Plexus: Bearish Market Gathers Momentum
December 6, 2011 NY futures have moved considerably lower since our last report on November 17, with March dropping 518 points to close at 91.30 cents.
The bearish wave, which has been gathering momentum in recent weeks, became potent enough to breach the “Chinese Wall” of support, taking prices to new 14-month lows. The move was all the more impressive since it happened in the face of very strong US export sales, totaling more than 2.5 million statistical bales over a 3-week period. But as the old saying goes – “it’s not the news itself that matters, but how the market reacts to the news”!
Interestingly, it was the speculators that were responsible for the selling, as they either bailed out of long positions or added new shorts in reaction to a technical breakdown in cotton and all the uncertainty surrounding the sovereign debt crisis. In the week of November 22, during which the market dropped 10 cents in just three days, large and small speculators sold 11’386 contracts net, while the trade (+10’707 contracts) and index funds (+679 contracts) were net buyers.
After three weeks of stellar numbers, the US export sales report of this morning reflected a more routine course of business during Thanksgiving week, with Upland and Pima sales increasing by just 84’100 running bales net for the current marketing year, while another 19’000 bales were sold for 2012/13. Although net sales are still growing thanks to China, it is troubling to see that another 35’900 running bales were cancelled in eight different markets, led by Pakistan, Turkey and South Korea. The pace of shipments is also a negative, as just 163’400 running bales were exported last week, bringing the total for the season to 1.85 million statistical bales so far, the slowest pace since 2000. The backlog of outstanding orders now amounts to over 8.6 million statistical bales.
When we look at the current US balance sheet, we have supply for the season at 18.9 million statistical bales (2.6 beginning stocks plus 16.3 crop). From that we need to subtract 10.5 million in export sales (not counting the 1.3 million in ‘optional sales) and 3.8 million bales for domestic mill use, which leaves around 4.6 million bales for sale. Although the US is by far in the best shape among exporters, it doesn’t mean that holders of unsold US cotton feel less of an urgency to get rid of their remaining bales. Given that there is no carry in the market all the way out to December 2012 and considering the fierce competition from other origins, holding out for higher prices may not be a winning strategy this season, unless one were to believe that the market will rally enough to pay for the carrying charges.
Fortunately there is the Chinese Reserve, who has been taking a huge load off exporters’ and domestic suppliers’ shoulders over the last six weeks and who is expected to continue to buy a lot more in the months ahead. As of today the Chinese Reserve has procured over 5.0 million statistical bales in the domestic market and probably at least 4.0 million bales in the international market. By absorbing the world’s production surplus into its stocks, the Chinese Reserve is acting as a counterforce to the extreme volatility we have seen in the cotton market since the summer of 2010.
When we compare the price swings in the Chinese and the international market, we notice a striking difference. While the CC Index in China has dropped some 80 cents from its high of 215 cents earlier this year to its current price of 135 cents, the A-index has collapsed from a high of 243.65 cents to a current quote of 98.15 cents, a swing of over 145 cents or nearly twice as much as the CC Index. The futures market is not far behind the A-index, with a difference of around 136 cents.
While international prices have been overshooting Chinese prices on the way up, they were also dropping much more significantly on their way down. In fact, the A-index is currently about 35 cents below the CC index, while March futures are about 44 cents lower. This price relationship has stretched way beyond the historic norm and is therefore likely to snap back at some point. The question of course is in what manner? Since China seems to be digging in at the government support price, willing and able to absorb a massive amount into its Reserve, it is unlikely that Chinese prices are going to fall significantly anytime soon. If this assumption is correct, international prices may start to recover, because mills in other parts of the world will eventually gain an edge over their Chinese counterparts. The fact that Chinese yarn imports have shot up significantly over the past couple of months seems to point in that direction.
So where do we go from here? Although the physical market remains depressed and lower prices appear to be a certainty, the wide price gap between China and the rest of the world is starting to open up arbitrage opportunities along the supply chain. The market is currently bearing the brunt of the Northern Hemisphere crop pressure and the longer it can withstand this pressure – with the help of Chinese buying – the better the chances for a rebound as we progress deeper into the season.
Macroeconomic developments will also continue to play a major role in the pricing of cotton as we move forward. After disappointing German and Italian bond auctions last week, Central Banks around the globe have reacted by making it cheaper for lenders to borrow in US dollars. This is signaling to the market that Central Banks are standing by to inject more liquidity into the system to keep it afloat, which ultimately is inflationary. For this reason alone it may be dangerous to go short at current levels. As confidence returns, investors may once again hit the ‘risk on’ button and many of the specs that sold the market last week may return as buyers.
However, while the downside may be limited, the market won’t find a lot of room to run to the upside either. The stocks that China is currently accumulating will prevent that from happening. It therefore all adds up to more sideways action in the months ahead.
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