The Cocoa Derivatives Market In the UK

ABSTRACT

There are generally two ways involved in trading cocoa – through futures derivatives and through options derivatives.  An examination of these two methods indicate that the main distinction between the two derivatives is that in futures derivatives, the buyer has the obligation to buy or sell the commodity, whereas in options contract, it is merely an option to buy or sell the commodity.  The futures derivatives, since an exchange such as the LIFFE acts as a counterparty, also has a set margin price which allows traders to better anticipate the risks involved in the fluctuations of cocoa prices.

INTRODUCTION

            Cocoa is thought to have been cultivated as a crop initially by the Maya in South America, where cocoa played a large part in the religious, social and medicinal dimensions of life.   It originates from the genus Theobroma, a group of small trees found in the Amazon basin and other tropical areas of South and Central America.  Cocoa, when combined with spices, served as a luxury drink in the Aztec empire.  It was brought to Spain in the 16^th century by the Conquistadors, and for nearly a century, chocolate – made from cocoa, sugar, cinnamon and vanilla – became an exclusive drink of the Spanish Royal Court, until it eventually achieved a wider popularity in cocoa houses of major European cities.  The receipt for “chocolat” (literally translated as “warm beverage” in fact, was attributed to the European community by the Spanish Conquistador Cortez during the 16^th century.  As the popularity of the chocolate drink grew, chocolate houses started appearing alongside coffee houses throughout the 17^th and 18^th century.  In 1828, Conrad J. Van Houten, a Dutch manufacture, began the landmark transformation of cocoa from a beverage to a solid form.

Van Houten found that a liquid cocoa butter (called liquor) could be pressed out of ground cocoa beans and then used as a base to make chocolate candy.  The mixture of cocoa mass, sugar, and cocoa butter (and also milk, in the case of milk chocolate) allowed the manufacture of chocolate.  Van Houten also invented alkalisation, which not only neutralized unpleasant tasting acids, but also improved colour and solubility.  Cocoa was reported to have been used as a form of currency until the 1840s.  Daniel Peters, a Swiss candy maker, invented milk chocolate 40 years later, and further increased the attraction for chocolate and the demand for cocoa beans.  The use of cocoa in the food manufacturing business today is widespread.  Cocoa butter is utilized in the production of chocolate and cosmetics; cocoa powder is used for baking, beverages, and coatings; and shell and residue for animal feedstuffs (Sucden, 2007; Infinity Trading Corporation, 2007).

            Production levels for cocoa are largely dependent on the cultivation policies of the various producing countries, as well as climatic and weather conditions, and prices.  A cocoa tree takes 5 to 7 years to reach its full production capacity from planting.  Cocoa products are made from the beans, or kernels of the cocoa fruit.  There are approximately 40 seeds, or beans, to each fruit, and the beans grow all year round, with thousands of small flowers, of which only 20 to 40 actually develop into fruit.  Once the cocoa beans are harvested, they are fermented and dried, and then cleaned, blended, and fragmented at the factory.   A winnowing machine is then used to remove the shells from the beans leaving cocoa nibs, which are alkalised before, during, or after roasting.  Once the fat is pressed out, it leaves cocoa butter and cocoa powder (Sucden, 2007).

            Consumption of cocoa is generally measured in terms of grindings.  Global consumption is reported to be approaching 3 million tones.    Cocoa is consumed predominantly in countries of relative high income.  To date, leading cocoa bean importing nations are the United States (US), the Netherlands, and Germany.  The US is the leading importer of cocoa products such as cocoa butter, liquor, and powder today.  Cocoa beans are traded in tonnes, among producers, exporters, importers, trade houses, processors, and manufacturers.   The International Cocoa Organization (ICCO) was set up to encourage price stability in a historically and potentially volatile marketplace.  During the 1980s, a bugger stock management scheme was set up to purchase cocoa in order to stem the rate of price decline, but was unfortunately unsuccessful and lead to the liquidation of the ICCO (Infinity Trading Corporation, 2007; Sucden, 2007).

CHAPTER ONE:    BACKGROUND

Section A.      Introduction of the Futures Market of Cocoa

            Countries which produce cocoa for export work through a chain of local traders and central sales organizations.  In these countries, traders, buyers, brokers and agents carry out their trade and together form the marketing parties which agree on the quality of the cocoa for trading, the time and place of delivery, and the quantities.  Since supply of cocoa tends to be extremely vulnerable due to climatic changes, the price of cocoa also tends to rise or fall during the year because of these climatic changes.  Cocoa buyers – which is the cocoa-processing industry and its clients – naturally want to cover themselves against these price fluctuations.  The futures market in cocoa owes its very existence to these uncertainties.  The world price of cocoa is determined by what is called the futures market of cocoa.

Without the need of conducting personal or face-to-face meetings, buyers and sellers of cocoa are able to conclude contracts about the future deliveries of cocoa beans on the futures market.   At the time of negotiation of these contracts, the cocoa beans which are the subject matter of the contracts have usually not even begun to grow.  In other words, the subject matter of the contracts are not yet existing cocoa, but this actually provides for an opportunity for a lively and exciting global trade on cocoa.   These contracts, no matter where executed, have to be registered with what is called a “clearing house.”   Through the clearinghouse, a delivery commitment can be nullified by completion of a sales contract for the same quantity and month of delivery.  The clearinghouse also serves to settle the differences in price (European Cocoa Association, 2007).

            There are only two places where cocoa futures contracts can be exchanged: the London International Financial Futures and Options Exchange (LIFFE or Euronext.liffe) and the Coffee, Sugar, and Cocoa Exchange (CSCE) under the New York Board of Trade (NYBOT) (International Cocoa Organization, 2007; Sucden, 2007).   The most important futures market thus for cocoa trading are in London and New York.  Price trends however can be closely followed from anywhere in the world (European Cocoa Association, 2007).

Section B.       Overview of the Cocoa Futures Derivatives in the UK Market

            As mentioned in Section A of this chapter, LIFFE in London and CSCE in New York, constitute the two main futures markets for cocoa.  The contracts are guaranteed by the London Clearing House and the Commodity Futures Clearing Corporation of New York.  The two contracts demonstrate a strong correlation but still offer arbitrage possibilities to parties to a sales contract for cocoa.  Both the LIFFE and CSCE contracts represent a high proportion of trade participation.  The contract in London is traded in pounds sterling per metric tonne of fermented cocoa, in bags (or in bulk from May 2000), and from a number of origins, with discounts applied to some.  The LIFFE contract has been traded exclusively on LIFFE’s Connect trading system since November 2000, and now over 80% of the world production is deliverable against the LIFFE contract.  On the other hand, the contract in New York is traded in dollars per metric tonne of beans of any origin, as long as they meet the import standards.  The CSCE has also set premiums for different origins of cocoa (Sucden, 2007).

            LIFFE and CSCE provide the facility and trading platform that bring cocoa buyers and sellers together, in addition to setting and enforce rules to ensure that cocoa trading takes place in an open and competitive environment.  For this reason, all bids and offers must be made through the exchange’s clearing house, either through an electronic order-entry trading system as in the case of LIFFE contracts, or through a designated trading pit by open outcry, as in the case of CSCE contracts.  The result is that each exchange’s clearinghouse acts as the buyer to all sellers, and as the seller to all buyers (International Cocoa Organization, 2007).

Section C.      Plan of the Dissertation

            The primary objective of this dissertation is to provide for an in-depth examination and analysis of the role of cocoa as a form of derivatives in terms of managing financial risks by focusing on the future market of cocoa trade in LIFFE.  As such, the thesis breaks down this objective into the following aims:

• To provide for a brief background of the futures market of cocoa as a derivative under the LIFFE.
• To discuss the futures of cocoa as trade in general, with a discussion on the concepts of derivatives, forward contracts and futures contracts, options and swaps, and futures and options derivatives.
• To examine the commodity market, futures market, and option market for cocoa, as well as the usefulness of derivative contracts of cocoa.

CHAPTER TWO:   LITERATURE REVIEW

 

Section A.      Futures of Cocoa as Trade

            Futures traders are traditionally categorized into two groups: 1) hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes, and includes producers and consumers of a commodity; and 2) speculators, who seek to make a profit by predicting market moves and buying a commodity “on paper” for which they have no practical use.

   In traditional commodities markets, for instance, farmers often sell futures contracts for cocoa beans they produce to guarantee a certain price, making it easier for them to plan.  In modern financial markets, as another example, “producers” of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.  The social utility of futures markets is mainly in the transfer of risk, and the increase of liquidity between traders with different risk and time preferences, from a hedger to a speculator (Wikipedia, 2007a).

            Trade of cocoa as a market factor is heavily influenced by the differences in time, place and price.  Producers like to sell when the price is high, and buyers naturally prefer to buy when the price is low.  Between the buyer and the seller, there is a trader who is prepared to buy at high prices and to sell when prices are falling.  By means of a futures market contracts, traders get to cover themselves against risks.  In this way, traders protect themselves, and also their suppliers and their buyers against price fluctuations, while making money into the bargain.   For instance, traders provide their clients with additional services by financing transactions in advance on behalf of their suppliers or buyers; or by securing certain types of cocoa for their client which, without intervention, may have been bought under less advantageous conditions (European Cocoa Association, 2007).

Section B.       Brief History of Derivatives

            Derivatives are financial instruments that have no intrinsic value, but derive their value from something else.  These financial instruments hedge the risk of owning things that are subject to unexpected price fluctuations, such as cocoa in this case.   There are two main types of derivatives: 1) futures, or contracts for future delivery at a specified price; and 2) options, which give one party the opportunity to buy from or sell to the other party at a prearranged price (Davies, no date).

            The first exchange for trading derivatives was with the Royal Exchange in London, which permitted forward contracting.   The Dutch Tulip bulb mania was characterised by forward contracting on tulip bulbs around 1637.  The first futures contracts have been traced to the Yodoya rice market in Osaka, Japan around 1650.  These were evidently standardised contracts, similar to today’s futures contracts, although it is not known if the contracts were marked to market daily and/or had credit guarantees (Chance, 1998).

Though the origins of futures trading can be supposedly traced to Ancient Greek or Phoenician times, the history of modern futures trading can be traced back to Chicago, US in the early 1800s.  In 1848, the Chicago Board of Trade (CBOT) became the first futures exchange in the world.  In 1851, the forward contracts were introduced, while standardised futures contracts were introduced in 1865.   In the 1970s, the financial futures contracts developed and allowed trading in the future value of interest rates.  These, in particular with respect to the 90-day Eurodollar contract introduced in 1981, had a huge impact on the development of the interest rate swap market (AllExperts, 2007).

            Futures market participants fall into two main categories: 1) commercial (hedgers) and non-commercial (speculators) traders.  Commercial traders or hedgers are market participants who try to avoid or reduce a possible loss in the cash market by making counterbalancing transactions in the futures market.  On the other hand, speculators do not produce or use a commodity, but risk their own capital by trading futures in that commodity with the hope of making a profit from the price changes (International Cocoa Organization, 2007).

            To enter into a transaction with a futures exchange’s clearing house, a broker must deposit a specified amount of money to guarantee his or her commitment to the terms of the contract.  The money is called “initial margin” and is a 2-10% proportion of the total value of the contract sought to be entered into.  Once the contract is open, the position is then “marked to the market” daily.

Should the futures position lose value, such as when the market moves against it, or the trader is long and the market goes down, then the amount of money in the margin account will decline accordingly.  For instance, in the case of cocoa, if the price of cocoa declines by one dollar per tonne, or $10 per contract (i.e. a cocoa futures contract calls for delivery of a lot size of 10 tonnes of cocoa beans), this amount is subtracted from the accounts of all buyers and added to the accounts of all sellers.  Should the amount of money in the margin account fall below the specified maintenance margin, which is set at a level less than or equal to the initial margin, then the futures trader will be required to post additional variation margin to bring the account up the initial margin level.  But on the other hand, should the futures position be profitable, then the profits will be added to the margin account.  It should be noted that, while the initial margin is small, a trader with a large and consistently losing position may have to tie up significant volumes of cash to maintain the margin (International Cocoa Organization, 2007).

Section C.      Forward Contracts and Futures Contracts

            A forward contract is an agreement between two parties to buy or sell an asset at a pre-agreed future point in time, separating the trade date from the delivery date.  It is primarily used to control and hedge risk.  Forward contracts involve a forward price which the buyer and seller agree on in advance.  The forward price in these contracts should be differentiated from the spot price, which is the price at which the subject matter of the contract changes hands on the spot date, which is typically two business days.   The main distinction between the spot price and the forward price is the forward premium or forward discount.  No actual cash changes hands in a forward transaction, and once the transaction is collaterised, an exchange of margin will take place pursuant to a pre-agreed rule or schedule, but otherwise, not asset of any kind actually changes hands until the maturity of the contract (Wikipedia, 2007b).

            A standardised forward contract which is traded on an exchange is known as a futures contract (Wikipedia, 2007b).  This is a standardised, binding agreement to make or take delivery of a specified quantity and grade of a commodity at an established point in the future (called the delivery date or final settlement date)  and at an agreed upon price.  The pre-set price is called the futures price, while the price of the asset on the delivery date is called the settlement price.  The settlement price usually converges towards the futures price on the delivery date.  The contract buyer is obligated to take delivery of cocoa according to contract terms at a specified date, while sellers are obligated to make delivery.  Buyers can be considered as “long” and seller “short” in the futures contract.  This contract is called “standardised” meaning that the terms, size, and duration of the contract are predetermined and meet certain criteria, leaving only the contract price as the negotiable variable (Infinity Trading Corporation, 2007; Wikipedia, 2007a).

            Futures contracts, also referred to as futures, are exchange-traded derivatives, with the exchange’s clearinghouse acting as the counterparty on all contracts (Wikipedia, 2007a).

            Forward and futures contracts are very similar in that both involve the delivery of a commodity on a future date.  There are however important differences between these two types of contracts.  Futures contracts are always traded on an exchange, while forward contracts are traded over-the-counter, or may simply be a private signed contract between two parties.

   Certain forward contracts do not have to strictly follow a standardised form unlike futures contracts. Settlement of the price also differs between the two contracts – future contracts are settled at the settlement price which is fixed on the last trading date of the contract, whereas forward contracts are settled by the delivery of the commodity at the specified contract price.  In terms of physical delivery of the commodity, the forward contract specifies to whom delivery should be made, while in the futures contract, the counterparty is chosen randomly by the exchange.  Lastly, there are no cash flows until delivery in forward contracts, while in futures contracts, there are margin requirements and daily mark-to-market of the traders’ accounts (Wikipedia, 2007a).

Section D.      Options/Swaps

            Options

Options are a kind of derivative contracts wherein the future payoffs to the buyer and seller are determined by the price of another security.   Options include call options and put options.  A call option is an agreement wherein the buyer or holder has the right – but not the obligation – to exercise the option of buying a commodity at a set price (called the strike price) on a future date, in the case of European style options, or of buying at a set price not later than a future date, in the case of an American style option.

The seller or writer, on the other hand, has the obligation to honour the terms of the contract.   The second type of option contracts is a put option, which is an agreement whereby the buyer again has the right, but not the obligation, of selling a commodity at the strike price or on or before a future date, and the seller has the obligation to honour the terms of the contract.   Since the option gives the buyer the right, and the seller an obligation, then the buyer is required to pay an option premium to the seller.  The buyer is then considered to have the long position while the seller has the short position (Wikipedia, 2007c).

            Swaps

            A swap is an over-the-counter derivative where two counterparties exchange one stream of cash flows against another stream, known as the “legs” of the contract.  Swaps are used to hedge certain risks, such as interest rate risk, and for speculation.  Since these are over-the-counter derivatives, they are negotiated outside exchanges and may not be bough and sold like securities or futures contracts.   Since each swap is a unique contract, the only way to get out of the obligation is by mutual agreement of the parties to tear up the contract, or by reassigning the swap to a third party, with the requirement of acquiring the consent of the counterparty (Wikipedia, 2007d).

Section E.       Futures and Options Derivatives

A notable difference between an option contract and the futures contract is the position of the buyer.  In an option contract, the buyer or holder is given the right, but not the obligation, to buy or sell.  The owner of an options contract may exercise the contract.  On the other hand, in a futures contract, the buyer has the obligation to buy or sell under the contract (Wikipedia, 2007a).

An advantage of futures contracts is leverage.  Since futures transactions do not require full advance payment for the commodity, and simply require payment of the margin,  the buyer of a futures contract which increases in value, or the seller of a futures contract which decreases in value, can realize a profit which can be substantial in relation to the commitment of capital.  For instance, assume that an investor has purchased cocoa futures contracts, each representing 10 metric tons of cocoa, with a $1,100 margin deposit.  If the investor bought one contract at $1,250/metric ton, or 12,500 worth of cocoa, and sold the contract when cocoa reached $1,410/metric ton, he would then realize a profit of $1,600 ($160 x 10 metric tons = $1,600) or a 145% return on the initial margin deposit, which is returned when the position is liquidated (Infinity Trading Corporation, 2007).

On the other hand, in the case of options contracts, since the option buyer or holder is under no obligation to enter the futures market, then losses are strictly limited to the purchase value – in other words, there are no margin calls.  Should the underlying futures market move against an option position, then the buyer can simply let the option expire worthless.  The potential gains are unlimited, net of the premium cost.  This unique feature of options contracts allows hedgers to guard against adverse price movements at a known cost without foregoing the benefits of favourable price movements.  In an options hedge, gains are only reduced by the premium paid, unlike in futures hedges, where gains in the cash market are offset by futures market losses (Infinity Trading Corporation, 2007).

CHAPTER THREE:                      COMMODITY MARKET FOR COCOA FUTURE MARKET

 

Section A.      The Market for Cocoa and its Profitability

            Raw material cocoa has been and continues to be an important source of income for many producer countries.  Yield differ from year to year, due to many factors such as climatic circumstances, making it necessary for the governments in these various countries to be closely involved in the ups and downs of cocoa production and its export.  International treaties have been concluded as well in support of these countries, such as the Treaty of Lomé.   In this treaty, the European Community (EU) commits itself to refrain from levying import duties on cocoa imports from a number of producer countries.   Attempts to stabilize the price of cocoa have involved the inclusion of long-range price agreements in treaties between producer and consumer countries.  Unfortunately, such treaties have not been very successful in practice.  For instance, in the early 1990s, some West African nations privatized their raw materials industry, and this process is still continuing (European Cocoa Association, 2007).

            The cocoa trade strictly involves a tropical plant, since cocoa thrives only in hot, rainy climates with cultivation generally confined to areas not more than 20 degrees north or south of the equator.  The cocoa tree takes 4 or 5 years after planting to yield cocoa beans, and from 8 to 10 years to achieve maximum production.  The fruit of the cocoa tree appears as pods primarily on the trees’ trunk and lower main branches.  Once these pods become ripe, they are cut down and opened, and the beans are then removed, fermented, and dried (Infinity Trading Corporation, 2007).

            The cocoa butter and cocoa powder which are extracted from these beans are used in a wide variety of products, ranging from cosmetic to pharmaceuticals, but its primary use is in the manufacture of chocolate – drinks and candy alike.  The Ivory Coast is the leading cocoa producing nation, followed by Ghana and Indonesia, then Nigeria and Brazil (Infinity Trading Corporation, 2007).

            Cocoa is consumed predominantly in countries of relatively high income, with the US, the Netherlands, and Germany, as the leading cocoa bean importing nations.  The three counties accounted for an estimated 54% of world imports in 1995-1996 on cocoa.  The US is the leading importer of cocoa products such as cocoa butter, liquor, powder, accounting for 12% of world imports (Infinity Trading Corporation, 2007).

Section B.       How Cocoa are Traded

            In examining cocoa trading, a distinction must be made between the actual or physical markets and the futures or terminal markets.  Most of all cocoa coming from origin countries is sold through the physical market.  The structure and length of the cocoa marketing channels differ from region to region within the same producing country as well as across producing countries.   One channel involves the cocoa farmers and exporters and at least two middlemen, the small traders and wholesalers.  Small traders are the ones who buy the cocoa beans directly from the farmers by visiting each cocoa farmer.  The small buyers then sell the beans to wholesalers who in turn re-sell the beans to exporters.  Another channel is when cocoa beans are sold directly to exporters by a farmers’ cooperatives, or even directly exported by the cooperative (International Cocoa Organization, 2007).

            The cocoa beans are then brought to the ports for export.  These cocoa ports must be favourably situated with the cocoa-processing industry, such as Amsterdam. Once the cocoa beans reach the port for export, they are stocked in warehouses where they are graded and subsequently loaded into cargo vessels.  These warehouses should typically have cement, non-flammable floors without cracks and crevices for insects to hide, and should be at a floor level higher than the surrounding land to prevent any possible flooding and to allow water to flow away.  In certain producing countries, cocoa beans are processes in the conditioning plant located in port warehouses due to the high moisture level of the cocoa beans and the high variance in their quality.  Hand or mechanical conditioning is used to blend poor quality with good quality cocoa beans (International Cocoa Organization, 2007).

            Once the cocoa beans arrive at the warehouses, warehousing companies check the loads for quality and/or weight by taking samples of each consignment and separating the damaged parts.  The warehousing companies also handle the completion of documents and the settling of possible damages (European Cocoa Association, 2007).

            Once the cocoa beans have been graded and loaded into cargo vessel, they are then shipped either in new jute bars or in bulk, with the latter shipment method growing in popularity over the recent years for being up to one-third cheaper than conventional shipment in jute bags.  Bulk transports involve the cocoa beans being loosely dumped into containers.  Loose cocoa beans are loaded in shipping containers or directly into the hold of the ship, in what is called as the “mega-bulk” method often adopted by larger cocoa processors.  The sacks or containers may be stored in warehouses or directly transhipped to the cocoa processing industry.  Modern silo today can also produce cocoa blends at the client’s specifications.  Transport is by road, rail, or water (International Cocoa Organization, 2007; European Cocoa Association, 2007).

            Aside from the logistical side of cocoa trading discussed, warehousing and inspection companies also have other important functions.  Under rigorously controlled conditions, their sheds also store consignments for the London futures market – the LIFFE.  It is thus not surprising that warehousing companies have been well-known for their reliability, flexibility, and knowledge of the logistics involved in cocoa trading (European Cocoa Association, 2007).

            It should be noted that cocoa futures contracts are more used to offset the risk of adverse price movements rather than as to secure the supply of cocoa beans.  The futures contract, as earlier defined in this dissertation, is an agreement to make or take delivery of a specific quantity and quality of cocoa beans at a pre-agreed place and time in the future.  Such being the nature of the agreement, cocoa futures contracts tend to be interchangeable, except with regard to the delivery time (International Cocoa Organization, 2007).

Section C.      The Users

            Cocoa cultivation initially spread into the immediate vicinity of the cocoa tree: from Brazil and Mexico to Central American and the Caribbean area.   In the 16^th century, the Spanish also introduced cocoa to the Indonesian archipelago, and to West Africa, which no account for more than half of the yearly world crop.  Production of cocoa beans in Southeast Asia has also increased in recent years (European Cocoa Association, 2007.)

            Cocoa has grown in more than 35 countries, with the cultivated areas covering between 3.5 and 4.5 million hectares, with each area yielding as estimated annual production of 2.7 million tonnes of cocoa beans.  The most important producing countries of cocoa beans trading in LIFFE, CSCE, or both, as well as the amount of cocoa traded from these countries,  are:

• Ivory Coast 1,100,000 tonnes
• Ghana    300,000 tonnes
• Indonesia    300,000 tonnes
• Nigeria    165,000 tonnes
• Brazil    160,000 tones
• Cameroon    125,000 tonnes
• Malaysia    100,000 tonnes
• Ecuador    100,000 tonnes
• Dominican Rep.      55,000 tonnes
• Columbia      45,000 tonnes
• Mexico                  40,000 tonnes  (European Cocoa Association, 2007).

Each exchange wherein these producing countries trade their cocoa is normally regulated by a national government, or semi-governmental regulatory agency.        In the UK, the LIFFE is regulated by the Financial Services Authority, while in the USA, the futures exchange is regulated by the Commodity Futures Trading Commission.  In other countries, the role is performed in Australia by the Australian Securities and Investments Commission, in Hong Kong by the Securities and Futures Commission, and in Singapore by the Monetary Authority of Singapore (AllExperts, 2007).

Section D.       Price Development for Cocoa Market and Volume of Cocoa Traded in the World Market

            Cocoa prices mainly respond to supply and demand factors.  International prices usually follow a long-term pattern which is linked to the cocoa cycle (estimated to be over 20 years).  During high demand period for cocoa, there is a supply surplus that results in falling and eventually stagnating prices.  As a result, low prices due to overproduction generally have a negative impact on harvesting.  This encourages farmers to switch to other crops – a factor which again permits world cocoa prices to rise.  Thus, the cocoa cycle is characterized by boom and bust effects (United Nations Conference on Trade and Development, 2006).

            Cocoa prices experienced an important increase in the 1970s, which encouraged production in countries like Malaysia and Indonesia.  Since the beginning of the 1980s, unfortunately, cocoa prices have declined.  In spite of a modest recovery in the mid-1990s, international cocoa prices are low compared to those prevailing in the 1970s (United Nations Conference on Trade and Development, 2006).  According to a report by Burden (2002):

“In 1972, the International Cocoa Organization (ICCO) attempted to stabilize cocoa prices by creating export quotas and a Buffer Stock program to absorb excess production. Prices were relatively high through the 1970’s so the Buffer Stock program was not implemented until 1982. By then, the quota system had been discontinued by a new agreement made in 1980. The Buffer Program ran out of money after purchasing 100 thousand tons in 1981. It was not until 1988 that another 150 thousand tons were purchased. Member countries funded this Buffer Stock program by paying levies on imports and exports.

The program was suspended as member countries started to have problems paying these levies and experienced disagreements. The 1993 agreement called for the liquidation of the Buffer Stocks over the next five years. Notice how the price of Cocoa rallied during those years contrary to logic. As silly as it may sound, resumption of the Buffer Stock program has become an issue again since the price of cocoa dropped so low in the year 2000. It is interesting to note that the price of cocoa did rally significantly in early 1981, in response to the expectation of the purchases by the program. But once the program was implemented, the impact was minimal in helping prop prices up “ (Burden, 2002).

FIGURE 1

WORLD PRICES AND PRODUCTION OF COCOA (FROM 1971/1972 TO 2005/06)

(Source: UNCTAD, data from International Cocoa Organization, quarterly bulletin of cocoa statistics.)

            The ICCO has consistently monitored daily cocoa prices since 1960.   The daily price for cocoa beans is calculated using the average of the quotations of the nearest three active future trading months on the LIFFE and on the NYBOT at the time of the London close (International Cocoa Organization. 2006).   Table 1 below shows the averages of the daily prices of cocoa beans from 1960-2006 as collated by the ICCO.