NY futures moved slightly higher this week, as March advanced 47 points to close at 61.90 cents.
Price action was constructive, as the cotton market managed to arrest last week’s decline and then transitioned into a slight uptrend, albeit without much conviction. Despite the relatively small closing range of just 74 points in March over the last five sessions, the market was quite active with an average daily trading volume of around 28,500 contracts. Mill fixations and the sale of basis-long positions provided support, whereas spec and possibly renewed trade selling kept values from gaining much traction.
The cotton market continues to be torn between bullish and bearish forces, as a fairly constructive cotton balance sheet points to higher prices, while the threat of Chinese reserve sales and a gloomy macro picture temper any enthusiasm.
The latest USDA supply/demand report of January 12 showed the first ROW production deficit since the 2002/03-season, as cotton production in all countries other than China is going to amount to just 77.7 million bales, whereas mill use in markets other than China is estimated at 78.4 million bales. This ROW production shortfall of 0.7 million bales compares to surpluses of 11.7, 12.2, 16.5 and 27.3 million bales in the previous four season.
Since China is still expected to import 5.5 million bales, mainly as a result of the obligatory Tariff Rate Quota (TRQ), the ROW shortfall actually increases to a rather substantial 6.2 million bales this season. As a result the USDA expects ROW ending stocks to drop to just 38.3 million bales and a corresponding stocks-to-use ratio of 48.9 percent, both of which would be the second lowest levels in 12 seasons.
Only in the 2009/10-season were stocks tighter at 31.8 million bales and a stocks-to-use ratio of 46.4 percent. In the other ten seasons since 2004/05, stocks in the ROW have measured between 38.4 and 44.1 million bales, with stocks-to-use ratios between 53.5 and 65.6 percent.
In other words, supplies are rather tight in the ROW this season. Not only have mills 11.4 million fewer bales to choose from this season, as ROW production has dropped from 89.1 to 77.7 million bales, but the percentage of premium grades is lower as well. Just look at the US, where the tenderable percentage has slipped below 56% for the season, which compares to 71% a year ago.
So far this tighter supply situation has only been reflected in strong high-grade basis, whereas the general market level hasn’t gone anywhere. Since availability is much tighter than last season, when the futures market managed to reach 68 cents at some point, shouldn’t we be well on our way to 70 cents?
Yes, but there are three factors that are keeping the cotton market on a short leash this season. The first one is the strength of the US dollar, which has led to bullish cotton trends in pretty much every other currency but the US dollar and the Chinese Yuan, making it difficult for mills to pay much more than the current price, especially with man-made fibers getting cheaper. At the same time these local bull markets encourage non-US production, which has negative implications going forward.
The second factor is the uncertainty in regards to China’s cotton policy. There are strong rumors that China will finally make a valid effort to reduce its massive stockpile of 10-11 million metric tons, or 45-50 million statistical bales. Although China would prefer to sell its stocks to the domestic market, simple arithmetic tells us that this may not be a viable option.
We have China’s crop at 4.8 million tons this season and believe that cotton imports will amount to around 1.0-1.2 million tons, which would put the seasonal supply at around 5.8-6.0 million tons. Since we further believe that China’s mill use is not much more than 6.2 million tons at the moment, there is not a lot of room to squeeze reserve stocks into this equation. This leads us to believe that China will sooner or later have to opt for exports.
We realize that our numbers are lower than the USDA, which has the crop still at 5.18 million tons, imports at 1.2 million tons and mill use at 7.08 million tons, allowing for a little more room to dispose of stocks locally. However, based on our trusted local sources we believe that Chinese mill use is nowhere near 7.1 million tons this season.
The third factor preventing cotton prices from moving higher is the gloomy economic outlook. With stock markets in retreat and deflationary forces taking hold all over the globe, neither speculators nor commercials are in an ebullient mood at the moment. As pointed out last week, the threat of another credit event is real and we believe that it won’t be too long before we see the first wave of defaults, starting in the energy and emerging market sectors.
US export sales were one of the bright spots in an otherwise lacklustre week. Combined sales of Upland and Pima cotton amounted to 206,000 running bales for both marketing years, with 15 markets participating. Vietnam once again led the way with 73,900 running bales. Shipments of 84,700 running bales were slow, but we believe that adverse weather may have played a role in that. Total commitments for the season now amount to 5.6 million statistical bales, whereof 2.6 million bales have so far been exported.
So where do we go from here? Looking at the cotton market in isolation, prices should be headed higher! However, for reasons mentioned above, there is too much adversity forestalling an advance. Speculators are likely to reduce their long exposure in the current environment and the trade isn’t chasing the market either.
Only if at least some of these obstacles (strong dollar, Chinese reserve policy, deflation/risk of recession) get removed do we see a clearer path to higher prices. In the meantime the market will probably remain mired in indecision and fluctuate a few cents up or down from current levels.
Since we perceive a heightened risk of a systemic event, we would advise our readers to seek some cheap protection in the options market!