To millions of Americans, coffee is the beverage of choice when it comes to looking for a boost in productivity. As it turns out, so far this year, this form of black gold has also been giving a healthy boost to investors' portfolios. As shown on the chart below, coffee prices as measured by the iPath DJ-UBS Coffee Total Return Sub-Index ETF (NYSE:JO), have outperformed the S&P 500 by over 85% since the start of the year. How might this surge influence the share prices of companies that profit off the sales of coffee? Secondly, will the price of the underlying commodity continue to move higher?

iPath DJ-AIG Coffee vs. S&P 500

Coffee In Brazil

Brazil is the world’s leading producer of green coffee. Arabica, which is the most commonly used type of bean in gourmet blended coffees, is one of the country’s primary exports. In 2012, Brazil led the world in production with just over 3.04 million metric tonnes. Unfortunately, the southeastern region, near Sao Paulo and Rio de Janeiro, has been experiencing the worst drought in over 50 years. The extremely dry weather is one of the main factors that has caused the spot futures price on the Intercontinental Exchange (ICE) to move above $2.00 per pound. As you can see in the chart below, coffee is now trading near its highest level in over two years.

Coffee In Brazil

Coffee ETNs

For traders looking to take advantage of a continued move higher, the most popular choice is an exchange-traded note. These assets are used to track the performance of a market index minus applicable fees. One popular choice is the the iPath-DJ-UBS Coffee Total Return Sub-Index ETF mentioned above. However, another ETN that is gaining popularity and may be worth a close look is the iPath Pure Beta Coffee ETF (NYSE:CAFE). This fund was designed to provide investors with exposure to the Barclays Coffee Pure Beta Total Return index and reflects returns that are potentially available through an unleveraged investment in futures contracts.

Based on the chart below, many traders will be watching the $27.18 level as closely as a possible area of resistance. Ideally, a move above this level would be accompanied by a sharp increase in volume, which would signal a confirmed break higher. Target prices would likely be set at the next psychological resistance area, which is near $30. Most traders would likely look to protect this trade and lock in a favorable risk/reward ratio by placing a stop-loss order below the 50-day moving average, which is currently at $22.49.

Coffee ETNs

Rising Costs To The Consumer

Rising coffee prices can be great for traders and investors who own shares of the various ETNs mentioned above, but in most cases this is not great news for the companies who sell coffee to the everyday consumer. Higher prices for the coffee, which is the primary input for companies like Seattle's Starbucks (Nasdaq:SBUX), means that profit margins are likely to get squeezed or that higher prices are passed through to the consumer.

As you can see from the chart below, the price of Starbucks is negatively correlated with the price of coffee. This is as expected and is similar to the relationship of rising fuel costs and the stock prices of various airlines. Notice how the 50-day moving average is declining and acting as a zone of resistance (shown by the red arrows) compared to the rising support role that it has on the commodity charts? Interestingly, the 50-day moving average has recently crossed below the 200-day moving average in a long-term technical sell sign known as the death cross (shown by the blue circle). This long-term sell signal suggests the price of SBUX shares will likely remain under pressure until global supply recovers.

Rising Costs to the Consumer

The Bottom Line

Severe drought in Brazil has caused coffee prices to spike so far in 2014. After such a move, it will be important to remain mindful of risk management and the placement of stop losses. As shown above, the nearby long-term moving averages may provide an interesting area of support for traders looking to trade the underlying commodity. For coffee-related companies, such as Starbucks, the rising prices will continue to pinch margins and could be a ceiling for any move higher in the short term.

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