Editor’s Note: Days before Halloween, the candy industry is experiencing an Ebola shock-au-chocolat. For consumers on the streets of New York City, the price of a Kit-Kat has shot up 10 cents, and as Paul Solman reports on the NewsHour below, some parents weren’t above stocking up on Halloween candy last week.
But where is that price shock coming from? The chocolate we buy in stores comes from an integrated supply chain. It starts in West Africa (hence the fears, perhaps over exaggerated, about Ebola), with the actual cocoa farmers. They sell cocoa to large agribusinesses like Cargill and Archers Daniel Midland, which then sell processed cocoa beans to candy manufacturers like Nestle and Cadbury.
The warehouses of these large companies aren’t necessarily experiencing a cocoa shortage; there’s plenty of the commodity out there, says Manhattan hedge fund manager David Martin. A commodities trader since the 1980s, Martin says that the price of cocoa has been rising and falling as fears about the Ebola outbreak ebb and flow.
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Whenever markets swing, whether it’s the price of cocoa that’s shooting up or the value of stocks dropping, economists ask questions about human psychology. In other words, do human fears drive volatility — what Nobel laureate Bob Shiller wrote about in “Irrational Exuberance”? Or do market fundamentals — a real change in the cocoa supply, for example — move the market? (By the way, hear more from Shiller at the bottom of this post).
In the case of Ebola and chocolate, Martin, as you’ll read below in his edited conversation with Paul, comes down on the side of emotions driving price swings. And although he may see those human fears as irrational, as a commodities trader, he makes money trading these kinds of price spreads.
Watch Paul’s Making Sen$e segment, and in the post below, read more from Martin about how the cocoa industry works and whether Ebola is really posing a threat to the supply of our Halloween candy.
— Simone Pathe, Making Sen$e Editor
Paul Solman: So, a couple months ago, the price of cocoa shoots up —
David Martin: So, you have a long-term growth in demand, first of all, but add to that the fact that the weather may not have been that great for the crop this year. And then you add a scare like Ebola, which may take out the workers, and people start to panic. Now, remember, it’s a luxury item, it’s a candy bar, it’s chocolate, but if you tell people they can’t have it, they freak out, and they’ll pay whatever they have to pay to get it.
Paul Solman: But it’s a little crazy, isn’t it? I mean, Ebola, chocolate? The countries that are affected by Ebola actually aren’t the producers of chocolate, for the most part?
David Martin: That’s true, but to answer that question, I need to explain a little about the dynamics of the market. Basically, you have these countries growing an agricultural commodity — the beans, the cocoa beans — you have large food processors, companies like Archer Daniels Midland, Cargill and Bunge, buying these beans to process them into chocolate liquor, chocolate cake, chocolate powder, that they then sell to the chocolate manufacturers — company names that most households know, like Nestles or Kraft or Cadbury. Those people buy the processed beans to make the chocolate that we all buy in the store.
If you shut down all commercial activity in a country because the people are paranoid that they’re going to get infected with a virus, and some of the workers actually do become infected, it can cause disruption to this whole chain of events that supply the world with cocoa and chocolate. That’s the problem. That’s also why there’s hysteria when there’s a port closing or a port fire, and they can’t get sugar or coffee beans out of Brazil, and the price shoots up, and then they discover that there’s no damage, and the price comes back down again.
Where Ebola started to spread in countries bordering the Ivory Coast, where most of this cocoa comes from, you see the market shoot way up; it’s panic. Since the beginning of this year, since January, up to November, right now, the price of cocoa is up 20 percent. It went up much higher — to 35, 40 percent before that happened.
Paul Solman: So what we’re seeing over the course of the year is a rise, you think, due to more demand from China in particular. But then the real spurt comes with the Ebola scare and then that dissipates pretty quickly?
David Martin: The first spike was in March, when the first reports of Ebola started to circulate.
Paul Solman: And then it subsides, and then it looks like people are starting to get worried again.
David Martin: That started in the middle of May. But the other thing you need to remember too is that there’s somewhat of a delay from the news coming out. Remember, this is the price of cocoa in the future. A lot of this cocoa in the early part of the year has already been harvested, it’s already in the warehouses, it’s already being delivered to the companies that are going to manufacture the chocolate.
The future price of cocoa [goes up out of fear] that they can’t get it out of the country because there’s no workers to deliver it. Or because of some sort of other hysteria that I don’t want to buy this bag of raw cocoa beans because it was handled by people that may have the Ebola virus. Doesn’t sound logical, but in a fear situation like that, people aren’t going to touch it.
Paul Solman: How often does something that at least seems pretty irrational drive prices to spurt like that?
David Martin: It doesn’t happen that often. I would say once every four or five years, depending on things like disease scares, like the Ebola virus, like draughts, like port closings or strikes or fires or natural disasters, tsunamis, that sort of thing.
Paul Solman: When was the last time something like this happened in the cocoa market?
David Martin: In 2011, when someone was trying to corner the cocoa market in London. It did drive the price up actually higher than it’s been right now, but generally, when someone tries to corner the market in a commodity, the market finds out about that, and it always ends in tears.
Paul Solman: Chocolate war! So this guy was called Choco-finger, like Goldfinger, and he tried to hoard the cocoa to drive up the price. What happened to him?
David Martin: He blew up; he lost all his money because the exchange started to tell him he had to reduce his position. The market participants got wind of this, and they sold it in front of him, driving the price lower, and I don’t know if you’ve ever seen the movie “Trading Places” from the 1980s, but it was basically that situation.
Paul Solman: So, are there people who, you think, speculated up at the top there? And have lost their shirts because they thought, “Oh my goodness, cocoa was going to go sky high, because of the Ebola threat?”
David Martin: There are definitely people who bought at the top, and probably got stopped out, meaning they stopped their losses at this point. But, a lot of the people who bought it aren’t necessarily speculators; they’re companies like Nestles or Cadbury or Kraft that need to buy this.
We’re coming into the holiday season, which is a very large consumption period. These are chief financial officers of global companies who actually are buying it because they need to buy it. And if they pay the higher price, they’ll probably pass it on to the consumer at some point.
But there are a lot of smaller manufacturers that don’t have the luxury of giant warehouses and being able to buy a billion dollars worth of cocoa for 10 years out. And they’re more hand-to-mouth, and so they actually are more susceptible to the fluctuations in the market prices. I think the long-term prices will continue to increase, and in any market like this, if I was a buyer, I would wait when the price dips down to buy it. But I think the long-term trend is actually up.
Trading Price Discrepancies
Paul Solman: So how do you make money for yourself and for your investors?
MORE ABOUT ARBITRAGE
David Martin: So we don’t necessarily trade the direction of the overall market, but we trade price discrepancies between the different futures markets — the prices between cocoa or coffee or sugar for delivery in different months. We trade the spreads between prices, more of a spread arbitrage of the different prices.
What that means is that the cocoa price for December may be very high, but for March it may be low. So we’ll sell the expensive month, buy the cheap month, and wait for that relationship to come back into balance, if we think it’s overvalued. So we’re less exposed to these giant spike moves, and we’re looking more to trade the differences in prices, and not exactly whether it’s going up or down.
Paul Solman: But this is how long-term capital management went bust, isn’t it?
David Martin: They had a number of very smart quantitative people on their team, and I think what happened is they got too big, too fast, and got involved in markets that they didn’t really understand. I’ve been following these markets for 25 years. Investors often ask me, “well, how far back have you tested your data?” And I say, I haven’t tested my data, I’ve lived it.
Paul Solman: So you’re pretty confident that you understand when prices get out of whack for one month versus another future delivery, and when it’s reasonable to expect that they’ll come back into alignment.
David Martin: That’s correct, and we trade with a certain risk profile, meaning profit-to-loss ratio. We’re not always right, of course, but, when we are wrong, we get out at a certain price point to stop our losses.
What’s Moving the Market?
Paul Solman: So is this more a story about market fundamentals or about irrational market psychology?
David Martin: I think it’s more about irrational market psychology for the time being. The world is not running out of cocoa right now. But people are panicking. It’s an opportunity for professional traders to take advantage of this rally because it is irrational and emotional. And generally in markets when there’s chaos, the guy who can weave through the market, see what’s happening, make sense of it, and quietly do what he thinks is the right thing and sit back and wait, the chaos does subside. There is order once again, contrary to public belief, and the relationships that we generally follow as professional traders do come back into balance.
Paul Solman: And so, the trader who sold up at $3,400, is that what that is? That’s the person who said this Ebola stuff is crazy, people are overreacting, I’m going to sell at this price and profit thereby.
Martin: That’s correct.
Paul Solman: But where did the fear come from, and why is it, in your view, sort of irrational?
David Martin: So, look at this Centers for Disease Control map of West Africa for a second. The bordering countries, in dark orange, are areas with confirmed and probable cases of the Ebola virus.
A lot of the people who live in these areas come to work in the Ivory Coast to help with the harvest. If they fall ill or die, they can’t come to work. If they do come to work and they’re infected, they infect these people, and then there’s no one left to process the harvest. There’s no one left to pick the beans, deliver them to the port, and make this whole system flow. So the fear is that if you disrupt this commercial activity, this whole supply chain, that’s going to cause the price to skyrocket, because they just can’t get the commodity. It’s simple supply and demand.
And then, what do you say to consumers who go to the grocery store and there’s no chocolate bars on the shelf? Or they can’t buy their hot cocoa? Cocoa’s in a thousand different things that we like to buy in the store. Consumers don’t like that. Add to that the fact that they see the images on the news of people suffering and dying, and everyone just afraid to even go near them; that’s a pretty emotional story, I think.
Paul Solman: So that doesn’t sound like an irrational fear; it sounds perfectly reasonable.
David Martin: Your logic is reasonable, but it’s irrational because there is plenty of cocoa in the supply chain right now, in the pipeline. So, the price skyrocketing like that is irrational, and it is an opportunity for professional traders.
Paul Solman: I was talking to a veteran Harvard Business School professor today, who had been a trader in his youth on the Minneapolis Grain Exchange. He said this reminded him of the traders, of which you were one, who used to look outside, see that it was raining, and say, “Ahh, I’m gonna sell, because it’s raining, bad weather, price goes down,” although this was in Minneapolis and had nothing to do with the grain harvest in the United States. That stuff actually happens?
David Martin: Less so, but it has happened a lot in the past. And it is irrational, but again, as a professional trader, we look for opportunities and chaos and hysteria like that as moneymaking opportunities.
Solman: How so? Sounds like a crass question, but how, as a professional trader, do you “play” the Ebola scare?
David Martin: It’s very difficult to sell into a market like that because you can’t really pick a top, but there are strategies to do it on the way up, where you participate in part of that rise without exposing yourself to losing your shirt.
Paul Solman: So you see the fear starting, and you buy cocoa because you figure the price is going up, and then at some point, you go, “Wait a second! I’m going to start to get out now, because it’s got to be the case that people are overreacting, and the price will fall.”
David Martin: That’s correct. And we have a lot of different technical programs that we use to measure that fear, to measure that volatility. When we see enough is enough, we get out, and we let the market calm down before we participate again.
Paul Solman: And this is like what’s been happening in the stock market recently?
David Martin: That’s true. But you have to remember one thing. The stock market has been like that for as long as there’s been a stock market. Price movements in markets in general aren’t about the values of the companies of the stock market. They’re not about the price of cocoa, or the price of coffee. They’re about the study of human behavior and how humans react. And that’s what most technical analysts study. You’re really studying psychology.
Watch 2013 Nobel laureate Robert Shiller explain how psychology affects markets.