NY futures drifted lower this week, as March gave up 78 points to close at 62.99 cents.
The March contract moved progressively lower in a relatively narrow trading range of just 113 points this week, as speculators seemed to pare some of their recently acquired long positions, while the trade bought back some of its shorts on the way down. As a result we saw March open interest drop from a recent high of 146,818 contracts on December 9 to a still considerable 135,738 lots as of this morning.
The most recent CFTC report as of December 8, when the market was priced at 64.44 cents, showed that speculators had boosted their net long position by another 1.83 million bales to 5.98 million bales during the week of December 2-8. The trade added 1.68 million bales on the short side during that time frame, boosting its overall net short position to 12.18 million bales. We believe that this number will probably mark the highest net short position in current crop futures this season.
Last week we submitted that the statistical position as presented by the USDA portends higher prices going forward, perhaps not in the immediate future, but at a later stage in the season when the tightness becomes more apparent. Global production has already been scaled back by 15.4 million bales compared to last season, and there are indications that further reductions could be in store.
Reliable sources out of China seem to have the crop quite a bit lower than the USDA’s 5.2 million tons, at possibly no more than 4.7/4.8 million tons. This would clip another 1.8 to 2.3 million bales from the global production number this season, although it would probably not have much of an impact on global prices, since China’s net imports are not expected to change because of that.
West Africa is another region that might not quite live up to its expectations. The USDA currently has West African production at 1.06 million tons, but we feel that this number could be closer to 1.0 million tons or even slightly below that. West African prices are of great significance when it comes to US loan redemptions, since Benin, Ivory Coast, Burkina and Mali currently account of 4 out of the 5 cheapest origins used to calculate the AWP (Adjusted World Price).
Indian cotton, which is currently the cheapest component in the AWP calculation, got a boost this week when the state government in Gujarat announced that it would pay a bonus of 13.6% over the minimum support price (MSP) to growers who sell their cotton to the Cotton Corporation of India (CCI). Although the MSP + bonus are currently still below the prevailing market price, this new measure will certainly solidify support underneath the market.
We also need to keep a close eye on Brazil, where El Niño is causing some problems with drought in the north (Bahia) and too much rain in the southern growing areas. This has the potential to affect yield as well as quality this season, although at this point we believe that the current USDA estimate of 6.5 million bales is conservative enough.
While there seems to be plenty of underlying support when we look at just the cotton fundamentals, the market is facing considerable headwinds on the macro front. Yesterday the Fed decided to hike interest rates for the first time since 2006, which in turn gave the US dollar a boost today, knocking the CRB index to yet another new low (minus 26% year-to-date). And there seems to be no bottom in sight yet!
Meanwhile China continued to let its currency slide further, with the Yuan now near 6.50 to the dollar. This trend is likely to continue and it could drag emerging market currencies with it, as capital flight and the urge to remain competitive add up to further depreciation. Credit markets are therefore becoming increasingly nervous, as the current environment makes it a lot more difficult for companies to service their debt.
However, amid all the doom and gloom there are also some bright spots to point out! Cheap energy prices, couples with still record low interest rates, are providing consumers and companies around the globe with a much-needed shot in the arm. The world uses around 94 million barrels of crude oil a day and with prices now around 70 dollars cheaper than in the summer of 2014, the transaction value has dropped by around 6.5 billion dollars a day or 2.37 trillion dollars a year! While that’s a problem for oil producers, it is of great benefit to anyone that consumes energy!
The same goes for the cost of money! It has never been cheaper to finance a house or a car loan, and sooner or later this cheap energy and low interest “tax cut” will work its way through the economy and boost aggregate demand, probably when the markets least expect it.
So where do we go from here? The market seems to have moved back to its ‘fair value’ near 63 cents, although speculators and the trade both carry much bigger positions than the last time we were at this level.
The risk to the downside is that a big chunk of the 6.0 million bales net long that the specs recently accumulated gets flushed out, which could happen if the macro picture were to deteriorate further. A stronger dollar, a stock market selloff or credit market jitters are all potential triggers, along with a potentially bearish turn in the chart. So far the market has been able to hold above the former long-term downtrend line dating back to July that has now become support, but a breach below 62.70 would open the door for a move to 61.50 cents and beyond that to 59.50 cents.
The trade on the other hand has a rather large short position in the futures market at the moment with over 12 million bales net and given the statistical situation we feel that a lot of market participants are looking to fix or buy cotton on the next break, which should translate into considerable support for the futures market. Given the strong basis in the US and the relatively small supply of machine-picked high grades this season, we don’t see too much downside from here. We therefore feel that the recent trading range will remain intact for now and maintain our slightly more optimistic stance for the second half of the season.