MAKE OR BREAK: Living Under the “Volcano” of China’s Cotton Policies

From Cotton Grower Magazine – April 2015

 

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For five years running, the surplus in global cotton stocks has cast an ominous shadow over the cotton market. Cotton farmers from Texas to Xinjiang, from Gujarat to Mato Grosso, have been fully aware that the world has produced more cotton than it has needed during that span. Yet cotton farmers continued to plant and harvest the crop, because the market has told them to do so.

To kick off his annual economic update address at the Mid-South Farm and Gin Show in late February, Joe Nicosia illustrated this point with an apt analogy. China’s massive cotton reserve has and continues to account for the bulk of cotton stocks globally.

“We know that as long as China holds a surplus, it doesn’t really matter how much cotton there is in the world, because we can only experience what is free and open to the rest of the market,” said Nicosia, the global platform head for cotton at Louis Dreyfus Commodities.

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“So life can be peaceful under the volcano for a period of time, as long as it doesn’t erupt. And if it does, that lava – that cotton – can flow slowly, sometimes oozing out into the market place. Or it can erupt, and we can get flooded with it.”

The message was clear. The manner in which China goes about ridding itself of its massive cotton reserves will have a major impact on cotton producers. For American growers, the slower the better.

During his sprawling 45 minute speech, Nicosia honed in on a number of the factors influencing the cotton market, which has languished in the 60 cent range for much of the past several months.

China accounts for over half of global cotton stocks, thanks to a policy the country began implementing in 2009/10. At the time, the country held little to no cotton in reserves. In response, the Chinese government set into motion a plan to prop up its own cotton farming and cotton milling industries – one that involved importing and hoarding massive of amounts of cotton.

For the last four years, Nicosia said, the Chinese government averaged 17.7 million bales of cotton imports annually from around the globe. For comparison’s sake, that’s more than the entire U.S. crop, which averaged approximately 16 million bales during the same timeframe.

Eventually, China was going to have to reconsider its policy of buying the world’s surplus crop, Nicosia said. The country is expected to import only seven million bales in 2015, and even fewer the following year. Instead of a policy that stockpiled cotton and propped up the global market, China is now implementing a target support price policy to prop up its own domestic producers. China’s old system served to prop up global prices, helping to perpetuate the problem of oversupply.

“So what we have is a sea change that took place, and a lot of it was driven by China stopping from buying the world’s surplus,” Nicosia said, “They finally realized that they couldn’t just buy it, and store it, and change the world. Because at the elevated price, everyone in the world continued to grow it, and (China was) the only buyer of it.”

China’s shift in cotton policy created waves in the cotton market around the globe almost immediately. As soon as the country began hinting that it would no longer be importing large swaths of the world’s cotton, prices began slumping.

Now, Nicosia says, the world’s producers will have to take corrective measures to bring prices back. While current prices are unsavory, they could be just what the doctor ordered for cotton to right-size its supply and demand scenario in the long term.

“In 2015 and 2016, the world is going to have to grow less cotton,” Nicosia says. “It cannot continue this. And those are the reasons why December delivery is substantially below where it was last year, and that’s why cotton prices went into the upper 50 cent range. Because we have to force (reductions in cotton production) to take place.”

Around the Globe

While it is a near certainty that cotton acreage will be reduced globally in 2015, some countries are more likely to draw back plantings than others.

Growers in Brazil, for instance, see their best returns when they double-crop cotton with beans. They are not likely to draw back acreage for this reason. Australia, another of the world’s leading producers of cotton, is unlikely to produce less cotton as well. Output there is already down due to drought conditions in recent years.

“If it rains in Australia,” Nicosia says, “they’re going to plant every acre they can to cotton.”

India is another major producer of cotton, and its policy of maintaining a minimum support price will ensure that there won’t be a significant acreage reduction.

Ultimately, the largest acreage reductions will come from two countries: China and the United States. Nicosia forecasts that 64 percent of the acreage drawbacks globally in 2015 will come from these two countries.

In China, the switch from government stockpiling of domestically produced cotton (often bought at levels of near $1.20 per pound) to a target price system will make cotton production less attractive. In the remote northwest region of Xinjiang, however, cotton production remains a viable option.

“When they shifted to the target price system, what they told Xinjiang was that ‘We’re going to promise you that same prices you were getting before, but in the form of a target subsidy,’” Nicosia said. This was a sweeter deal than the one growers in the country’s eastern regions were offered.

The robust target price is used as a tool of appeasement for the traditionally troubled region of Xinjiang. Jobs are scarce in the remote area, and the cotton industry employs hundreds of thousands of inhabitants.

As a result, Chinese acreage reductions, while sizable, won’t be as drastic as they otherwise might have. According to Nicosia, estimates for cotton production in China for the coming year fall anywhere from 24 to 28 million bales. That number would represent a noteworthy drop off from previous years. Still, expect the Chinese to tighten their own cotton balance sheets not by significantly reducing domestic acreage, but by significantly limiting imports from elsewhere in the world.

On the Home Front

In America, cotton’s drop in profitability will be too much for producers to ignore. Nicosia is expecting a 15 percent decline in U.S. acreage in 2015, down to 9.4 million acres nationwide. In January, Cotton Grower magazine released results from its annual acreage survey, revealing a similar projection of 9.7 million acres in the U.S. in 2015.

Nicosia believes the perception of cotton in the U.S. is worse than the reality.

“I wouldn’t sell your cotton equipment just yet,” Nicosia said, citing the rising loan values available to U.S. producers. He also referenced factors such as equity payments and other income like cottonseed prices. He urged growers not to underestimate the value of the rising yields they have been able to achieve in the U.S. in recent years.

“In net return, you’re probably still getting over 70 cents, and you can work your way through this in some other form,” Nicosia said.

That message of resolve to American producers – hundreds of whom were in the room during the presentation – was used to underscore Nicosia’s conclusion. Market prices will remain contained until China’s reserves are diminished significantly, he said.

“Focus your attention on maximizing your equity. For the next short years in here before we can make a dent in the total world carry out and the Chinese carryout, that’s where you’re going to get your marginal return,” Nicosia said. “With that, remember that life can be peaceful under the volcano.”

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