Where did many market analysts go wrong when earlier this year, they believed that the risk was to the upside in the cotton market? A lot of it has to do with the 800-pound gorilla that's been wreaking havoc in the market for much of the new millennium — China.
Mike Stevens, with Swiss Financial Services, speaking at the Ag Market Network's October market update, notes that early this summer, “it was widely anticipated that China would issue supplemental import licenses to their mills, which should have provided a rally as merchants lifted their hedges.
“The market consolidated nicely between 52 cents and 53 cents last month, awaiting an announcement from the Chinese, but it became increasingly nervous as China's cotton association, Cotlook, then the International Cotton Advisory Council started making major adjustments to estimates of both the Chinese crop and their demand.
“As the market started deteriorating technically, perception of the supply demand fundamentals began to shift as well. The weekly crop condition indices reflected marked improvement in the U.S. crop, leading most to finally acknowledge that not only was the Chinese crop getting bigger but the U.S. crop was getting bigger too.
“The October report resonated with two themes, larger supply and lower demand compared with September in both in the United States and in China.”
The result of this shift was that the cotton market basis the December futures lost 486 points between the September and October USDA crop production reports, while many analysts had been convinced the market was going to eventually break out above 54 cents.
Stevens noted that today, the pace of U.S. exports “has finally began to pick up and should continue to do so as long as the market stays below 52 cents. For the past two weeks (early October), U.S. cotton has remained competitive. When you look at the A-Index, the Memphis Eastern style cottons are not only in the Index, but they bouncing between No. 4 and No. 5 position.
“But we still can't lose sight of the fact that for now, we're going to be relegated to the role of residual supplier of the world's textile industries. Most mills here and abroad are going to continue to buy on an as-needed basis because they can't afford these carrying charge premiums on the board.”
Stevens says any attempt for the market to move back above 52 cents, “looking at the fundamentals as we know them, would probably be technical and would not have any staying power from a fundamental standpoint.
“With the AWP futures spread at historically close levels, expeditious use of the loan is obvious. The options market continues to give the right, but not the obligation to protect you from an unexpected move. It would at least appear from this point that the downside is limited.”
Carl Anderson, professor emeritus, Texas A&M University, says he was overly optimistic about cotton prices in mid-summer, “because the numbers we were looking at that time were a lot tighter in supply and stronger in demand than the numbers we're dealing with now. One thing I've learned over time is that the market is usually right.”
After it became clear that the market wasn't doing anything significant on either side, analysts began wondering what the market knew that they didn't. “Sure enough, when we got these October numbers from USDA, we find out that the fundamentals of world supply-demand are now in line with the price we have.”
USDA's October world supply and demand estimates are forecasting that world ending stocks this season will increase by 5.5 million bales. “That is substantial,” Anderson said. “The numbers were substantially changed in China — they had more stocks at the beginning of the year, they have a larger crop and they are not using as much cotton in their textile mills as earlier thought.”
The world stocks in stocks-to-use is now at 43 percent, compared to 38 percent last month. “If the opposite were true, we'd be seeing a market 5 cents higher. As it is, those are adequate stocks to meet demand and 50 cents a pound is about where cotton should be trading.”
Another weight on the market is plenty of supply in major-exporting countries. “We are one of the leaders in exports, but so is Uzbekistan, Pakistan, India, Brazil, Argentina and Australia, who all have to export to get rid of the cotton they produce each year. We have lots of competition in the world market and foreign countries can under-price us. And we have a lot of shipping and handling costs.”
Anderson says that with the elimination of the Step 2 competitiveness provision, producers should expect futures prices to be 8 cents to 10 cents below the A-Index and the farm price, depending on quality, to be 4 cents to 6 cents below the nearby New York futures. “For example a 58-cent A-Index with a 12-cent difference is 46 cents to the farmer.”
Anderson noted that certificated stocks are at a very high level — 750,000 bales. “That's a very large number that can threaten this market. Speculators are holding the equivalent of 16 million bales, and are holding on their bearish attitude.”
Anderson projects cotton prices for December 2006 to trade at between 48-52 cents. “I hope it will go a little higher, but with the supply of cotton in the world, I don't think we're going to get the A-Index up over 60 cents. So we have to have the A-Index going up before our nearby futures go up and before our farm prices can go up.”
But prices are expected to head up next spring, barring any negative surprises from the Far East.
“There is going to be a lot of talk about putting in more corn for ethanol, biodiesel and we have a lot of enthusiasm in the grain markets,” Anderson said. “I'm thinking we'll see cotton acres in the United States and the world back off a little bit and the market is going to have to respond and get us some more acres sometime around the beginning of next year.
“Low prices increase demand, and decrease acres planted. That's why I'm opting to put cotton in the loan and hold out for next year, and see if March is going to have to buy some acres. It would have to rally up above 55 cents, December 2007.
“Just remember, the rules were changed a little bit this year and from what I gather, it's going to cost a little more to put cotton in the loan. So check to make sure you know how it's going to work.”