Plexus: Futures Make Strong Move Over the Holidays
January 10, 2012
Plexus
NY futures made a big move to the upside over the holidays, with March gaining 750 points since December 22 to close today at 94.74 cents.
After closing at 85.12 cents on December 14, the market has rallied an impressive 962 points over the last 14 sessions. However, while this move looks quite constructive on the chart, the fact that open interest has been declining sharply on Tuesday and Wednesday should be seen as a warning sign. Typically a powerful uptrend is validated by strong volume and rising open interest, which signals that a trend has momentum.
Surprisingly, open interest increased by only 1’531 contracts since December 14, which is not what we would expect to see in a ten cents move. Even more disappointing is that March open interest decreased by 7’880 lots, with most of this drop happening over the last two sessions. This indicates that it was primarily short covering and profit taking that fueled the last four cents of the advance. Once the shorts are done covering, the buying will have to come from some other source, otherwise upside momentum will stall.
A lot of the short covering seems to be tied to the selling of physical cotton. When basis-long positions get sold to mills, merchants buy back the futures short that was hedging the physical long position. Over the last couple of weeks mills have been very active in covering their needs for nearby shipment, taking advantage of relatively attractive prices. The fact that the world’s biggest consumer of cotton, China, has engineered an artificially high price plateau (over 135 cents/lb) has created some welcomed breathing room for mills around the world.
The Chinese Reserve has continued to aggressively procure cotton in the domestic market, with today’s total now amounting to over 10.5 million statistical bales. If we include an estimated 4.5 million bales of purchases abroad, the Reserve may have already accumulated a total of 15.0 million bales. According to the latest USDA numbers, China is expected to have an 11.5 million bales production deficit this season, but if we add the 10.5 million bales that the Reserve has extracted from the market so far, we get to a statistical shortfall of 22.0 million bales, assuming there is no change in ending stocks. However, the impact of this shortfall on international prices may not be felt until later in the season, if at all.
If we take a look at how much cotton is currently still available to Chinese mills, we have 11.6 million bales in beginning stocks and 23.0 million bales in new crop that hasn’t been taken up by the Reserve. In addition to that China has already imported around 5.0 million bales since August, some of which belongs to the Reserve. For the purpose of this calculation we assume that 4.0 million of these imports are available to mills. When we add all these numbers up, we get to almost 39 million bales of free supply. From that we have to deduct mill use of about 3.75 million bales per month, which amounts to roughly 19 million bales since August. In other words, there are still some 20 million bales in available supply outside of what the Reserve currently owns, which means that there is enough cotton left to supply mills until April or May, even if the Reserve were to absorb another 3-4 million bales over the coming weeks.
Although many of the battered textile markets should continue to recover under China’s high price umbrella, the boost the market is desperately waiting for are Chinese import quotas. If we look at the statistical picture outside China based on the latest USDA numbers, we have beginning stocks at 33.9 million, production at 89.9 million and consumption at 66.3 million bales. In other words, the world outside China produces 23.6 million bales more than it needs this season and on top of that it has beginning stocks that cover six months of consumption. Not a pretty picture! What the market is hoping for is that all this Reserve buying will translate into massive import quotas, which would help to mop up most of the excess supply in the rest of the world.
Although we have no doubt that China will be a strong importer this season, the question is when and how much? As we have shown above, China still has enough cotton to last its mills until well into the second quarter, which is around the time planting decisions are made. The market may therefore need a lot of patience. Also, there is no guarantee that China won’t release some of its Reserve cotton back into the domestic market, which would mean fewer imports than expected.
So where do we go from here? China is clearly at the control switch at the moment! Without sizeable import quotas from China the market will probably struggle at current levels, because there is simply too much cotton around. However, traders seem to anticipate that import quotas will be issued at some point and short sellers are therefore cautious not to get caught in a trap. Also, from a technical point of view the market held and rallied off of an important long-term support area in the low 80’s, which suggests that a major bottom may be in place. Speculators seem to favor the long side at the moment, but are not entering in any big way as can be seen by the lack of new open interest. Index Funds will have some rebalancing to do, which should add a few thousand contracts to their net long position, while the trade is unlike to engage in any large positions at the moment. To us it all adds up to a continuation of the sideways trend the market has essentially been in since the middle of July.
GET THE NEWSLETTER TODAY!
