Cotton Pricing: Unusual Conditions, Unusual Opportunities

This has been an unusual season in several ways. First, we saw unseasonably high cotton prices during the fall and winter of 2009/10. These high prices stimulated a recovery of cotton plantings in the U.S. and elsewhere. There were excellent pre-plant and early season moisture conditions in important parts of the U.S. As of this writing, the USDA ratings of the U.S. crop condition have been notably good.

High cotton prices have continued throughout 2010, with an apparent old crop supply shortage relative to a recovering demand leading to an inversion of the futures market, i.e., old crop prices are higher than new crop. This is not typical, and it has highlighted the market’s attention on the transition to the new crop, and the size of those new supplies. Lastly, the early August price rally has provided some unusually late opportunities to hedge using simple option strategies.

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USDA’s bellwether August report painted a very bullish picture for the world cotton situation. If realized, the USDA numbers suggest strong world prices and no LDP payments for U.S. growers. The U.S. cotton outlook also remains bullish given the current USDA projections. If USDA’s August numbers play out, the U.S. ending stocks in 2010/11 will be only 3.2 million bales, roughly the same as the previous year. Historically, December contracts in “Stable Carryover” years have followed a sideways-to-gently-lower path toward expiration. This might give us a nearby futures price somewhere in the upper-60s to lower-70s. USDA is forecasting an average farm price between 61 and 75 cents, which jibes with the above futures pattern. If that were to happen, then the 2010/11 countercyclical payment rate would be negligible. The bullish outlook implies that income from the 2010 cotton drop will come mostly from the market. Have you prepared for that?

The September USDA report will be important in confirming, or revising, the August supply projections. A bumper crop for a major U.S. competitor could imply weaker U.S. exports, increasing carryover stocks and putting more pressure on harvest-time prices.

Nobody knows the direction or magnitude of future price movements with certainty. That is why your marketing decision should be like an insurance purchase.

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This outlook implies that growers are more responsible than ever for getting their cotton revenue from the market, versus from the government. A lot of growers have already reacted to historically high cotton prices by contracting with a pool or merchant. For those that haven’t taken any action, I would ask them to consider whether cotton futures between 75 and 85 cents would still allow them to cover their expected production costs. If it does, then I don’t see the sense in waiting.

It was possible when cotton futures were trading between 75 and 80 cents to lock in a flexible price floor in the upper 60s using put spread strategies (i.e., buying an at-the-money put and selling an out-of-the-money put). When the December contract breached 80 cents, put-derived floor prices in the lower 70 range became possible. These put strategies are flexible because if the futures and cash markets were to keep climbing, a grower could still sell his cotton in the higher cash market, and recoup whatever remains of his put option value. But if futures and cash prices slide, the increasing value of the put options provide an insurance payment.

What if prices don’t move a lot from this point forward? Well, if you don’t spend too much on your put option strategy (or your homeowners policy), you shouldn’t have much to complain about. It is not often that such a simple marketing strategy has been this affordable or this relevant.

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