A Cup of JO?

You wouldn’t know it from buying a Starbuck’s latte, but the price of coffee beans is down more than 30 percent in the past year. That’s mostly due to bumper harvests in Brazil, which accounts for a third of the world’s coffee production.

But we think the coffee oversupply is about to end.

The main driver is heavy rains in Brazil, which have damaged the country’s Arabica beans, and are expected to cut its output by about 20 percent for 2013. There’s also the possibility that both Vietnam and Indonesia will produce less of their Robusta beans in 2013, due to El Nino-related rains. And worldwide coffee demand is growing rapidly — especially in Asia.

It’s no surprise that commercial traders have loaded up on coffee contracts.

Over the next year, many of them expect the per-pound price of coffee to rise 50 percent—to $2.50 per pound—and possibly to $4 per pound over the next two years. By some estimates, traders haven’t been this bullish since 2003 and 2008, when prices rebounded.

A Special Brew

So how can you invest in coffee? One of the very few options for individual investors is an “exchange traded note” or ETN: the iPath Coffee ETN (NYSE Arca: JO), issued by Barclay’s in 2008.

JO is up 0.5 percent so far in 2013, after losing close to 40 percent in the past 12 months. Its down some 3.5 annualized the past three years. So not off to a great start. But we think this ETN likely to rebound strongly by mid-2013.

Still, ETNs are designed for knowledgeable traders. So it’s important to know the risks.

ETN Primer

ETNs are basically IOUs, issued by an investment bank. There is no underlying security or collateral.

JO, for instance, tracks the price of just one coffee futures contract that is a sub-component of the Dow Jones-UBS Commodities Index. In the past 10 years (through June 30, 2012), the coffee sub-component of this Commodities Index gained less than 1 percent annually. And it was down about 40 percent for the year ended last June.

If the issuing bank defaults, there goes your money, since there’s no collateral at stake. We think Barclay’s is good for the money, at least in the time frame we have in mind. But you never know.

ETNs are NOT ETFs (Exchange-Trade Funds). Both trade on the stock exchanges. But that’s where the similarity ends. ETNs are not regulated under the Investment Company Act of 1940. In case of ETN fraud or manipulation, you’re on your own.  Also, the pricing of the underlying index for JO and other ETNs is hard to obtain on a daily basis.

ETNs are short-term investment (six months or less) for these reasons:

(1) Terrible long-term returns. Because of the inherent volatility in the underlying commodities, most ETNs have been miserable long-term performers, including JO.

(2) Gradually increasing fees. Many ETNs, including JO, charge more than the stated rate (0.75 percent in JO’s JO). If you read the prospectus carefully, you’ll see that JO’s fee increases annually over time, based on the difference between its launch price and the current price. So the longer you hold, the higher your fees.

And you don’t have to worry about selling only a few months. ETN profits are taxed at the more favorable long-term capital gains rate, even if the ETN is held for only a few months. And you can write off any capital losses to reduce your taxes.

Final Considerations

The biggest risk to coffee pricing right now is a global economic downturn, which would weaken demand. But we don’t think that’s likely. For coffee lovers willing to take on substantial risk, JO is worth a look ASAP.

Bruce Vanderveen is a Florida-based freelance writer.