Old coffee, Brazil beans fuel panic selling before expiry

Wed Nov 21, 2012 1:30pm EST

* Spread at 18-year high as Dec longs rush to sell

* Some longs caught unawares by changes in ICE rules

By Josephine Mason

NEW YORK, Nov 21 (Reuters) - A combination of short memories and old coffee has fueled an unprecedented sell-off in benchmark arabica futures this week, as changes made two years ago to the age and quality of beans deliverable against the ICE Futures contract finally come into effect.

On Tuesday, the day before the first notice day for December coffee futures, that contract plunged over 5 percent and its discount versus March beans flared out to almost 9 cents per lb, the largest in 18 years, as traders who were long the contract rushed to dump it rather than roll into the next month. Rolling would mean selling the discounted spot and buying March at a big premium.

While the spot prices recovered slightly on Wednesday, the big discount to March remained in place at 8.4 cents.

A major reason for the selling of December is because new rules come into effect with the March contract, which will hike the discounts for beans stored longer than two years and considered past their prime, allow the delivery of Brazilian beans against the board and add fees for delivering material out of warehouses.

The massive swing in the spreads to adjust for the new penalties will only be temporary, lasting until the December contract expires on Dec. 18 and the March contract becomes the front month, but it is roiling the market at a tumultuous time.

March prices hover near 2-1/2-year lows close to $1.5 per lb as the market continues to struggle with growing supplies and lackluster demand.

"I think some longs may have got their fingers caught in the door here and overstayed their welcome. They waited too long to liquidate and were forced to liquidate in a dying contract during a holiday," said Sterling Smith, futures specialist for Citigroup.

At the time of the 2010 announcement, ICE's decision to accept Brazilian beans grabbed the headlines as it ended a decade-long debate over whether beans from world's top coffee grower would be of high enough quality for the board.

But hikes in age penalties have had a much larger impact, catching some investors by surprise as nearby spreads widened to account for the new pricing policy.

"The change in the discount schedule was significant enough that it is really what forced the spread to go wider," said a U.S. physical merchant.

"By the time you factor in (the additional costs and new discounts), it gets for a nasty surprise for somebody who didn't pay attention to the change."

SURPRISE DISCOUNTS

ICE first announced plans to introduce the changes on Dec. 10, 2010 to address criticism that beans were sitting in storage for too long and becoming too old to make decent coffee.

With months to go, the exchange issued a notice on Oct. 8 to remind the market of the upcoming amendment, but some longs were still caught off guard.

In essence, the exchange has accelerated the price penalty for stock older than 720 days. For instance, the new policy will deduct 100 points - or 1 cent per lb - for the first 30 days after beans have been certified for two years, rather than 75 points - or 0.75 cent - now. The deductions increase the longer the beans are stored.

In other changes, Brazilian beans will be deliverable against the board for the first time, at a discount of 900 points, and a rebate on loading out fees for those receiving beans from warehouses will be introduced.

DISCOUNTS

The first signs the market was adjusting to the new penalty and loading-out rates emerged on Sept. 18 when the December-March spread soared from almost zero to 3.9 cents, its widest since the end of 2011.

The spread remained in a narrow 4- to 6-cent range until Tuesday when it jumped to 8.7 cents. Traders held off buying from desperate longs until they secured a 8.7-cent discount to March to cover the cost of carrying stock into the new contract.

That 8.7 cents, traders calculated, would cover the new age penalties and loading out costs.

A second U.S. merchant said he had paid as much as 12.75 cents under the March price on Tuesday.

"If I tender that lot in March, I'll get penalized with a different age discount schedule," he said explaining the reason for the huge spread.

"The spread had to go to where the financial carry was, which accounted for age discounts, so the financial carry for first couple of lots was a 900-point discount."

Few expect big inflows of Brazilian beans immediately given the steep discount set by the exchange, but the market may have to deal with that possibility if demand weakens further and global output continues to rise, traders said.

For now though, the longs were facing a tough roll into the March contract, with many expected to be casting a fresh glance at the ICE rule book over the U.S. Thanksgiving holiday.

"Not all market participants are as knowledgeable as others and that causes days like (Tuesday). This is something where you were caught long and that's quite a rarity in commodities," said the first merchant. (Reporting by Josephine Mason; Editing by Bob Burgdorfer)

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