Is the world producing too much cotton, or consuming too little?
This is one of many questions to be answered whenever China decides to destock its reserve of cotton.
No doubt, cotton consumption has been hurt by higher prices inside China.
The cotton market is entering a third season of “disequilibrium” caused by China’s stocks-building program, says Joe Nicosia, global cotton platform head, Louis Dreyfus. The situation has caused a two-pricing system, one in which prices follow a tight supply of free stocks in the world and another inside China in which pricing is set by the state reserve at substantially higher levels.
Speaking at the Cotton Roundtable in July, Nicosia described the uncertainty of this situation as the good, the bad and the ugly of the cotton market. “In China, cotton producers are completely controlled by the state reserve, which buys 80 percent of their crop each year for $1.20 a pound. They dole it back out to their textile mills at slightly lower prices. At the same time, we find world prices for the cash and futures market at substantially lower levels, in the 80-cent to 90-cent range. World prices are more reflective of the total supply.”
As a result, the textile mills in China “are eagerly pursuing imported cotton whenever possible. But they need quota in order to do so.”
The “good” news is that China’s policy has built a persistent export demand for U.S. cotton, keeps U.S. carryout low and prices strong, according to Nicosia.
“We’re looking at a 2.9 million bale U.S. carryout for this coming year,” Nicosia said. “Traditionally, carry outs below 3 million bales provide rewarding prices. The majority of times, when we get below 3 million bales, we average over 80 cents a pound that season.”
However, a 2.9 million bale carryout for 2013-14 “currently finds prices at 86 cents,” Nicosia said. “Cotton futures have had to deal with China’s reserve policy and have been elevated higher than they’ve been in history.”
Nicosia doesn’t believe that China’s policy can sustain much longer, and that some change is on the horizon. “With the December 2014 cotton futures contract currently trading at 78 cents, the market has started to price in some sort of change.”
“This brings us to the bad,” Nicosia said. “The market diverging cotton policy in China has created an import quota dependency. Chinese mills there are anxious to import cotton whenever they get quota because the prices are cheaper.
“Furthermore, they do have the opportunity to buy cotton without import quota, but they must pay a 40 percent tariff. In order for cotton to be competitive in China with a 40 percent tariff, ICE (Intercontinental Exchange) futures would have to drop to a 70-cent to 73-cent price range.”
At today’s prices, “cotton demand in China is stifled. Higher prices encourage the use of cheap, local polyester. This places the world in a repetitive cycle of overproduction.”
China’s reserve policy has resulted in the world growing more cotton than it consumed by 22 million bales, 14 million bales and 8 million bales in each of the last three years.
“At the end of this year, the world will have an all-time high in surplus cotton, 94 million bales, which is equal to 86 percent of annual use. We forecast that the Chinese reserve which now holds about 35 million bales, will grow to 48 million bales. This leaves free stocks, or stocks available for the marketplace, at just 45.6 million bales, which is only 42 percent of use, which is a very tight ratio.”
“The question is, are we growing too much cotton, or are we consuming too little?”
There’s a lot of evidence for the latter, according to Nicosia.
“Cotton consumption in China has been crippled by their high domestic prices versus the world, and mills have turned to polyester and imported yarn. China is the largest polyester fiber maker in the world. It’s added about a million tons of new capacity in each of the last two years.”
Nicosia noted that there has been no recovery of the cotton blend inside of China. “In 2009-10, China’s spinning mills were using a 57 percent cotton blend. Today, it’s fallen to 43 percent. Furthermore, since cotton yarn can be imported without any tariff, the mills in China now import 8 million bale equivalents of cotton yarn. The top beneficiary of that has been the cotton farmers in India and Pakistan.”
Nicosia says the “ugly” could happen when China decides to destock. “If it does so in a manner that brings down prices equal to international levels, imports will decrease. The only way to revive cotton demand is through competitive pricing to their textile mills in order to revive consumption. So when fundamentals do matter again, the world is going to need to cut cotton acreage.”
Nicosia says the cotton market today “is inverted in anticipation of a possible policy change in China in 2014. The marketplace needs to work its way through 2013 with a low, and possibly perilously low, US carryout.
“As long as China continues to hold cotton off of the marketplace, it will be a benefit to U.S. growers. Any change in policy however, especially one to help their textile industry, will mean freer cotton availability and lower prices in China, which means less imports for China and less exports for the United States.
“Cotton is worth more now that will be in the future, so as a grower you should look to sell your cotton. Whatever you do, do not carry it through the inverse. The inverse tells you that you will lose both in value as well as in storage and interest.
“It doesn't mean you can’t be bullish. But don’t hold your cotton. If you want to be bullish, sell your cotton and buy a call option. Take advantage of the weather-related rallies and or the trade flows that move prices slightly higher. Be careful for 2014.”
The Cotton Roundtable is held each July in New York. It is sponsored by Cotton Incorporated, the Intercontinental Exchange, Bayer CropScience, Ag Market Network and Farm Press Publications.