Government Grind: Brazilian Coffee Plan Unlikely to Keep Prices Up

For the record, I'm against government subsidies and believe market economies should remain true to their mandate and remain market economies, free from government meddling. Government programs almost always create the wrong incentives, are inefficiently administrated and have the political impact of distorting the democratic process by essentially buying votes.

While America's history of botched government aid programs is not much better than the rest of the world's, a Brazilian scheme to keep coffee off the world market appears to be failing even before it begins.

Brazil's Plan

Here's the deal. Brazil is the world's largest producer of coffee, providing about 30% of global supplies. This year the country is forecast to harvest its biggest crop in over 40 years, upwards of 45 million 60-kilogram bags. This week a Brazilian coffee-farmer group and the government are finalizing details on a program to keep coffee off the market. The economic rationale: artificially holding back supply will drive prices higher.

But the whiff of failure is already in the air, weeks before the first "retention" funds are slated to reach coffee farmers' pockets. One problem is that nearly half of the farmers can't participate in the program. Indeed, nearly 40% of producers are ineligible for the retention credits because they're already in default from prior loans with Banco do Brasil, the government-controlled bank responsible for lending most official farm credits in the program.

A more serious problem is keeping farmers accountable. In the interest of speeding money to producers, Banco do Brasil is planning to let farmers have the money even before coffee arrives in warehouses. What will stop farmers, suffering from depressed coffee prices that are at a 17-year low, from diverting the harvest to market if they've already been paid off?

Even if the government were to efficiently administer the program, the total outlay of 690 million reales, about $250 million, will only pay to keep about 15% of the crop off the market. And ultimately, the program doesn't get rid of the coffee anyway; it's just a retention plan that creates a huge supply overhang.

An Early Harvest

Another factor that could pressure prices is the pace of the harvest. Although we are just weeks away from the beginning of the Southern Hemisphere's winter, a time that brings seasonal price spikes, the harvest has come early to Brazil this year and 25% of the crop is already bagged. The early harvest has essentially safeguarded a quarter of the crop from frost damage, and ostensibly from price spikes as well.

Traders have known about the supply-limiting program since it was approved by the government in February. But as the program's details and inefficiencies become better known, they'll have even less reason to factor in the higher prices that a retention scheme might bring.

That's why the head and shoulders pattern in the commodity is still compelling and appears uncompleted. Many head and shoulders make a measured move in which they travel below the neckline by the same distance as there is between the head and the neckline. The distance from the head (63.25) in September coffee (KCU2: NYBOT) to the neckline (55.50) in the chart below is 7.75. A distance of 7.75 below the neckline at 55.50 projects down to 47.75, which would complete the measured move.

Momentum and Pullbacks

In other markets, the soybean complex continues to prove itself with higher closes (see my May 21 and June 4 columns).

Natural gas (NGN2: NYMEX) is on the verge of triggering out of a pullback from a one-month low situation.

Finally, August hogs (LHQ2: CME) triggered out of pullback from a low on June 4, but may be providing a second short-entry opportunity should they descend below the previous trigger point. A second scenario is that hogs will stage a two-step pullback. The new trigger point for shorting will be the low of the high bar in the second stage of the pullback.

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