Cocoa originated out of the Columbian exchange of goods between Mexico and Central America and European countries after Columbus made his transatlantic trek. This basis for chocolate became a foundational ingredient in the developed world and was consumed in large enough quantities to warrant trading on the public market. Since its introduction to the New York exchange in 1925, Cocoa has grown into the ninth most traded commodity right behind sugar. Prices for both have increased substantially over the last few years but this rising valuation is a double-edged sword. To understand why, we need to understand the reasons behind futures trading.

A futures contract is a promise to sell the commodity or take physical delivery of said commodity on a specified date for an established price. Trading futures contracts is used for something called price discovery as well as risk transfer. Price discovery occurs when the pricing on each contract transaction allows the market to establish a commodity’s notional worth.  Producers, or commercial market participants, use commodity futures contracts to hedge against a volatile market while traders, or non-commercial market participants, seek to reap profits from shortages, surpluses and currency arbitrage. So how does this all apply to cocoa?

There are three main players in the cocoa industry are the producers, grinders and manufacturers. Even though there are 65 equatorial countries producing cocoa from central America to Indonesia, Africa – primarily the Ivory Coast and Ghana – supplies over 70% of the world’s cocoa. There is no production or export of cocoa in the OCED countries that consume the majority of it. Because of this concentration and the fact that cocoa is typically grown by smallholder farmers on farms averaging 2 to 4 hectares in size, production of the world’s cocoa is extremely vulnerable to political and civil unrest, antiquated farming practices, labor issues and the effect of weather, diseases, and pests.

For instance, in 2023 constant rain in West Africa, kept farmers out of the fields and encouraged crop disease. In fact, industry analysts are concerned that current cocoa production cannot replenish supplies to avoid a global deficit. How bad is it? Well, since the rainy season started May 1, West Africa’s precipitation has been more than double the 30-year average.

The situation isn’t much better in Cameroon where in the 2022-2023 season, the country exported 186,754 tons of cocoa beans, an 18.4% YoY decrease. This drop in production can be attributed to vegetative rest periods, security concerns, and the implementation of the 2023 Finance Act which levies a 10% exit duty on FOB value, increasing export cost cost per kilogram. Illegal exports to Nigeria further hamper production efforts by increasing input costs for farmers.

According to Ghana’s cocoa regulator, some of its cocoa farmers will be unable to fulfill their cocoa contracts for the second year in a row with the country’s 2022/23 cocoa crop expected to come in around 683,000 MT, a 13-year low some 24% behind initial estimates of 850,000 MT. This serious dip has been blamed on a lack of fertilizers and black pod disease. If El Nino rears its ugly head, we could see a further decline in global cocoa production.

This deficiency has already impacted the marketplace with the National Confectioners Association reporting that cocoa grinding efforts in the U.S., Canada and Mexico, dropped 17.92% in Q3 2023 compared to the same period in 2022. This will translate into higher commodity pricing. Good news for futures traders but for manufacturers, it’s different story.

Companies like Hershey have typically endured bad times because they were immediately able to pass the savings onto the consumer and during the last phase of inflation, the industry has been able to raise prices 13-20% and nobody flinched. End-users of confectionary treats, were classically bonded to well-known brands and willing to pay for their sweet addiction from a trusted name. However, we have become far more cost conscious since the pandemic and private labels, no-name brands that we once passed over are gaining enough ground to give major chocolate manufacturers pause.

In fact, sales of private labels in the U.S. grew 9% between January to June. Despite Hershey beating estimates, the increase in private label acceptance will only cut further into their bottom line as costs increase. In order to combat competition, American chocolate manufacturers are having to invest in R&D to reinvent products lines with innovative new offerings as well as a bevy of variations to existing chocolate treats, not unlike the Japanese confectionary market where you can buy 300 different flavors of Kit Kat.

So even though Hershey and other big names may remain cash positive in 2024, there will likely be decreased sales and a shrinking profit as competition heats up, so smart money may take advantage of the commodity in the form of cocoa futures and options to ride out this sector transition. Remember to do your due diligence and speak with an investment professional before making any portfolio decisions. Good luck to all.