Monday, February 2, 2009

Why are Cocoa Prices Rising?

The prices of the main ingredient used to make chocolate - cocoa - have been increasing over the last few months. One of the topics we look at in 001 is how prices are determined and we use the supply and demand model to give an idea of this process.

One reason that prices increase from the supply and demand model are if supply decreases or if the supply curve shifts to the left. In the article linked above, we can see a number of supply factors that can cause the supply curve to shift to the left - and if demand remains constant - prices rise in equilibrium. Let's see what is happening with the supply for cocoa in the world's largest producers of cocoa - Ivory Coast.

First, bad weather (cold and heavy rains) have had a negative impact on the production of the agricultural product. Second, "black pod disease" has been on the rise among cocoa, which will reduce overall output. Third, the rising price of fertilizer has lead to less fertilizer (Law of Demand) being used resulting in a decline in cocoa production. Fourth, there have been a number of strikes by farmers and customs personnel, which means less is being harvested or less is making it through customs and out of the country. Fifth, Ghana - the second largest producer - has produced less cocoa than last season.

Yet, there is one last reason why cocoa prices are increasing, and that is due to supply expectations. The basic idea is that if people expect that supplies will run low (even if there is enough supplies or inventory to meet current consumption) then prices will start to rise. According to the article, cocoa inventories are at 39% of global consumption which is down from 54% in 2005-2006. These declining inventories are leading buyers to expect supply problems in the future, resulting in current prices to rise.

While it looks like a perfect supply storm, some also forecast a decline in demand for cocoa next year, which may offset the current price increases in cocoa.

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