Rebound!

Cotton prices approaching a 15-year high. Consumer spending bouncing back, and mill use rising faster than expected. All effects of a global economy that’s recovering from one of the worst recessions on record.

Good news for global cotton? Absolutely. Trends that will continue into the foreseeable future? It depends on your time horizon. While optimism abounds, analysts caution that clear heads must prevail as we move into the next phase of rebuilding our industry.

“I think there’s a growing sense of comfort that the world economy and cotton economy have experienced a V-shaped rebound, “ says Terry Townsend, Executive Director of the International Cotton Advisory Committee (ICAC). “It went way down but now it’s coming up quickly. Much faster than many people thought. What’s so encouraging is the level of prices. Everywhere we talk to, the cotton area is rising. It’s just a matter of how much.”

The demand from a rebounding economy is merging with lingering effects of diminished supply, making for a rare situation where cotton producers, traders, and mill operators are all making money at the same time.

“There’s an old saying in economics that ‘If something cannot go on forever, it will stop,’” Townsend muses. “Nobody knows when the ‘stop’ will kick in, but at least for another season it appears it will be a very good one for cotton producers, ginners, and generally cotton merchants as well. It will help to make up for a lot of years of very difficult prices.”

Consumer Spending, Supply, and Demand

Excitement for the cotton industry begins with the consumer. In March, the International Council of Shopping Centers (ICSC) reported a 12.8 percent increase in sales at apparel specialty stores vs. the same period in 2009. Overall, U.S. retail chain stores saw March sales increase by 9 percent, the largest such year-on-year increase since 1999.

Not only is demand strengthening at the consumer level, but the upturn means that mills are being called upon to the replenish inventories that depleted in the face of the slowdown. Mill use is rising fastest in China, India, Pakistan, Bangladesh, and on a smaller scale, Vietnam. Eduardo (Eddy) Esteve of Ecom U.S.A. says that if textile demand is a good indicator of economic stability for cotton, we’re headed in the right direction.

“We’re seeing better than expected demand today and are optimistic that it will continue,” Esteve says. “We anticipate a 3-4 percent growth in textile consumption and, even with a 10 percent increase in production next year, we should still have close to a 5 million bale deficit during the 2010-11 crop year. Ending stocks will continue to decrease in the foreseeable future and this overall tightness in fundamentals should keep the market firm.”

World ending stocks slumped by more than 2 million tons (nearly 10 million bales) between 08/09 and 09/10. Cotton Council International reports that ending stocks in 09/10 were 44 percent of world consumption, the lowest stock-to-use ratio in 15 years. Combine low supply with high demand and the effect is what you’d expect. ICAC projects that 2010/11 world cotton production will increase by 12 percent, from 101 up to 114 million bales.

The biggest production gains look to be in the U.S. India’s ban on exports leaves an estimated 100,000 ton void in China, and the U.S. seems well positioned to regain a good chunk of that share. The U.S. Department of Agriculture’s March Report projects that U.S. producers will plant 10.5 million acres of cotton in 2010/11, up 15 percent from the previous year.

Maintaining the Momentum

Bottom line – it’s a good time to be in cotton. What factors will determine the strength of the economy going forward?

“The biggest risk factor for the economy remains U.S. housing,” says Townsend. “U.S. housing drug down the U.S. economy and that spilled over into the banking systems in Europe and threatened other countries. Foreclosures remain a huge risk, but it appears the U.S. economy is managing to recover even though the housing sector remains very weak.”

The need for the world economy to “rebalance” is a continuing factor. Townsend says the U.S. and Europe have to save more and buy less, while China, India, Brazil need to save less and buy more.

“The huge amount of debt that the U.S. and European countries are amassing will eventually need to be addressed,” Esteve says.”It’s affect remains hard to predict.”

Longer term, the need to continue driving consumer demand for cotton remains paramount. On average, the price of cotton is around 25% higher than polyester, and spinners will shift business to chemical fibers whenever they can. Consumer demand is what will pull cotton products through the value chain, and that demand depends largely on perceptions. Townsend says social issues play a key role.

“Cotton continues to be stigmatized for its water use and the use of chemicals. The industry needs to keep working to ensure that the trend in cotton production toward sustainability is encouraged and continues.”

He says that education about the distinction between child work and child labour is another critical factor.

“Children’s work has become so rare in the West that we now equate any kind of work as being unfair or being wrong. But other countries have other values and other practices in other economic conditions,” Townsend says. “Work that is hazardous or that is inappropriately arduous, that is child labour and needs to be curtailed. But much of what is alleged to be child labour is in fact legitimate and appropriate children’s’ work within a family setting. And the cotton industry needs to not only work with NGOs, governments, and producer organizations but to ensure that everyone knows the difference.”

Strength of the Industry

It’s easy in to find optimism in a bull market. But as cotton begins its resurgence, opinions vary as to whether the industry is stronger now that it was before 2008. International Cotton Association President Cliff White says there’s no doubt that the structure of the industry can be viewed in a positive light.

“Our structure has changed significantly in the last two years and we’ve seen significant moves away from family-owned cotton business to multi-commodity global businesses that have cotton as part of their vision.” White says. “If you look at the top trading companies in cotton right now, they are all such companies. What that brings is far more financial strength but also the appreciation for what’s going on in other commodity markets. That’s a big plus for our industry as well.”

Jean-Marc Derossis, U.K. Managing Director for Plexus Cotton Limited, agrees. He says we have no choice but to accept these changes as healthy ones, and move our industry forward.

“While it has been a sad occasion to see some of the most respected names in the cotton industry disappear,” says Derossis, “the cotton market had become so competitive that the risk/reward ratio was fast becoming unattractive. Some degree of sanity has been restored.”

Allenberg Cotton CEO Joe Nicosia says that while there’s been a tremendous opportunity for lessons learned, we have to make sure we don’t revert to bad habits.

“One positive from the last two years is that maybe people will better evaluate risk, especially in longer dated trades,” Nicosia says. “But already I see people abandoning that. I already see people creeping back into the situation where they are underestimating risk when they start to trade one, two, three years out. I think they are underestimating not just volatility, but underestimating the amount of risk they’re taking from many venues and not taking that into account in their decisions. Those can be counterparty risks, currency risks, credit risks, time risks, quality risks, sovereign risks, government risks – all of those kinds of things that people will blindly move through just to grab market share again. That leads to trouble down the road.”

Still, cautious optimism is a welcome change from many months devoid of any at all. Let’s see what kind of staying power it has.

Getting a Read on the Market

Cotton International Magazine surveyed some of the world’s leading cotton traders and merchandisers to get their perspectives on the market rebound.

 

Caption1:
Joe Nicosia
CEO; Allenberg Cotton Co.;
Executive Vice President, Louis Dreyfus Corp.

How would you characterize the current level of optimism among cotton producers and consumers?
“I think the production side is fairly optimistic. We’ve finally gotten cotton prices back up to levels that offer a relatively fair remuneration to the grower. Obviously they are hopeful that the prices could get a little higher, but I do think we’ve turned the corner as far as the reduction in acreage and the pessimism among the grower community. I don’t think that that optimism is unbridled optimism – I’d suggest it’s more cautious optimism – because again – because of the yield variation, there’s the potential to grow extremely large crops or smaller crops in a given year. I’m hoping for a more balanced situation this year. It looks like it’s going to be that way, but we’ve got to pay close attention to yield.

On the mill side, I think most of our mill customers have been somewhat surprised by some of the prices that they’ve been able to achieve on the other side, which have mitigated some of the pain they would have otherwise felt with the rising cotton prices. I think part of that was brought on because as we went through the recession, inventory levels were drawn down so low that the pipeline was empty. So when demand started to come back, they almost saw a multiplicative effect where not only did they feel the consumer demand coming back and the retail sales coming back, but they had to refill the pipeline as far as inventories go. And since that process takes time, the nearby prices that they were able to achieve were up rather substantially for the first time in quite a few years. It was the first time in a long time where they were in some cases turning down business and were able to make price increases stick.”

 

Caption2:
Jean-Marc Derossis
U.K. Managing Director,
Plexus Cotton Limited

What do you consider to be the leading indicators as to where the market is heading, and what are those indicators telling you now?
“Obviously, the first step in developing our own strategy is to look at the longer term supply and demand imbalances coupled with the physical market dynamics, i.e. when and where there will be pressure on producers and how well covered spinners are. While this would have covered pretty much all bases a few years ago, as of today it is only one of many variables that one has to consider to form a market opinion.

The composition of the open interest on the ICE market has become a strong indicator of market moves as well, since the Index Funds have moved massively into the cotton market. One also has to be a lot more attuned to the movements of outside markets: movements in the dollar, the stock market and the overall commodities complex trigger massive investment money in and out-flows that create substantial volatility in the comparatively small cotton market. This can be pretty counter-intuitive for anybody looking only at fundamentals.

As for what those indicators are telling us now, we have seen a remarkably strong physical market which has underlined the huge gap between supply and demand outside the U.S. at a time when the U.S. themselves had one of their lowest crops of the last ten years. This tightness, which has been exacerbated by the recent move of India to stop new exports, will remain until new crop cotton starts moving into the supply chain pipelines. Further down the line, there is a huge gap between production and consumption that has to be filled from this past season to the new season and crops, both in terms of acreage and yields. We will have to do very well during the growing season to make up for the deficit we have seen this year. On the other side, we have to be alert to any sign of economic deterioration – this could negatively affect consumption. One also has to assume that the current prices will start rationing demand.”

 

Caption3:
Eduardo Esteve
President, Ecom U.S.A.

What do you consider to be any positive outcomes of the difficult period our industry has just sustained?
“Unfortunately it takes events like we experienced in 2008 to show us how unpredictable markets can be. Our business is no longer about just fundamentals. We have to expect the unexpected and have to have protection in place to avoid the possible consequences. Risk analysis needs to be a daily part of our business, being aware of the worst case scenario, and having a clear strategy in place to protect oneself from the consequences is key. Our business is now more about managing market and credit risk while buying and selling the physical is almost secondary.

The good news is that at current levels, everyone seems to be making money and happy with their business. Prices are above the growers’ cost of production and yarn prices have increased along with the futures market allowing mills to operate profitably. It is rare to be at a level where everyone seems to be happy. Enjoy it while it lasts.”