NY futures exploded to the upside this week, as December rallied 872 points to close at 73.87 cents.
When the market broke above a near-term flag formation and a two-year sideways trend earlier this week, it triggered a massive amount of speculative buying that overwhelmed the bears. In just four sessions December surged more than 1000 points, going from an intra-day low of 64.45 last Friday to an intra-day high of 74.78 cents on Wednesday.
Daily trading volume was impressive, reaching as many as 65,821 contracts on Wednesday, a number we usually see during the Index Fund roll period. It was important that the market traded as much as it did after the locked limit-up close on Tuesday, because it allowed traders to manage their exposures rather than being trapped in another limit-up situation.
Open interest expanded by 38,778 contracts since last Thursday, reaching 221,774 contracts before today’s session, which matches the highest open interest for this date. Only in 2008 did we have a similar position, when 221,248 contracts were open on July 14.
The December open interest of 180,293 contracts (=18 million bales!) marks a record for this date, nearly 12,000 lots more than in 2008 and 31,000 lots more than last year. The big jump in open interest suggests that speculators got longer and the trade used the rally to sell into, although we need to wait for tomorrow’s CFTC numbers, which include options, to get a clearer picture of how these respective positions have changed.
One potential problem associated with such a large open interest is the financing of margin calls. A 22 million-bale short position generates USD 110 million in margin calls for every cent the market advances. Since margin requirements increased as well this week, we estimate that the shorts had to fork out close to a billion dollars in margin money.
Since we are in between crops and there is not a lot of current crop inventory left, while new crop is still growing in the field, we wonder how much additional financing lenders are willing to extend to trade shorts given the lack of collateral. This varies of course from trader to trader, but we may reach a point at which some shorts will find it difficult to stay in their position if the market continues to push higher.
The trade currently has clearly the weaker hand in this ‘money vs. cotton’ contest, mainly because there isn’t a lot of cotton around. Old crop is basically sold out, with the exception of a few remnants here and there, which means that the trade has to hope for an abundant supply of new crop cotton to fight back the specs at some point.
Looking at the latest USDA report, it becomes clear that this rally isn’t just a technically induced flash in the pan, but that there are fundamental reasons for prices to move to a higher price plateau as well. The WASDE report wasn’t particularly bullish, because the US crop went up by 1.0 million bales and the only reason US ending stocks didn’t increase is because export expectations were lifted as well.
The world numbers, as presented, were mildly bullish due to the changes in China, where mill use increased by 1.5 million bales each in the current and next marketing year in order to address the stronger than expected Reserve sales. However, China still has enough inventories to keep its mills well supplied for the next 2-3 seasons.
The world numbers should have been a lot more bullish, because the USDA missed the mark on India by a wide margin. Instead of reducing ending stocks in India, the USDA actually took stocks up slightly and now has them at 11.19 million statistical bales, or 14.3 million Indian bales. As pointed out last week, we feel that this number is some 4.5 million statistical bales or 5.75 million local bales overstated!
When we look at the ROW supply/demand numbers (=all countries minus China), the USDA has production for 2016/17 at 81.05 million bales and mill use at 76.6 million bales, which results in a 4.45 million bales production surplus. However, since China is expected to import 4.5 million bales from the ROW, this production surplus would be wiped out. In other words, the current ROW numbers suggest that ending stocks will remain exactly the same as they are now.
This means that the USDA expects this rather tight stock situation to stay with us next season! On the supply side there isn’t really much that can be done, because it is too late for additional acreage to be planted in the Northern Hemisphere, although Brazil and Australia might be able to add 2-3 million bales thanks to these higher prices. But by and large the ROW will have to live with a fairly tight balance sheet until late 2017!
US export sales continued to add 173,800 running bales to the tally before the market took off, with 17 markets buying and 20 destinations receiving shipments of 156,900 running bales. Total sales for the current season are now at 9.8 million statistical bales, of which 8.5 million have so far been exported. Commitments for the 2016/17-season are now at 2.2 million statistical bales.
So where do we go from here? The market has made a parabolic move to the upside this week, with new longs entering the market and many shorts being forced to defend short futures and/or call options. Some traders apparently fear a repeat of 2011 as evidenced by the buying of way out of the money call options with strike prices as high as 110 cents.
We don’t subscribe to this extreme bullish view, since unlike in 2011 China has still plenty of cotton to feed to its mills, while the ROW will find a way to manage. Let’s not forget that US high grades are now approaching 90 cents landed Far East for new crop, which is a tall order for mills unless yarn prices were to follow the lead of cotton. If prices continue to rise there will be some demand destruction, as mills will throttle production or switch to man-made fibers.
However, current crop is basically sold out and new crop is still an unknown, which should keep values well supported over the next couple of months. The market therefore remains vulnerable to weather issues until new crop gets harvested and the pipeline fills up again. Another risk is that speculators continue to juice up the market and thereby force some of the financially weak trade shorts out of the market.
The market will likely remain volatile in the near future and we see values trade in a range between 68-76 cents. Higher prices are possible if there are crop issues and the trade loses its cool.
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