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Perk up! Coffee headed higher

PIERRE ANDRIEU | AFP | Getty Images

Coffee is the worst performing soft commodity this year as rains in Brazil drive down prices, but experts say positive fundamentals should translate into a solid rebound.

Arabica coffee listed on the Intercontinental Exchange (ICE) is down over 20 percent year-to-date, with prices hovering at one-year lows around 130 U.S. cents per pound. But commodity analysts at Rabobank expect prices to climb 15 percent to 150 cents by year-end.

"The fundamental wheels of coffee should exert their upward pressure in the coming months as a significant supply deficit materializes in further stock declines both in producing and non-producing countries," Rabobank said.

Coffee outperformed among soft commodities in 2014 as a drought in Brazil – the world's largest coffee producer – limited supplies. However, favorable weather spurred heavy selling this year, which has been exacerbated by the Brazilian real's around 33 percent decline against the U.S. dollar over the past six months.

Lower output, higher demand

Rabobank expects a global deficit of 6 million bags in the current 2014/15 crop year, citing lower output from Brazil and resilient global demand. In the following year, they expect the deficit to hit 1.6 million bags.

The International Coffee Organization (ICO) shares similar views. In a market report published last week, it projected global coffee output of 142 million bags for 2014-15, compared to an estimated 149 million bags consumed.

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"Given the lower production levels in 2014/15, it is expected that [inventory] stocks will be used to supply the market. This would normally result in higher prices," said Mauricio Galindo, the ICO's head of operations.

Despite recent rainfall in Brazil, only 48 million bags of coffee were harvested in 2014/15, a drop of 7 million bags from the previous year due to a harsh 3-month drought in early 2014, Rabobank said.

The bulk of coffee crops typically grow on new tree branches; given that last year's dry weather conditions hindered tree growth, the 2015-16 crop will be hurt as well, the bank said.

Strong demand from North America, Europe and Japan will also underpin higher market prices, the ICO said. On average, these regions post a 1.6 percent rise in annual demand.

The bear case

Not everyone is as optimistic, however.

"We have been constructive of Arabica coffee prices since January 2014, but the technical fund unwind of late puts our price outlook targeting levels north of $2.00/lb in jeopardy," said Citi analysts in a recent note.

Citi said that a variety of technical factors could continue to pressure prices in the short-term, such as funds cutting 80 percent of net length on ICE futures since late November, category gross shorts up 7-fold, and the Brazilian real poised to weaken to 3.00-3.10 per dollar.