New York futures dropped precipitously this week, as December lost 346 points to close at 59.73 cents/lb, while March fell 353 points to close at 58.75 cents/lb.
The narrow five-week sideways trend ended abruptly on Monday after another failed attempt to take out the recent highs led to a reversal that pushed prices below key support at around 61 cents, triggering a wave of spec selling over the ensuing sessions.
March had rallied all the way up to 63.70 cents on Monday morning on what appeared to be another round of spec short covering, but it started to run out of fuel going into the monthly USDA supply/demand report. When the numbers failed to inspire additional buying, values started to cave in and March ended the session 238 points below its high. The fact that volume of nearly 78’000 contracts was the highest in four years added validity to this reversal and set the stage for aggressive spec selling.
The USDA report contained basically no surprises, apart from Burma being added as a previously unrecognized cotton producer and consumer with 630’000 bales in production and 700’000 bales in mill use. These additions helped to offset reductions of 500’000 bales in China’s production and mill use numbers. Other notable changes were production increases in the US (+140’000 bales) and West Africa (+150’000 bales), while Central Asia (-120’000 bales) and Australia (-100’000 bales) saw their crop numbers lowered.
Global ending stocks are now predicted at a record 107.36 million bales, which are 5.63 million bales more than last season. More importantly, ROW ending stocks are expected to increase from 38.8 to 45.2 million bales, a jump of 6.4 million bales, as Chinese imports of 7.0 million bales won’t be enough to offset the ROW production surplus of 13.3 million bales. The only way to remedy this inventory overhang that now exists in China as well as the ROW is to discourage production and to stimulate consumption via lower prices.
The most recent CFTC report as of November 4 showed the trade at 6.0 million bales net short, while Index funds were 5.9 million bales net long and speculators had just a very small 0.1 million bales net long. However, as we pointed out last week, this basically flat net spec position is quite deceiving, because it is the result of relatively large blocks of spec longs (6.7 million bales) and spec shorts (6.6 million bales), which have the potential to accelerate up or down moves.
We believe that the volatile trading action we have witnessed over the last 10-12 sessions is directly linked to this interplay of spec short covering and spec long liquidation, with the latter having gained the upper hand when the market broke to the downside this week.
Speculators were net buyers of 3.4 million bales since September 30, but judging by this week’s action they may now be in the process of rebuilding their net short position. This brings back the old dilemma of who is going to take the long side if both speculators and the trade intend to go short.
The futures market is a zero sum game, which means that there has to be a long for every short. Index funds are the only group that is long in the futures market, but they are not expected to increase their position anytime soon since they are dictated only by money flows. Therefore, it is not possible for both speculators and the trade to increase their net short position at the same time. One of the two has to be a net buyer!
During the market’s decline between May and July we saw the trade reduce its net short position, while speculators increased theirs. Back then the trade was selling its dwindling old crop inventories, which required it to buy back short hedges, plus it was not quite ready to sell new crop futures yet. However, this time around, with Northern Hemisphere crops starting to stack up in warehouses, the trade may have a greater sense of urgency to seek some downside protection, often via bearish options strategies.
So where do we go from here? With both the fundamental and technical picture pointing to lower prices, spec and trade selling is likely to weigh on the market until a level is reached at which buyers are willing to step forward in greater numbers. Support may come from the cash market, since non-US growths have not been following New York down to the same degree, especially in India. We still feel that the A-index, which was at 67.40 cents/lb this morning, will find support near 65/66 cents, which in turn should help to stabilize the futures market at around 57/58 cents. However, since markets tend to overshoot, we cannot rule out a quick move to 55 cents, although the market would probably not stay there for very long.
Upside potential has become very limited at this point, since growers and merchants will be ready to sell rallies in order to lock in a spread to the AWP. Therefore, the market is most likely to remain in a sideways trend in the foreseeable future, albeit at a slightly lower level than in previous weeks.