Plexus: European Economy Impacts Cotton Market

NY futures ended the week slightly lower, as December dropped 124 points to close at 71.39 cents.

The cotton market weakened earlier this week after renewed jitters about Spain and Italy led to another “risk off” move by money managers that put pressure on the entire commodity complex, including drought-stricken corn and soybeans.

Alarm bells went off after Spanish ten-year yields spiked as high as 7.75% this week, while Italy saw its yields rise to 6.7%. However, it didn’t take long for policy makers to respond, as ECB president Draghi assured markets today that the central bank would do whatever it takes to rescue the Euro. What that means is that the ECB is determined to keep its printing press running at full throttle. Emboldened by the announcement, traders quickly rushed back into buying riskier assets, along with the Euro. It’s becoming quite obvious that these recurring “risk off” episodes are less and less pronounced, as traders seem increasingly reluctant to react to bad economic news, realizing that central banks are able and willing to “paper over” any problem with another sea of liquidity.

These central bank interventions are slowly but surely changing the dynamics of the market, as speculators are less inclined to short stocks and commodities. Even though a bearish stance may be justified from a fundamental point of view, traders are starting to get tired of fighting the Fed and its cohorts. Just look at the paradox in the bond market, where we have an unprecedented mountain of debt, yet interest rates are at historic lows. The Fed has rigged the game in the US treasury market by becoming its biggest buyer, thereby suppressing interest rates. The Fed currently owns more than USD 1.7 trillion in treasuries, easily surpassing China’s USD 1.2 trillion holding. Although the bond market may be the most obvious target of Fed intervention, traders in other markets are starting to understand that this ever-increasing amount of liquidity in the system is acting in favor of higher nominal asset prices and short-selling may therefore become a futile effort.

Today’s US export sales report was quite constructive at 153’100 running bales net for both marketing years. What impressed us most is that a total of 19 markets participated in the buying of Upland and Pima last week. This seems to indicate that US cotton is attractively priced and that other origins may not be so readily available anymore. As of July 19, the US has now sold 13.0 million statistical bales, of which 11.3 million bales have so far been exported. With 12 days to go in the marketing year, we should therefore get fairly close to the current USDA export estimate of 11.6 million bales.

Assuming that exports will reach 11.6 million bales by the end of July, there will be around 1.4 million bales in export sales that get carried into the new marketing year. In addition to that there are currently 2.8 million statistical bales on the books for the 2012/13 season, which means that there will be around 4.2 million bales in total export commitments at the beginning of August, most of which are for nearby shipment. In addition to that we need to reserve around 0.9 million bales for domestic mills for the August/October period. Adding it all up, it amounts to around 5.1 million bales in commitments against which there are beginning stocks of just 3.3 million bales on August 1. Even though some export sales may still get canceled, we are likely to end up with a very tight if not overcommitted situation until new crop brings relief. This is the reason behind December’s relative strength versus March. Also, the fact that the certified stock has dropped quite considerably over the last couple of weeks, going from 132’000 bales on July 10 to just 59’000 bales today, suggests that there isn’t much cotton to spare in the coming months. Short sellers are therefore quite wary of December – rightly so!

When we look at the current cotton market, we see a lot of similarities to the sugar market, or rather the two sugar markets. As you may know, sugar is traded in two separate futures contracts, a world contract and a US contract. The reason for this is that the US sugar market is being insulated from world prices through domestic support and import quotas. This has resulted in US sugar trading at a substantial premium over world sugar for decades. Sounds familiar? All we need to do is switch US sugar for Chinese cotton and we too have a tale of two markets. China has created a price island as well via its domestic support and import quotas, and its domestic market is still priced at over 130 cents/lb, or about 50 cents above the A-index and 60 cents above NY futures.

The link between the Chinese market and the world market exists mainly via imports, be it raw cotton or yarn. This season China has already imported 22.6 million statistical bales and it is likely to surpass the USDA estimate of 23.25 million bales. By allowing a massive amount of imports in at much cheaper world prices, China has thrown its mills a lifeline, while at the same time supporting farmers by absorbing 3.1 million tons of domestic cotton into its strategic reserve at prices of over 140 cents/lb. However, common sense dictates that this modus operandi can’t go on forever. China cannot indefinitely increase its strategic reserve, although it has already promised farmers to once again buy their cotton at even higher prices than last year.

Something has to give, although we are not quite clear yet what it will be. Reduced cotton imports, a shift of cotton to food acres and possibly offering reserve stocks to domestic mills with some kind of an incentive are all within the realm of possibilities. One trend that is clearly emerging is that Chinese mills are importing yarn at a record pace, thereby taking advantage of the much cheaper cotton price elsewhere and the fact that there are no import quotas on yarn. Pakistan and India are the two main beneficiaries of this trend so far, which will only grow stronger while this huge price difference between China and the world market remains. We feel that the statistics are not adequately reflecting this dynamic yet and that we should eventually see a pronounced increase in mill use in the aforementioned origins.

So where do we go from here? Due to the fact that China is running its own market at a much higher price level and is shouldering a large amount of the world’s ending stocks, we feel that the situation in the rest of the world is not nearly as bearish as it is generally perceived. Yes, there is plenty of cotton to go around for some time to come, but we don’t see any of the major origins pressuring values at the moment. Prices in some of the traditionally cheaper origins seem to be well supported for various reasons. Pakistan and India are benefitting from Chinese yarn imports, while Brazil and Argentina are looking at a big acreage shift to soybeans going forward. The US is basically sold out until new crop and Central Asian origins and Australia are not dumping their prices. Apart from pending issues with high priced contracts, mills seem to be operating with profitable margins at current levels. In the near term we don’t see any reason for prices to break out of their 65-75 cents trading range, but given the huge price disparity that exists between cotton and food crops, we feel that the market may firm up somewhat once we approach the Southern Hemisphere planting window.