Riding Out Cotton’s Flooded Market

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From Cotton Grower Magazine – April 2016. First in a series on influences providing optimism for cotton’s future.

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There is a theme emerging in Joe Nicosia’s annual economic updates, delivered each year at the Mid-South Farm and Gin Show in Memphis, TN. When it comes to global supply and demand, it seems Nicosia finds corollaries in natural disasters. For the U.S. cotton industry, that is not a comforting thought.

Take, for example, the speech he delivered last year. Nicosia, the global platform head for cotton at Louis Dreyfus Commodities, began his address in February 2015 by likening China’s massive cotton reserves to a dormant volcano.

“So life can be peaceful under the volcano for a period of time, as long as it doesn’t erupt,” he said. “And if it does, that lava – that cotton – can flow slowly, sometimes ooze out into the market place. Or it can erupt, and we can get flooded with it.”

Over the last year, that volcano of Chinese cotton stocks did begin to flow out into the market, severely suppressing world cotton prices along the way. There are rumors that 2016 could see a more severe eruption out of China, as well.

During the 2016 economic update, Nicosia likened these developments to another natural disaster – a flood.

“Little by little the tide is turning,” he said, acknowledging how the market is now flooded with cotton. “It’s going to take a little bit of time to get in and get out. But let’s see what’s left when the water recedes.”

How Did We Get Here?

Addressing a crowd of hundreds of Mid-South cotton professionals, Nicosia explained how we arrived at cotton prices that have languished between the high 50-cent and mid 60-cent range for the past year. The factors that led us to such suppressed prices, he said, began in 2011, when the Chinese government implemented a policy of buying and storing massive cotton stocks in response to then-skyrocketing cotton prices.

“The Chinese cotton policies have had, and are going to continue to have, a huge impact on the world and be a drag on prices,” Nicosia said.

From 2011 to 2014 the Chinese government executed a policy of paying domestic farmers prices that far exceeded the global market, encouraging domestic production while propping up the rural Chinese economy. While that cotton began to fill Chinese warehouses, the country also imported large amounts, becoming the leading export destination for U.S. cotton.

During this period, the policy gave a boost – albeit an artificial one – to the global futures contracts. Because China withheld the vast majority of the cotton it took from the global market, world stocks were effectively tightened. In reality, however, the Chinese were eventually going to have to offload their reserve stocks.

The Chinese began that process, while changing their underlying cotton policy, in 2015. Because the government had bought cotton from domestic producers at elevated prices, and because those same stocks had sat in reserve for years, all the while reducing quality, the Chinese will ultimately lose “tens of billions of dollars” while liquidating their reserve, according to Nicosia. Nonetheless, the government is forced to move forward with the planned draw down of cotton reserves.

“The volcano is ready to go,” Nicosia said. “The elephant in the room is the Chinese state reserve. It was at 50 million bales, it’s down to about 45 million already. They’ve liquidated some. They own half the world’s stock.”

As an influx of cotton hits the world market, prices naturally decline. The result is that fewer acres of cotton will be planted around the globe in 2016. If there is a silver lining to suppressed prices in 2016, it is that natural laws of economics – supply and demand – will once again drive decisions. By causing significant reductions in acreage, the market, as Nicosia puts it, is doing its job.

“We think the job of the market today is to make sure we keep acreage in check,” Nicosia said. “It doesn’t want you to grow any more acres. It wants you to wait until 2017/18, so we can get into this China reduction.”

And it appears the market has already started to do its job, as global stocks decreased, if only slightly, in 2015/2016.

“Everyone in the world grew less cotton in 2015/16,” Nicosia said. “The United States, India and China had the majority of that acreage reduction.”

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A significant reduction in Chinese acreage is an undoubtedly good thing for prices. As Nicosia pointed out, the surest pathway to cotton price recovery is for China to begin consuming more cotton than it produces each year.

Of course, a reduction in American acreage is ultimately beneficial for global carryout as well, although that is a bitter pill to swallow for U.S. producers. Nicosia stressed that perseverance is key during this difficult time in U.S. agriculture. After all, the rest of the world’s cotton producers are struggling with the same price woes.

“So, the tide changed,” Nicosia said. “There’s a quote from Warren Buffett that says only when the tide goes out do you see who’s been swimming naked.”

Digging In for 2016

For U.S. cotton producers, 2016 is going to be a challenging year. Nicosia offered some advice on how to navigate these troubled waters.

“We think, the number one thing, is conserve your capital,” Nicosia said. Then, for pricing: “58 cents for December cotton is cheap – it’s cheap for a reason though. It’s cheap because it doesn’t want you to plant too much cotton. It wants to give China room to breathe, to liquidate this crop.

“Today, if cotton prices go from 58 to 65 cents, your cotton is not going to be worth any more. The way the U.S. government program is structured, especially with the adjusted world price, cotton below the loan, in equity form – you’re not going to receive any more for your cotton until the prices go above 70 some-odd cents. So what you see is what you’re going to get. Now that doesn’t mean you can’t profit from a rising price of cotton. The question is do you do it by growing it or do it by owning it?”

Urging the producers in the room to consider buying December calls, Nicosia noted that if the U.S. has a small crop in 2016, 58 cents will ultimately be undervalued.

While those numbers may not provide much comfort for U.S. producers, there are positive developments on the global market for U.S. cotton. Nicosia cited American cotton’s sustainability and traceability as a major factor in creating demand for the U.S. crop.

What’s more – the glut of global stocks will only get smaller from here, making conditions favorable for a price recovery in the coming years. If there was a note of optimism in Nicosia’s message, it was that the fundamentals for global cotton prices have likely found their floor. As he pointed out, the current marketing year should make a noteworthy dent in global supply.

“The world carryout should drop by another 7 to 8 million bales this next year going forward, unless we have absolutely wonderful weather and huge yields everywhere,” he said. “That’s good news.”

For now, U.S. producers can only hunker down for the year ahead.

“Be patient. Be cautious. In the short term, stay alert and conserve your capital,” Nicosia said in closing. “2016 may not be the greatest year for it, but it’s going to get better after that, especially in the long term. The future looks bright for us as these stocks and structural deficits in China improve.”