Global Changes Force America To Become United States Of Adaptation
January 28, 2009 Challenges can make your business stronger by re-focusing your energy and reconsidering long-term assumptions. The growing period may be difficult, but in changing times, challenges force us to adapt so that we can succeed in the future.
According to Joe Nicosia, Allenberg Cotton Company CEO and incoming president of the American Cotton Shippers Association (ACSA), the U.S. cotton merchant and industry currently face major challenges from abroad and at home — challenges that will probably cause fundamental shifts for the future of U.S. cotton.
Taking a wide perspective of the industry, Nicosia sees two major hurdles for U.S. cotton: competition from grains for acreage and competition from increasing cotton production in India.
Competition from grains represents a fundamental shift of priorities for the U.S. cotton industry, Nicosia said, as past concerns focused on the demand side as cotton vied with man-made fibers for a place in global spinning mills. Cotton will continue to fight that same war, but the battle will take place on a different front: cotton will fight for acreage at the producer level to help ensure a supply that is available and cost-effective for spinning mills. Now, with grain prices as attractive as they’ve been in a long time pairing with uncertainty for cotton, the battleground is the ground itself as cotton needs to fight for a shrinking planted area.
“In light of lower domestic production, we used to worry about cotton economics around the world, and we worried about man-made fibers and their competitiveness to cotton. Today, we are back on the other side of the equation. We are much more concerned about the production side of the equation as opposed to the consumption side of the equation,” Nicosia said.
“Now we get bigger competition coming from corn, beans and wheat, and to a lesser degree sugar, and it is a fight for acreage. So our focus is more international and on all commodities, as opposed to only the cotton economics. The shift to lower cotton acres will probably be a long-term shift, especially in the United States. As long as the U.S. government continues to mandate usage for biodiesel and ethanol, I think it is a permanent shift unless that changes.”
Global Shifts
Higher commodity prices and a shift in production to grains is not just a U.S. issue. All around the world, growers continue to weigh their production decisions based on price, infrastructure and marketability.
However, Nicosia said most production areas will gravitate toward certain crops when prices remain at higher levels for a sustained period, causing geography-based increases. Crop diversity has an inverse relationship with price; as prices rise, producers begin to consolidate acres into their most profitable investment.
“There is no doubt that certain parts of the world can grow other crops more favorably according to their region. For example, Brazil is much better at growing beans than they are at growing corn, and the U.S. is more successful at growing corn than most other places in the world. At the same time, countries for their own internal reasons — whether it be for food security or distribution — don’t want to go to monoculture. But as prices go up, you will see a tendency for countries to lean towards their most productive and profitable crop,” Nicosia explained.
“I think you will see a slight subtle shift in acreage allocation on a global basis. We are already seeing this in the U.S. with the shift to corn, and soybean prices are reacting to that as well. The U.S. is slightly different because it is one of the lucky countries in that it is highly productive in most of the traditional agricultural crops.”
U.S. producers have already made their decisions for the 2008 crop, but as the industry looks to acreage in 2009 and beyond, Nicosia said forecasting analysts should look at the broader picture. Success in challenging times demands a strategy that looks beyond traditional models, and this is especially true when considering cotton’s profitability compared to other crops. Old methods of comparing futures prices as a scale of profitability must be reconsidered for a new scenario.
“I think people need to be a little bit careful when they look at traditional measures of profitability. I see many people in the grain industry who call up long-term charts to show how under-valued cotton is, and I think that is sloppy work, because they are looking at models that don’t take into consideration the yields and productivity increases that have taken place in cotton,” Nicosia said.
“When they just look at futures pricing, they are not looking at the equivalency of either profit or revenue generation that is taking place per acre. The people that do that kind of work don’t take into consideration the nuances particular to cotton — things such as storage rebates, ginning rebates and money from seed,” Nicosia said. “Yet these things can be a substantial portion of the growers’ revenue stream, especially in the United States.”
Competition Abroad
While U.S. cotton faces a challenge on the supply side as it fights for acreage against grains and other crops, the U.S. industry also is up against great challenges from other growths, particularly from India, that weren’t as much of a threat three to five years ago.
Exacerbated by the loss of the U.S. domestic mill market, this competition is not cyclical; it is a paradigm shift that will continue to challenge the U.S. industry.
“The loss of our domestic mill consumption has come on very quickly in the last several years, and I don’t think that is going to change — it has somewhat stabilized at this lower level,” Nicosia said.
“While our domestic mill customers are still important to us, it is now a lower percentage of our business, and it will continue to shrink. As far as the U.S. cotton merchant is concerned, we have become extremely export oriented, and the ability of U.S. cotton to stay competitive in this environment is really our biggest challenge.”
As far as direct competition, the biggest competitor for the U.S. is India, especially for Chinese consumption. Not only does India have an advantage from cheaper transportation costs, but because financing for storage is very limited, much of the crop must be sold immediately following harvest. Combined with India’s proximity to the market, these factors make Indian growths highly competitive.
“There is no doubt that today India is the largest competitor of U.S. cotton in the world, and part of that is because Indian growths have the tendency to be some of the more attractively priced cottons,” Nicosia said. “Most countries tend to be undercapitalized when it comes to holding their crops at harvest. It is hard for the U.S. to compete with the Indian crop at harvest because it is large and it needs to be sold, and the ability to hold that stock is limited. It is going to find a home at any price.”
“The challenge of the U.S. cotton merchant going forward is going to be to manage our inventories and manage our crop sizes against a world that is under-financed and under-capitalized during their harvest periods,” Nicosia continued.
“I don’t think this is going to get better in the short term, especially with the volatility of prices and the concerns about being able to hedge forward. You just have to accept the fact that the excess India bales are going to be marketed, and we are going to have to maintain our market share in spite of India,” Nicosia noted. “We are going to have to understand that at some point of time — and it happens a little differently each year — India will sell out, and prices do go up, and we are going to have to learn to market our bales alongside India.”
Challenges At Home
If lower U.S. acres, decreased domestic mill consumption and increased competition abroad weren’t enough, the U.S. cotton merchant is now facing one of the most difficult challenges ever with the instability of the NY futures market. Speculative funds with a seemingly unlimited amount of money have created wild fluctuations in the market and incredible margin calls that limit merchandizing firms’ ability to hedge their positions. The mayhem of March will soon not be forgotten, and many cotton merchants were forced to make decisions that would otherwise have been avoided.
“There is no doubt, when you look at the total open interest of the speculative and index positions which are larger than the entire U.S. crop that will be grown next year, obviously you are going to be open to some pretty wild swings in prices. What happened in March was very unfortunate because it created a giant shift of wealth from one party to another, for reasons that had very little to do with cotton,” Nicosia said.
“In general, the cotton industry underestimated and mis-priced its risk,” he continued. “Because of that, when those large margin calls came, it put great strain on the industry, and in some cases, to those who were unable to meet such large margin calls in a 24-hour period, it caused them to do some things that were very defensive and not necessarily economic.”
Nicosia believes the industry will price that risk more carefully in the future, and he hopes that ACSA and the U.S. cotton industry can influence change that will stabilize this situation. At the time of publication, a public meeting between the Commodity Futures Trading Commission and industry stakeholders was scheduled for April 22, and ACSA leaders planned to speak at that hearing.
Whatever the outcome at that meeting, one thing is certain: merchants will have to re-think how they hedge their risk in the future.
“I do think the industry will start to price that risk more appropriately going forward, and I think you are already starting to see that right now. One of the problems with this scenario is that the ability for price discovery in the further out months is more difficult to obtain. But I think as the industry re-liquefies — as its capital base returns — you will also see the forward price discovery mechanism return as well, but I don’t think that it will be as cutthroat as it was,” Nicosia said.
“I think people will start to demand a slightly better return to take that risk on. In retrospect, the industry was taking on a lot of risk for very little or no gain, accepting that risk at face value and believing that the delivery mechanism would always work. The delivery mechanism does work and will continue to work, but the fact is that it didn’t work for a very short period of time.”
A Merchandizing Storm
Considering the latest changes in the NY futures market in tandem with the developments on the international front with India, U.S. cotton merchants face a new problem marketing their cotton, especially with rising commodity prices. Because cotton prices have been higher than the loan level (and Nicosia believes they could go higher in 2009/10), merchants no longer will have their storage and interest fees forgiven. As the residual supplier to the world markets, U.S. merchants will store cotton longer, and this could mean more fundamentally difficult problems for the merchandizing sector. Offseting these costs using good marketing techniques will be essential for success.
“The biggest challenge and the biggest change that U.S. cotton merchants face for our businesses today versus where we have been, is the change in our marketing patterns and what it means to handle cotton inventory when things are not tied up into the U.S. loan,” Nicosia said. “For many years, we learned to run our businesses through equities and the adjusted world price scenario, where the adjusted world price was at the loan level or lower. In that scenario, we essentially had free carry, but now interest and storage charges are no longer forgiven.”
“So the ability to market large crops, especially as the residual supplier, takes on a whole new dimension, as opposed to when cotton was tied up in the loan and had free carry,” Nicosia continued.
“The ability of the U.S. cotton merchant to adjust to this will be critical to survival. The ability to use board spreads, options and futures hedges correctly to offset those risks and costs associated with carry will be critical, especially because we know that at harvest we are the residual supplier in the world. For the cotton industry, that is probably our biggest challenge going forward.”
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