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Hedging for a cocoa shortage

A hedge fund socked away 240,100 tons.

August 9, 2010 at 10:11PM

Since Armajaro, a London-based hedge fund, took delivery of 7 percent of the world's annual cocoa-bean production last month, there have been whispers about evil speculators.

On July 2, 16 cocoa companies complained to NYSE Liffe, the global derivatives business of the NYSE Euronext group, that the market had been manipulated and called for more regulation.

Armajaro's retort is that its position should not influence the market's long-term fundamentals. But that has not stopped prices surging, nor the fund's boss, Anthony Ward, being dubbed "Chocfinger" by British tabloids.

Far less attention has been paid to the fund's thesis. Unusually, it took physical control of the 240,100 tons it purchased in the cocoa futures market for just over $1 billion. The beans now lie refrigerated in warehouses in undisclosed locations across Europe. They can stay there for up to 20 years, although Armajaro hopes to have taken profits long before that.

Ward reckons cocoa production in Ivory Coast is slumping faster than commonly acknowledged. The West African country produces more than a third of the world's cocoa -- some 1.37 million tons per year since 2005, according to the U.N. Food and Agriculture Organization. But years of underinvestment following a civil war in 2002-04 could jeopardize this.

The yields of cocoa trees drop after 30 years of production, and the last planting cycle was in the 1970s, according to Sudakshina Unnikrishnan of Barclays Capital. Nestlé, a food giant, plans to spend about $105 million to help plant 10 million new trees in the next decade. But they are likely to produce 1,500 tons of cocoa, a tiny fraction of the country's output.

Cocoa production is difficult to mechanize, and the peculiarities of Ivory Coast mean it will be hard to ramp up activity quickly. Most trees are owned by around 900,000 smallholders who often scale back on insecticides when their costs rise, as they did in 2008.

That matters because higher rainfall in recent years has increased the prevalence of "black pod," a fungal disease that lowers cocoa yields. High taxes also put farmers off: It is estimated that about 40 percent of the international price of cocoa goes to the government.

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The real risk for the hedge fund may be a rise in supply from elsewhere. Indonesia and Nigeria have ramped up production by several percentage points annually for the past 10 years. Yields in these countries are high due to increased use of hybrid seeds, which the government promotes.

As cocoa prices have risen, more countries have been drawn in. Colombia recently announced plans to repair its flagging industry by doubling the land under cultivation. Given a lag time of four years between when a cocoa tree is planted and when it bears beans, supply could be more robust than Armajaro thinks.

At least demand is on the hedge fund's side. Existing consumers can be relied upon to chomp chocolate, and newcomers are getting a taste for it.

Beijing confectioners built a 33-foot replica of the Great Wall and the terra cotta army with 80 tons of chocolate earlier this year, a sign of the country's newfound enthusiasm for the bean. The average Chinese person is estimated to consume only 100 grams of chocolate a year -- a hundredth or so of the amount devoured in northern Europe.

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about the writer

THE ECONOMIST

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