Decline in cocoa grindings may signify industrial change

Chocolate as the poor man's luxury is starting to be affected by the global slowdown especially in the EU. The largest demand for cocoa is in Europe and the latest grinding numbers show another  slowdown. The slowdown in the second quarter was 18 percent while the third quarter declined 16 percent. The North American grindings were down by 9.8 and 2.2 percent in the second and third quarter. This suggests that demand is falling and something to watch more closely over the next quarter. However, like any market, looking at just the simple numbers may not provide the correct insight.

Cocoa beans are grinded into powder and butter. Grinders make money based on the combined ratio, the price of butter and powder divided by the cost of beans. This is a simple arbitrage no different than what is seen in other markets from soybeans where profits are determined by the crush and refiners where profits are based on the crack spread. If demand decreases there will be less grinding yet grindings will also be effected by the amount of butter and powder that this held in inventory. If there is a build of butter and powder and the combined ratio declines, destocking will reduce the grinding for any period. if spreads on products move higher, grindings will increase. The latest combined ratio suggests that grindings will again pick-up. 

The cocoa tree flowers in two cycles of six months the whole year round. Like most crops there will be periods of excess supply based on harvest that have to be controlled to maximize the price to farmers. About 40% of the crop is lost to pests and disease every year. An average tree produces 30 usable pods, which will leads to about 2 pounds of dark chocolate. The weather is critical and the location of production cannot change, although Malaysia is planning to increase production. The producers want to minimize market volatility.

The grindings will also be affected by changes in the market structure for cocoa. There has been an excess of grinding capacity which as caused the build in butter. There is a change in the market grinding capacity and where it is done. The EU and Switzerland usually represents 40% of the world grinding, but there has been a marked switch in grinding locations closer to the source in Africa and the places of new demand such as Asia. Grindings will decline in Europe not  because there is a double digit decline in demand but because grindings are done elsewhere. The grinding decrease in Asia has not been as large as seen in Europe. There are government incentives to have more value-added production in Africa.

There is also a new marketing system in the Ivory Coast, which represents a third of the world production, which has placed more uncertainty in the cocoa industry. The Ivory Coast will be regulated by the Cocoa and Coffee Council who will control the daily auctions which will set a guaranteed price for farmers and the export price. There will be a limit on how much any exporter can buy of the crop. There would be a stabilization fund which is used to minimize the difference between the farmers and export price. These changes in the distribution of cocoa from the farmer to the grinder has caused the market to be more cautious. 

Ghana also runs a state controlled system that guarantees a fixed price for farmers and is the second largest producer while Indonesia is the third largest bean producer although its crops have been of poorer quality with falling productivity from older trees. Nigeria is the fourth largest producer. The top four represent 74 percent of the world's production, so if some of the traditionla sources of production chnages the rules of the game, there will be a market reaction regardless of supply and demand conditions for cocoa and chocolate.