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US: Frozen Orange Juice Special

The bull market in Orange Juice ended in 2007. At least that is what the monthly chart appears to show. The unprecedented run up in prices that began in 2004 peaked earlier this year as the 06/07 Florida orange harvest yielded a paltry 128.9 million boxes – one of the lowest production years ever. Prices have since declined as the market shifted focus to the new crop, only to rally again on dry Floridian weather patterns. Yet, with Florida harvest approaching, the strength may be short lived. There appear to be opportunities for option sellers in the juice market now. But before we begin discussing them, we must first understand what has brought prices to their present levels.

In 2004, the landscape for Orange Juice prices changed dramatically as 4 major hurricanes ripped through different segments of Florida’s growing regions. Florida groves suffered substantial long term damage, having lost over 16% of their commercial citrus trees. The state was reduced to about 65 million fruit bearing trees, enough for a decent crop in a high yielding crop year but still not enough to come close to production figures of pre-2004 levels

In the five years prior to the summer of 2004, Florida produced an average of 226.2 million boxes of oranges per year (1999-2003). 2004’s storm damaged crop produced only 149.6 million boxes of oranges. 2005 faired only moderately better, producing 151 million boxes of oranges.

Growers had higher hopes for the 06/07 crop but those hopes were soon dashed. It was hoped that replacement trees planted in 2004 would possibly produce some early fruit to help add to yields. But alas, most trees were not yet mature enough to yield fruit. In addition, the crop suffered from other problems. The freeze in February 2006, thought to be benign at the time, had an impact on yield after all. The canker eradication campaign that was active in 2006 cut into production as well. In the end, the 06/07 harvest produced only 128.9 million boxes of oranges. The market spent most of late 2006 and early 2007 factoring this figure into prices.

As spring 07 approached in Florida, however, the market again began to focus on the upcoming crop. The outlook was decidedly more optimistic. Trees were in good shape. Young trees planted in 04 were ready to yield fruit. Many analysts were projecting an 07/08 crop size upwards of 200 million boxes. Juice prices plummeted.

An unusually dry summer resulted in those estimates being shaved. October’s USDA supply/demand report forecasts Florida’s 07/08 citrus crop at 168 million boxes. The lowered forecast resulted in another rally in juice prices – which brings us to where we are now.

While 168 million boxes is below the original estimates, it is still more than 23% larger than last year’s harvest. The market appears to have priced in the lowered expectations and now sits ready for harvest. It is our opinion that this is where the opportunity exists.

What many don’t realize is that there is another key fundamental at work in this market that tends to bring heavy speculative buying into FCOJ nearly every year around this time and has probably helped push juice prices higher again. More importantly, this seasonal rally is often followed by something that can be of tremendous benefit to a call seller – a precipitous drop in prices into the month of December.

While many traders in North America may be familiar with this phenomenon, international investors may be asking themselves why they should bother investing in a market that seems to be so “localized.” Read on and you may find your reason.

This time of the year often finds speculators buying up orange juice contracts (and call options) in anticipation of the Florida “freeze season.” An early freeze in November can harm the existing orange crop as harvest approaches.

Therefore, the anticipation of freeze season for Florida oranges encourages the market to build in a risk premium. By December, however, the market has often done so. Coincidentally, this is when harvest begins in earnest. The production season coincides with the freeze season. What does that mean? That means that while speculators are often bidding up prices of Frozen O.J. futures in October/November, harvest usually begins in November/December. Therefore, barring an early frost, the market goes from a frost premium in price to a situation where Orange supply is the highest it will be at any time during the year (right at harvest time). Thus O.J. prices often go from their highest points of the year to their lowest in a matter of a month. This phenomenon is unique to the O.J. market but can often present a very lucrative opportunity for call option sellers.

We at Liberty Trading feel this way for two reasons.

1. Because of the volatility this creates in OJ calls
2. Because of a shifting fundamental that has, in our opinion, greatly reduced the risk in the trade (See below)

Is Freeze Season still Freeze Season for Florida Oranges?

With offices located in Florida, we are probably quoted more on the Orange Juice market than any other commodity by the news media. Yet, FCOJ also happens to be one of the least written about commodities on the board. This is why we believe that Orange Juice happens to be a great market to trade fundamentally. There simply is not a great amount of information available to the general trading public about Orange Juice. At least not as much as there is for markets like soybeans or crude oil, where the public has easy access to updates on crop conditions, soil moisture, storage builds or export quotas.

What many investors may not know is that there has been a basic fundamental change in Orange production in Florida over the last 15 years. Much like the Coffee market (which also prices in a `freeze premium` in the month of May) key orange production areas have gradually moved out of the high risk freeze areas in recent years. In the late ‘80s and early ‘90s, Florida`s orange crop was ravaged by a series of freezes. Instead of replanting trees in those same freeze prone areas, producers began planting trees much further south in the state. Today, Florida orange producing areas are significantly further south than 10-15 years ago, thus far less susceptible to the damaging freezes that we saw in the late 80`s and early 90’s.

More recently, the heaviest hurricane damage to Florida groves came in areas of central Florida. Many of these trees were replanted in counties further to the South as well. Nonetheless, prior to 2004, this seasonal November price rally in O.J. stubbornly persisted. This was due primarily, in our opinion, to the small speculator.

The market did not follow these seasonal tendencies in 05 or 06, primarily due to uncertainty surrounding the severely reduced yields resulting from prior year’s hurricanes.

The year 2007 has been a quiet one for storms however, and the market appears to have a pretty good handle on the crop size. (Liberty Trading’s official estimate is slightly higher than that of the USDA’s.)

With higher yields and more stability returning to the market, we see Orange Juice prices trending back into line with seasonal norms this year.

The Strategy: Selling Calls

We look at selling calls in this market as the highest probability way to profit from a cyclical down swing in OJ prices. Timing futures trades, even in trending markets, is difficult. With call selling, one does not need to determine where prices will go, only where prices will not go. Therefore, in selling calls at strikes well above the current price of OJ, one does not necessarily need FCOJ prices to decline to profit. Although one should be comfortable with the risks involved in writing option premium before embarking on a campaign, the call seller’s only profit requirement is for prices to remain anywhere below his strike price through expiration.

Many traders talk of trading with the trend but few find it easy to do so, seeking instead fast and sizable rewards by trying to pick tops and bottoms. We advise against this. As we state repeatedly in our book and our columns, selling options in favor of the fundamentals can substantially increase the odds of one’s success. In FCOJ, we have known fundamentals corresponding with a strong seasonal tendency.

As option sellers, we could be looking at an ideal situation for call selling over the next 2-4 weeks in the Juice market. While call premiums appear to be at attractive levels now, additional spec led strength could still add to over-inflated premium levels, making for excellent call option sales. Volatility premium still remains in the options – left over from prior year’s storm related price swings.

In regard to the potential for cold weather, we are not suggesting that a crop damaging freeze is not possible. Only that it is much more unlikely than it was 10-15 years ago. However, even in the unlikely event that a cold snap would occur, we feel if option sales are executed at higher strike prices, traders should be able to ride out all but the most severe freeze.

Stock option sellers take note. The margin requirement on futures options can be substantially less than that of stock options. The OJ options we priced this week had margin requirements vs. premium of about 1 to 1. In other words, put up $500 in margin to collect $500 in premium.

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