Runaway Prices
January 27, 2011 By Carl G. Anderson
Professor Emeritus
Texas A&M University
The market environment of the U.S. cotton industry is being restructured subject to the complex and erratic forces of export demand. As a result, financial risk for industry participants – producers, merchants, cooperatives, and textile mill buyers – has increased substantially.
The combination of foreign supply, demand, and policy creates a sensitive relationship impacting the market place. The dynamic forces of economic and weather-related conditions and speculative trading by managers of billion dollar funds are stirring up the supply-demand forces, causing unexpected price movements. The Chinese deficit gap of more consumption than production is a dominant force in the cotton market.
Low cotton prices the last five years contributed to increased world consumption that exceeded production. World ending Stocks fell to the lowest level in 15 years. Scarce supply (particularly in China), adverse weather, erratic foreign trade policies, and a weak dollar ignited an explosion of buying futures contracts by both industry participants and mega fund managers. The use of electronic trading based on mathematical models added speed to the futures’ price movements.
However, given economic principles and favorable weather, an effective supply-demand price relationship will surface in time as production exceeds use. Market forces will signal well in advance when the balanced supply-demand situation is forthcoming. High prices increase production and reduce consumption. Too, the U.S. produces a small part of the world cotton crop. Thus, a rapid recovery of foreign production could curtail export demand in a season. Exports from the U.S. have averaged 12.97 million bales in the last four years (2006-2009).
A look back to the mid-1990s “A” Index price rally above 91 cents per-pound shows that world acreage and production increased substantially while demand was relatively stable. The Index price rose sharply in 1993 and 1994 from 71 cents per pound to 91 cents, and then dropped to 53 cents by 1999.
With polyester price far below cotton price, foreign textile mills are shifting to higher blends of man-made fibers. Since August, December 2011 futures price has lagged far behind the December 2010 price.
The market perspective for the 2011/12 season includes increased cotton acreage from this season, a large world crop, sluggish demand, and a lower price level. The price surge is expected to encourage more cotton production worldwide.
Weather permitting, prevailing supply-demand indicators suggest that world carryover stocks will increase moderately by the end of the 2011/12 season. There is a slim chance adverse growing conditions could hold the 2011 futures price above $1.00 per pound range.
This season’s record cotton price has set the stage for another round of increasing stocks. Weather and economic conditions will determine if it will take more than one season for much lower prices to surface.
In an erratic market, the key to improving income is to observe world market conditions and develop pricing skills to protect against adverse price moves. Pricing strategies combining futures with options “hedging the hedge” will provide a safeguard against runaway margin calls.
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