Softs: Overlooked & Misunderstood

'Softs' led the pack in commodities last year, why doesn't anyone talk about them?




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Transcript

Softs:  Overlooked & Misunderstood
Season 4: Episode 3

 Katz: Welcome to the Real Spiel with Ryan and Kurt. This week we're going to talk about softs a little bit, an often overlooked and maybe less understood commodity sector.  But when we say softs, we're talking about cocoa, coffee, cotton, sugar, globally important commodities but that maybe the commodities don't always get the headlines but looking back since the beginning of 2023 softs were actually the leading sector the commodity winner, if you will until early 2024 and the biggest winner being cocoa up, I believe over a hundred percent on a one-year basis. Kurt just wanted to talk to you a little bit about these commodities, the concentrated production and these commodity markets make them much more susceptible to weather patterns and natural disasters. Maybe you can start off with Western Africa, the production of cocoa, and what we've seen over the past year, and why we've seen such a run-up in cocoa prices. 

 Nelson: Yeah. Great to talk with you, Ryan. Cocoa is an interesting story. Softs, I think, as well, are very interesting. Cocoa has been a major commodity. It's been traded for decades. Going back to the early 2000s, traded in a range between, say, $2,000 to $3,000 a ton. It's really broken out spectacularly since the beginning of ‘23. It trades, much like other commodities that we discuss and that we follow, it trades on inventories and on scarcity. Commodities, more than financial assets, trade on supply and demand. Demand for cocoa, demand for chocolate has remained strong globally, and supply has been significantly constrained. When you reviewed your list of softs before, one of the things that a listener might notice is that these are all agricultural commodities. They're all grown. You can't make them in a factory. You make chocolate in a factory, but cocoa is a bean that grows in a pod. And so, they all are produced, they're affected by weather and climate, and they're also geographically constrained. So, as you pointed out, about 70 % of cocoa comes from West Africa. So, what are the fundamentals around cocoa recently? Well, inventories are very low. Their major crop cycle goes from roughly say October to January, February or so each year. There is a midseason harvest, which is much smaller, and for the first time in years, the forward contracts, so Nestle and Hershey and other major chocolate producers, the contracts for delivery of cocoa can't be met for the first time, as I said, in many, many years, maybe even over a decade, from that first primary harvest. And so those supply contracts are only going to be completed or closed through this secondary harvest. So, we already have low inventories, and then I think the harvest is down roughly in the 30 to 35 % range over the year prior. So, we're not getting another harvest cycle, which is supportive to restore inventories and keep prices contained. That's just led to this long multi-month persistent run-up in price. It doesn't show any signs of alleviating because the only thing you can do is wait for the next harvest. We're waiting until the next September, October timeframe before we have another shot at it in global markets. 

 El Nino was a big factor. As a weather pattern, it affected other softs as well, such as coffee growing regions. But the way it's affected West Africa was poor harvest conditions. There is a forecast for a transition from El Nino to El Niña, which may happen starting in the summer of ‘24. That could lead to better rainfall and conditions in West Africa but that's I mean that's predicting the weather and that's months down the road. It's really hard to see right now. What we know is that supplies are tight and output is lower than normal.

Katz: Yeah, absolutely. I mean when people think of commodities obviously oil, metals, gold, corn but these are often overlooked commodities, the soft sector and just wanted you to talk a little bit about kind of the typical commodity benchmarks on how they treat these smaller commodity markets.

 Nelson:  Sure, I mean the two main benchmarks that that come to mind are the Bloomberg Commodity Index or BCOM and the original GSCI now called the S&P GSCI index and these are important price benchmarks but they're really designed to be a basic beta representing the overall market so their commodity composition and the weights assigned to them are really just based around production and liquidity, so they're really not focused on risk or return in their composition. As a result, softs tend to feature very small in the overall portfolio weighting for the BCOM and GSI. And even within those, the individual components can tend to be really small and have a very minimized effect. I believe that cocoa and GSI is only three-tenths of 1%. And then in the BCOM index, cocoa used to be a member, but today and for a number of years, cocoa has been excluded from their eligible universe. So, this price rally in cocoa didn't have any effect whatsoever there. So, I think these softs are important. Coffee and sugar have also done very well for similar reasons, related reasons to why cocoa is done so well. Weather has created harvest problems in both of those important agricultural crops. And they are geographically constrained, so there's not a lot of alternate sources to go to. For example, coffee, 40% comes from Brazil, 20% comes from Vietnam. Those are small, growing regions. And so, when you have a disruption to supply and to output or to harvest, there isn't anywhere else to go. Particularly if buffer stocks and inventories are low, that means the only thing that can really give is price. 

 Katz: It's interesting to hear that those well-known commodity benchmarks either hold zero or near zero exposure to some of these globally important commodities that seem to have some significant, potential upside for investors.

 Nelson: Yeah, I think it's important for listeners to remember that commodities have been around for a long time. If we were to dial back 40 years, popular commodities that traded on exchanges were things like orange juice and pork bellies. Now, frozen concentrate orange juice isn't as important. It still has a future, but it's diminished in size. Instead of pork bellies, we traded a large commodity called lean hogs. It's just the contract that's been successful and is important for traders in hedging price today. But there is a diverse group of commodities that investors can access, and sometimes these benchmarks do tend to overlook the ones that are important globally and liquid, but just smaller. 

 Katz: Absolutely. Thanks, Kurt. And thank you for listening in. This has been The Real Spiel with Ryan and Kurt. For any questions, comments, feedback, we'd love to hear from you at therealspiel@uscfinvestments.com.

 And we'll talk to you next time.