NY futures continued to surge higher this week, as December rallied 533 points to close at 95.76 cents, while March jumped 565 points to close at 94.73 cents.

The bull market received additional fuel this week when India announced that it would postpone its export registrations until at least October 1. The Indian textile industry has been asking the government to restrict cotton exports until January, when a more accurate assessment of the crop size will be possible, after stronger than usual monsoon raised concerns about this year’s output. The previously announced duty free quota of 5.5 million bales was already smaller than traders had hoped for and this postponement has been adding more uncertainty to an already jittery market.

The current cotton market reminds us of a game of ‘musical chairs’. The delay by India, the world’s second largest cotton exporter, is further reducing the pool of available sources, just weeks after the world’s fifth largest exporter, Brazil, saw its prices explode to prohibitive levels and has recently even issued a duty free import quota of 1.1 million bales. Since the export policy and availability of the third largest exporter, Uzbekistan, remains largely uncertain at this point and number four Australia won’t bring any relief until well into the second quarter, the US is currently the only big chair to sit on.

That became quite evident when the latest US export sales report was released this morning, since last week no less than 845’600 running bales of Upland and Pima cotton were bought by 21 different markets. Quite remarkable was that 256’000 of those bales were for the 2011/12 season. For the current season export commitments now total 7.9 million statistical bales, of which only 1.2 million have been shipped so far. For the 2011/12 marketing year we have sales of already 0.5 million bales, which is over five times as many as last season.

As we have stated repeatedly, mills are primarily attempting to secure needed supplies down the road for fear of not finding them later on, but they have continued to buy the vast majority ‘on-call’. The latest ‘On-Call’ report showed an increase of 876’500 bales in unfixed sales last week and there are now an unprecedented 10.54 million bales that still need to be fixed, of which 9.28 million are on December, March, May and July. By letting this number grow bigger week after week, mills are undermining their hopes for a meaningful correction.

The latest CFTC report showed that the trade had a 15.3 million bales net short position as of September 7, while the long side was split between index funds (6.9 million bales net long) and speculators (8.4 million bales net long). A while ago we talked about the role the index fund long position plays in a bullish market environment. Since index funds are driven by money flows in and out of commodities, they don’t react to fundamental and technical signals like speculators and commercials do. This tends to lead to an imbalance between market-driven longs and shorts; in this case the 8.4 million bales in spec longs and the 15.3 million trade shorts. While that is no problem in a neutral or bearish market environment, in a bull market it tends to exacerbate moves to the upside. In recent years we witnessed such extended moves in several markets, most notably grains, sugar and crude oil, and now it seems to be cotton’s turn.

We feel that trade shorts currently have a tough time managing their sizeable net short position in futures. We estimate that the trade so far had to come up with some 1.3 billion dollars in margin money since July 20. Since there is hardly any inventory available as collateral, we imagine that banks are quite reluctant to extend additional credit to traders at this point. We therefore have a market in which the shorts are forced to play defense, yet there are not too many traders willing to take the other side, since speculators prefer to ride this uptrend for as long as it lasts, while members of the trade are handicapped by cash constraints.

We believe that the relative strength we are seeing in December and March compared to the back of the board has a lot to do with this tight cash scenario. Although there is certainly a fundamental and technical justification for this bull market, if statistical tightness were the main driver, then the July contract would not be limping behind like it currently is. In other words, if there are fundamental reasons for December to trade beyond 95 cents, then July looks like a steal to us at 92.50 cents.

Once the crop is in, we believe that the inversion that exists within current crop futures will begin to reverse itself. We have already seen the October contract fall below December after it had traded at substantial premium several weeks ago and the Dec/March spread has started to reverse as well. Merchants will then once again have the opportunity to use certified stock to force carry back into the market. Regardless of the directional trend of the market, we believe that it does not make sense for March to trade at a 200-point premium to July, because it will be towards the end of the season when pipeline stocks are going to be the tightest.

So where do we go from here? Looking at the chart the market has now eclipsed all previous highs on the continuation chart going back to 1995 and the next upside target is the all-time high of 117 cents. So from a technical point of view there is not much in the way of higher prices at the moment. As we have explained above, the shorts are quite defenseless at this point due to cash constraints and may increasingly be forced to buy protection as the market moves higher. All these factors are combining to fuel this bull market and have actually become self-reinforcing. What could possibly stop this runaway market? Maybe the harvest will bring about a different mindset among traders and we may also see some demand rationing take hold. However, we wonder whether these factors will weigh in soon enough to prevent a dreaded melt-up in the futures market.

Best Regards