Pierre Andurand Says the World Could Run Out of Cocoa Inventories

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1:13Hello and welcome to another episode of the Oddbots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, can I tell you something? It's slightly embarrassing. This could be many things, but yes, go on. Okay, so I had a self-realization the other day. I think I might have prepper tendencies. I didn't know that, but that doesn't totally surprise. It sort of fits. You're like, yes, you're paranoid. This makes total sense. I kind of get that. So the reason I had this realization, we recorded an episode recently on the big surge in cocoa prices. Yes. And a few days after that episode came out, I was like, hmm, I should buy some chocolate just in case.

1:56So I went on Amazon and I bought like an industrial size package of Milka chocolate. And I was like, I'll just keep it in the pantry. It'll be really convenient. It'll be there for emergencies. I'm sure I won't eat it at like 10 p.m. when I'm craving something sweet. I'll just keep it there for a long time. And so I ordered it. And then, you know, what happened? Tell me the rest. OK, so the first thing that happened was I never got the chocolate, which is kind of weird for Amazon. They just never fulfilled the order, and the supplier was like, oops, we don't have enough chocolate, I guess. But then secondly, as soon as I did it, prices of cocoa started falling.

2:35This was the market saving you from a bad trade, basically. So you put in an order right at the top. Sometimes you need a little luck in life, and now you can buy the dip. That's right. I was fully refunded at the top of the market, and now I can buy when it's slightly more reasonable. But I have to say, I'm looking at the chart of cocoa futures right now. So they surged above 11 ,000 and then they came back down. Let's see, we're about 8 ,000 right now. So it's been something of a roller coaster ride. And the thing that I don't really understand is when I look at coverage of the cocoa market at the moment, there seems to be consensus that supply is going to be an issue.

3:18So I know Bloomberg published a survey of traders where basically everyone was saying that they think prices are going to go higher. We could see over$15 ,000 later this year. But in the meantime, prices are sliding. So there seems to be a disconnect there. Totally. Well, look, I mean, even if the fundamentals are say, okay, this market is in deficit or, you know, all these growing conditions, like at some point, as they say, you know, trees don't grow to the moon or trees don't grow to the sky, whatever it is. So at some point, like you can have like solid bullish fundamentals and the price. I mean, it really is crazy because last, you know, in December we were looking at 4 ,000.

3:55So we're still, you know, double so far this year. Yeah. Well, I have to say we do in fact have the perfect guest. We're going to be speaking to someone who timed the big cocoa trade a lot better than I did personally in my pantry. But we're going to be speaking with Pierre Onderon. He is, of course, the founder of Onderon Capital Management. We're going to talk cocoa and a bunch of other commodities. So, So Pierre, thank you so much for coming back on AuthBots. Hi, thanks very much. My pleasure. So maybe to begin with, talk to us about how you got interested in Coco. Because my understanding is you put a big trade on, a long position earlier this year.

4:34It paid off massively. But this isn't a sort of normal type of trade for you. This is something that was a little bit different. Yes. Well, generally, my background is more in energy trading. but I've traded quite a bit of metals as well, a little bit of agricultural products. But I have one analyst who is very good and who told me in January, Pierre, you should look at cocoa. So I'm like, okay, I don't know anything about it. Tell me about it. And he gave me a really good presentation that was really interesting. So then we really digged in really deep together to really understand the fundamentals of the market.

5:07And basically we have a massive supply shortage this year. I mean, we see production down 17 % relative to last year. Most analysts out there have it down 11%, but that's because they tend to be very conservative. You know, they have lots of clients and they don't want to worry the world. So they come with relatively conservative estimates. But really tracking the exports from the main exporters, mainly Ivory Coast and Ghana, that we present together about 60 % of world's production. We see basically Ivory Coast exports down 30 % year to date. I mean, season to date. and Ghana down 41%. So just those two countries together since the start of the season, which is the 1st of October, are down 800 ,000 tons.

5:55And now we have what you call the mid crop that is starting, but that represents only 20 % of the balance of the season for West Africa. And that's not going to be enough to really change the deficit that we have this year. So we have a deficit of 800 ,000 tons from those two countries. And then looking at all the other countries, we have, I think, some are slightly positive, some are slightly negative. But basically, we get to a deficit of 800 ,000 tons this year. And so that's the first time we have such a decline in supply. And that's very hard to make it fit. So at first, you eat into current inventories until you run out of inventories, and then the price can go anywhere.

6:38So when we look at, OK, what makes the price of cocoa? It's always about supply versus demand. But what has been capping the price between$2 ,500 a ton and$3 ,000 a ton? It was not demand because demand is extremely inelastic. I mean, you can study that historically when you have a recession or not, when prices go up a lot or not, I mean, demand generally goes up. And that's because the amount of in dollar terms that people consume in cocoa is very small. I mean, I did a back of the envelope calculation the other day. I mean, at basically$10 ,000 a ton, even though it's four times the more recent historical prices, out of a market of 5 million tons of demand per year, you know, you have like 8 billion people on the planet.

7:28So in average, it means that people consume 1.7 grams of cocoa per day, which at$10 ,000 a ton represents 1.7 cents per day. Okay, that's the average person. Many people eat nothing and a few eat 10 times that amount. Like Tracy. I was going to say, I can personally attest that my chocolate demand is very inelastic. But yeah, but you know, let's say if you eat even one full tablet, right? So 125 grams a day, every single day for the whole year, which is quite a lot, right? Of a high content of real cocoa, because you know, your milk and milk chocolate, you have like less than 10 % cocoa in it.

8:07So the price can go up 10 times. Your tablet is only going to double in price. It's not going to react very much to the cocoa price. But if you take a high chocolate content, like a tablet, 125 grams, that means that you probably have a maximum of 50 grams of cocoa beans equivalent in it. That means probably a lot less. Then you get to an expense of$14 per month at current prices, which is an increase of$10 per month relative to when we had a more normal price. So it means that demand for more reasonable chocolate lovers, that increase in price in cocoa just corresponds to$2 to$5 per month. So people are not going to eat less chocolate because of that.

8:53So it means that prices really are capped by the amount of supply you get. So if you can't get enough supply, the price can go up a lot until we get more supply. And when do we get more supply? Well, that's in part due to the weather. If you have much better weather, then you might get more supply of cocoa beans the next year. But we have some issues that are also structural. So when we look at the reasons for this large decline in production this year, I mean, a lot of the reasons are actually structural. I mean, we can look at four reasons why cocoa bean production has gone down a lot this year.

9:32I mean, first, I should give a little bit of background of why cocoa is so concentrated in West Africa. I mean, it's mainly because it requires very specific temperature, rainfall and humidity conditions. And that's why most of the production is concentrated around a certain latitude. So 70 % in West Africa. And then you have 21 % in Latin America and 5 % in Asia and Oceania. So the main reasons why we lost a lot of production this year is number one, weather. So some of it due to El Nino. We had a period of time when it was too hot and a period of time when we had way too much rain. Second is climate change.

10:14So climate change is every year shifting the weather patterns, generally unfavorably for cocoa productions. Then you have two diseases. You have one called the black pot disease that comes from a fungus. And it occurs mainly during the rainy season. It's spread by rain splash. So it can't grow when it's dry. And then you have a virus called the swollen shoot disease. It's not a new disease. It was discovered in 1936. It's transmitted by millibugs, but it decreases cocoa yields a lot. So basically a tree that has that swollen shoot disease loses 25 % yield within the first year and 50 % within two years.

10:55And the tree dies within three to four years. And we've had like actually a spread of that disease like over the last year. And then also we had less usage of fertilizers, mainly in Ivory Coast, due to high fertilizer prices and also shortages due to the Russian invasion of Ukraine. So, you know, everything is linked. So some of it might be solved if we get better weather. I mean, for next year, we should have La Nina and not El Nino. So that should help at the margin. But we still have issues with climate change. We still have issues with black pot disease and swollen shoot disease. And there's no indication that we get more usage of fertilizer in Ivory Coast because actually the farmers are still getting relatively low prices and they're still struggling to make ends meet.

11:42So a lot of those supply issues are actually structural. This was already a really fascinating answer, and in particular, just that point about how if a commodity just does not take up much wallet share, then yes, it can go up, but you don't get that same sort of demand destruction as if it were really creating a big financial burden on the end consumers. Something I'm curious about with COCO is, you know, when I think of like oil, we are just like, we're swimming in data about oil. There are multiple big, well-funded international statistical agencies that track it. You can get inventory data easily.

12:18There's OPEC, there's et cetera. With COCO, and I'm curious, you know, you said your analysts brought it to your attention in January. In my mind, I've imagined that there is less robust information and it's more scattered, et cetera. Maybe I'm wrong, but does that present more opportunities to identify moments where there's something going on in the market and traders and analysts aren't seeing it? You know, we managed to get enough relevant data actually to understand what's happening. You have some consultants that are specialized and every month they have a team doing surveys of the main producing regions to understand.

12:54And then they work on their forecast on how much they think production will grow. So actually you have some specialists. So actually we get enough data to understand how. So what did your analyst see or how was your analyst able to see something in the supply and demand situation that he felt and you felt was not being identified by the analysts who cover this closely? I think it's mainly an understanding of how much prices have to move to balance the market you know okay people sometimes people can trade that market for like 20 years they've been used to a range of prices and they believe okay the top of the range is a high price for an apple but they don't really ask themselves what makes that price right and sometimes taking a step back can help i mean what makes the price is mainly the fact that in the past you would have a supply response if prices were going up but if now you get you don't get the supply response or the supply response takes four or five years, then you need to have a demand response.

13:55And a lot of people look at prices in nominal terms. So you hear people saying, oh, we're at all-time high prices in cocoa. But that's because they look at prices in nominal terms. Previous high in 1977 was$5 ,500 something dollars a ton of 1977 dollars, which is equivalent to$28 ,000 a ton of today's dollars. So we are still very far from previous highs. And so you have to look at a bit more history and understand in the past how prices reacted to a shortage, how long it took to recover for that shortage to actually solve itself and what's different today. So there's a ratio that we look at that most people look at.

14:37It's actually the inventory to grinding ratio. So it's a measure of inventory to demand. What we call grinding is basically industrial companies that take the cocoa beans and they want to make chocolate with it. So it's a process. And some of them make the end product chocolate directly. Some of them sell back the product to other chocolate makers. And so basically a typical grinder would take cocoa beans and make cocoa butter and powder with it. And the prices of both those elements also went up even more than cocoa beans, which means that actually we probably had some destocking everywhere in the chain.

15:17So it looks like demand when we look at the chocolate makers, the end demand for chocolate didn't go down at all. It looks to be flat on the year. grindings look to be down three three and a half percent this year despite the fact that the end demand is the same in volume which means that they've been destocking cocoa beans actually and so we had like destocking everywhere at the end chocolate level at the cocoa beans at the cocoa butter and and cocoa powder level so we had destocking everywhere on the chain and now we have the largest deficit ever on top of two previous years of deficit and it looks like next year we will have a deficit so we're in a situation where we might actually run out of inventories completely i mean this year we think we will end up with a with an inventory to grinding ratio so inventory at the end of the season of 21 for the last 10 years we've been between 35 and 40 roughly at the previous peak in 1977 we were at 19 and that's what drove us to 28 000 a ton of today's dollars.

16:23If we have another deficit next year, then we might go down to 13%. So I don't think it's actually possible. That's when you really have a real shortage of cocoa beans. You can't get it, and that's when the price can really explode. And so understanding that, you have to slow down demand, and we know that demand can't really be slowed, so that's when you can have an explosion. And remember that these commodity futures, you need to have they're actually physically settled, right? So if somebody wants to take delivery, they have to converge with the price of the physical if you have no physical somebody wants to take delivery the price can't go anywhere so it's a dangerous commodity to short right if you have no no physical against it and actually you know sometimes we read news that the funds have been pushing cocoa prices it's actually completely untrue because the funds have been selling since February.

17:12They actually went from a length of 175 ,000 lots, so that's 1.75 million tons of cocoa lands, I think it was around like September last year in average, or a bit earlier, to 28 ,000 lots, to 280 ,000 tons at the moment. So they sold more than 80 % of their lands, actually and the people who've been buying the futures from the funds it's producers because they're producing a lot less than they expected so what has been happening in the cocoa market is that you had a reduction of what we call the open interest where both the longs reduce their lands and the shorts reduce their shorts and then we get into a market where you have less liquidity because you have less exposure you have less longs and less less shorts and then the volatility volatility increases.

18:06So in the past, when people were comfortable being, let's say, having a 100 loss position, now because it moves more than 10 times more than in the past, we're going to have like a 10 loss position, right? So the market became more due to the fact that we had a massive move and we have a massive deficit. So everybody reducing their positions. And because of the increased volatility, we have less activity and that's what makes the price more budget type that way.

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20:10It's built to grow with your business, whether you are just starting out or already scaling up. Plus, it's easy to use, customizable, and designed to streamline every process, so you can focus on what really matters, running your business. Thousands of businesses have made the switch, so why not you? Try Odoo for free at odoo.com. That's O-D-O-O dot com. This is something I find fascinating. So the way the financial markets sort of interact with the underlying real commodity and how that ends up influencing price. given the dynamics that you just laid out where because of you know structural changes in the market both in cocoa and then also in the way it's traded this new volatility making people maybe less inclined to short and leading to decreased trading volumes are you still long cocoa in this environment or have you like a lot of other people backed off at this point well you have to be careful about the sizing of your position because it's something that is It's clearly less liquid than the commodities I'm used to, which are, for example, oil or natural gas.

21:21So it's a lot less liquid. And in a market like that, it's a lot more volatile. It's not always volatile, but when you have a large deficit and low inventories, it moves a lot. So you have to calibrate your position to be able to take a 50 % move against you on the way. So that's what you have to do. It doesn't mean that you have to be out completely because I still think that there's more upside than downside. I think we still have the potential to go above$20 ,000 a ton later this year or next year. Versus on the downside, maybe we go from, if you look at a December contract, it's at roughly$7 ,000 a ton today.

21:56Maybe we go back down to$5 ,000. So you have like a$2 ,000 a ton downside versus$13 ,000 to$15 ,000 or maybe more upside. So it's still worth having some lands in terms of probability. But now, I mean, it could go down. The probability that it goes back down is not zero. But for that, a lot of things need to go right. You need a bumper crop in West Africa next year. And it means you need to have the perfect weather in West Africa from now to the end of the year in order to have a really good crop for next year. And it might happen, but it might not happen. You need to get extremely lucky for that to happen.

22:36So I think the balance of probabilities are still that we will have a deficit next year on top of the very large deficit this year. We believe we have 800 ,000 tons deficit out of 5 million ton market size, right? So it's a very large deficit. If we have the production going back up roughly 10 % from this year to next year, we still have a deficit of 300 ,000 tons or so next year. That brings us to 13 % stock-to-grinding ratio, which would be much lower than what we had in 1977. So we still have, I think, a high probability of having much, much higher cocoa prices. You know, even if they go there, we might have big drops like we've seen the last month or so, the last two weeks.

23:24But we might make new highs and then have big drops again and then make new highs. Or if over the next four months we realize that we're going to have, from all the surveys we get every month in Ivory Coast and Ghana, that the crop next year will be amazing, then the prices will probably come off from here towards, I don't know,$5 ,000 or$6 ,000 a ton. But they're not going to go back down right away to$2 ,500 a ton because we have very low inventory. So we need to rebuild stocks everywhere in the supply chain. These inventories, so you've been talking about the stock inventory to grindings ratio or the stocks to grindings ratio within the sort of cocoa or chocolate supply chain.

24:07Who are the holders of the stocks and how do you get that? Like, how is that data collected? So basically you have the exchange. So first you have exchange stocks. So we have weekly data in European exchanges and the U.S. exchanges. So in the U.S., for example, everything's held on exchange pretty much. So everything in exchange. In Europe, only 20 % of the inventories on exchange, 20 % of the European stocks are on exchange. The others are really with chocolate makers or that they need to hold stocks directly to make the chocolate. And then you have some also obviously at the producing region.

24:47And that's something that we can see the inventories at the port in Ivory Coast and Ghana. So the main exporters, you can actually follow the amount in inventory there. And then the West, what we don't know, is inferred statistically. So there's a bit of noise in what that total amount of inventory would be. But you have some firms that are specialized in it that will come up with an estimate of the number. So they'll do some surveys and they'll do some cross-validation to make sure that the numbers are up at the end. Out of curiosity, and just widening this out to a few other commodities, have you observed any similar dynamics in something like coffee, which has been getting a lot of attention recently, or orange juice?

25:33I ran into some guy called Mortimer who was telling me that Brazil is supposed to have a bad harvest this year. That's possible. I haven't followed orange juice. I mean, we looked at coffee quickly. It looked interesting as well because you get big losses in production from Vietnam. But we didn't see from far something that was so exciting, so we didn't try it. Orange juice, we haven't, I don't know. But I would say that generally the shift in weather patterns due to climate change are going to bring some structural stories into soft commodities. And so we'll have to look at more and more of those soft commodities because it's not only going to be from one year to another.

26:18You're going to have that everything could change due to random change in weather. You have this underlying climate change that is also a trend that will impact production over time. And so we have to identify the commodities that will be impacted by that. Talk to us a little bit more about, obviously, we've had you on in the past, primarily talk about oil. And as you mentioned in the beginning, you don't trade ag as much. There's sort of a different space for you. Other than the size of the market, and I guess, as you mentioned, it's all physical delivery futures. What are the other dynamics that are different when you go from trading a commodity like oil, which is gigantic and liquid, to a commodity like cocoa?

27:02Well, you have to follow the – I mean, cocoa, I think, is less complicated than the grains because in the grains, your weather can impact production so quickly. versus for cocoa. It does impact production, but it takes maybe five years to, you know, when you plant a cocoa tree for, I mean, three to five years for that cocoa tree to give you cocoa beans. This is for grains, you get it right away. So you get like a slower production response. So it should be when you have a big supply issue and that you have issues due to climate change, you should have like a larger move than for grains. So it should make it easier in a way to have positions that you can hold for longer that are a bit more structural than for grains, I would say.

27:49That's my understanding, at least for now. And there's enough data to I mean, enough data meaning like a week we get a bit more data on how the new crops are doing, mainly in Iboricose and Ghana, to have a good understanding of what the crop will be the production will be the following year. So I feel like we have enough data to understand in which direction we're going versus the grains. I feel like the grains can move up and down a lot and it's more complicated. You have to look at a lot of tiny details versus cocoa where you have maybe one mega major producer and another very large one. Speaking of climate change, can we talk a little bit about copper?

28:35Because this is also a commodity where I feel like there was a lot of discussion about it being in structural short supply as the world moves towards electrification. But then over the past couple of years, prices went down, I guess because of concerns over the outlook for economic growth. And just relatively recently, so starting sort of February of this year, prices are going up again. What's your thesis when it comes to copper? I think copper should go up a lot. Basically, we are going from, basically over the last, let's say, 15, 20 years, we were in a market where demand was growing about half a million tons a year and supply was growing half a million tons a year in average, right?

29:20If you look at long-term averages. It was over time a balanced market. We had times where it was tight, times where it was in a bit of a surplus, many during the pandemic or during financial crisis but overall it was a balanced market now due to the energy transition we are getting as obviously as we have to electrify the world we have new demand from electrification of transport so it means that not only to make the electric vehicles but also to supply more electricity overall in the world to for that energy transition. So you have to work on the grid to have more renewables and renewables take a lot more copper than like nuclear plants or like fossil fuel generated electricity.