Market Comments – January 21, 2016

NY futures were little changed this week, as March edged up just 19 points to close at 62.09 cents.
 
The cotton market has so far been immune to the gyrations in the global financial markets, as it continued to trade sideways for a second week in a row. In fact, the March contract has now settled the last eleven sessions in a very tight range of just 106 points, between 61.41 and 62.47 cents. 
 
This is not to say that there was nothing going on in the cotton market, as average daily volume remained quite active at around 26,000 contracts, while overall open interest increased by some 7,000 contracts to 188,857 contracts. In other words, there seemed to be quite a bit of churning, as mills became more interested in buying and fixing below the 62 cents level, while speculators wanted to lower their long exposure in commodities in light of the shaky financial markets.
 
The latest CFTC report of January 12 showed that speculators and the trade swapped a considerable amount of futures and options, as specs reduced their net long by 2.34 million to just 1.58 million bales, whereas the trade cut its net short by 2.68 million bales to 7.64 million. Index Funds accounted for the difference, as they too reduced their net long by 0.33 million to 6.05 million bales. 
 
The trade net short position has seen quite a significant drop over the last five weeks, as it has contracted by no less than 4.54 million bales from a season high of 12.18 million bales on December 8. This rapid drop in the trade net short suggests that business might have been a lot more active than generally believed, especially in non-US growths like Brazil, West Africa and India.

The latter two, which make up all of the current quotes used to calculate the AWP, have been quite strong in recent weeks, as crops in Pakistan and India got scaled back further, which in turn has boosted imports from West Africa. Prices in India have shot up again this week and traded at their highest level of the season. Already firm basis levels for premium grades have been getting firmer across the globe. 
 
Against this backdrop one might assume that NY futures should be trading higher as well. But apart from a dismal macro outlook and the threat of Chinese reserve stocks holding the market back, we also need to consider that the futures market doesn’t necessarily represent the premium quality segment. The futures contract allows for grades as low as Low Middling and Middling light spotted to be delivered, with staple lengths as short as 1.1/32. 
 
We just have to look at the current composition of the certified stock to see that a potential taker wouldn’t find much worthwhile in there. The latest recap showed that out of 64,000 bales there were less than 3,000 bales Middling 1.1/8 and higher, whereas 44,000 bales consisted of various grades with 1.1/32 and 1.1/16 staple, which are undesirable at the stated price. Therefore, NY futures currently represent more of a low-grade value, which helps to explain why the basis for premium grades is strengthening.
 
The strong US dollar might be another reason why the futures market has been encountering resistance lately. For example, even though the futures market is still at more or less the same price level as a year ago, importers have to pay a lot more for cotton in local currency. In the case of Turkey the US dollar has appreciated 26% year-on-year, against India and Indonesia it has been over 9%, while Vietnam has seen a more moderate 5% change.
 
The rumors in regards to the upcoming Chinese reserve auctions are starting to take some shape. Apart from the offered volume, which seems to be in the vicinity of around 2 million tons (9.2 million statistical bales), the main feature is the offering price, which will apparently be market-driven based on an index formula.  It is further rumored that the government would procure some 0.8 million tons (3.7 million bales) of Xinjiang cotton, which would put the net release at around 1.2 million tons or 5.5 million statistical bales.
 
It is not clear whether this reserve cotton would initially be offered to just the domestic market or whether exports are part of the new plan. Since we don’t see the statistical room to fit 5.5 million bales net into the Chinese local market this season, let’s figure out what would happen if the whole lot got exported instead. How would that affect the ROW balance sheet?
 
As we have seen last week when the USDA released its latest set of numbers, the ROW is projected to have a production deficit of 0.7 million bales - its first shortfall in 13 seasons! Since China is expected to import 5.5 million bales, but would in this assumed worst case scenario also export 5.5 million bales from its reserve, ROW ending stocks would remain little changed from last summer.
 
In other words, apart from a bearish kneejerk reaction at the time the news gets released, the market should be able to digest 5 million bales of Chinese inventory over the next 6-9 months, considering that global production is probably going to end up at no more than 98-99 million bales when the final tally is in. By the way, China has already imported 2.0 million bales between August and December, so the ROW bulls are currently ahead in the count.
 
So where do we go from here? The market continues to be wedged between bullish and bearish forces, with neither side currently strong enough to change the sideways direction.
 
On the bullish side we have a tight ROW balance sheet and an even tighter premium grade situation that has the potential to move the market higher. However, as we have explained above, it remains to be seen whether this scenario has the strength to move the broader market or whether it simply plays out in the high-grade basis.
 
The US dollar might assume a bullish role as well, since we expect it to weaken at some point this year, possibly when the Fed is forced to reverse course in another attempt to rescue the flailing economy. 
 
On the bearish side we have these massive Chinese reserve stocks, which have the potential to turn the proverbial “elephant in the living room” into a “bear in a china shop”. An announcement to release stocks would probably scare the market and lead to an initial selloff. Although prices might recover thereafter, the thought of having several million bales of Chinese stocks hitting the market for years to come would weigh on the market’s psyche going forward.
 
Then there is the tough macro environment, which is likely to get a lot worse before finally turning the corner. The risk is that deflationary forces will lead to a negative feedback loop that drags the global economy down and negatively affects consumption.
 
Given the all this uncertainty and considering how cheap volatility currently is, we strongly recommend using options strategies to navigate through this difficult market environment