the Ivory Coast – the world's largest producer of cocoa – and the potential for slowing demand as global growth slows sequentially.

From a consumption perspective, the U.S. and Europe are the largest consumers of cocoa. In fact, 16 of the 20 world's top consumers (on a per capital basis) are European countries; by some estimates Europe consumes more than 40% of the world's cocoa. In aggregate, developed countries consume more than 65% of the world's cocoa, with North America being the second-largest consuming region after Europe. In total, the world will consume somewhere on the order of 3.6 million tons in 2010.

Interestingly, while developing countries are growing demand at a slightly higher rate than developed countries, it is only marginal, as developing demand is expected to grow at under 2% this year. (This is in comparison to higher demand growth for more essential commodities such as oil, copper, etc.)

From a demand perspective, since chocolate is considered a specialty item and not a necessity, we would expect demand for it to wane in slower economic growth periods. As we've noted, we expect both U.S. and global growth to slow sequentially going into 2011, which will curb consumption patterns, particularly for nonessentials such as cocoa.

As a case study of what can happen to cocoa demand in slower economic times we can look to Germany. The demand for cocoa in Germany grew at an annual rate of -2.8% from 1990 to 2000 and then accelerated to annual growth of 0.9% for the ensuing decade. As the economic growth patterns of Germany improved, so too did its demand for cocoa.

But the real story in cocoa is production. Almost 70% of global cocoa production occurs in Africa – the top five producers globally are the Ivory Coast, Ghana, Indonesia, Nigeria, and Brazil. The Ivory Coast, though, dominates production with approximately 45% of the world's production occurring within its borders. So, as the Ivory Coast goes, so too goes the price of cocoa.

Currently, things are not going well in the Ivory Coast. As of November 14, according to statistics from the Ivory Coast government, arrivals of cocoa crops at ports in the Ivory Coast slated for overseas transports are down almost 15% year-over-year. We believe this negative news is already priced into the commodity, as it was expected that production was lagging due to new quality standards.

Prospectively, the recent Ivory Coast elections are likely a key driver of future supply growth. The elections, which had been on hold due to political turmoil since 2005, were certified by the United Nations. According to the UN:

"Despite some minor incidents and anomalies, it was peaceful and in line with international standards."

In fact, more than 83% of eligible voters went to the polls. The result of the presidential election was that no candidate received more than 50% of the popular vote, but a runoff is scheduled for November 28th between Incumbent President Laurent Gbagbo and rival Alassane Ouattara. It seems likely that peaceful and democratic transition of government will occur.

This is important, as it would allow the government to begin to function at a normal level again and start to mandate, and support, a much-needed modernization of the cocoa industry. In time, this should lead to a cocoa production boom in the region.

So, are we kookoo for shorting cocoa? We don't think so, but only time and price will tell.

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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