NY futures accelerated their move into uncharted territory this week, with December rallying 1877 points to close at 140.45 cents, while March advanced 1786 points to close at 136.66 cents.
The market posted new historic highs every single day of the week and the December contract has now basically doubled in price since July 20, climbing from 73.01 cents all the way up to 140.45 cents. It’s hard to believe that less than two years ago, on November 11, 2008, the spot month was trading as low as 36.70 cents.
We believe that the following forces are driving this unprecedented bull market:
1) A bullish supply/demand story, particularly in the case of China
2) Shortage of available cash among the trade
3) A shift in asset allocation in reaction to loose monetary policy
We have repeatedly argued that the USDA has overstated China’s stock numbers by a considerable margin over the last two seasons. In just 18 months, since May 2009, the Chinese Reserve has auctioned off around 16.5 million bales of its stockpile in an effort to supply the domestic market with much needed supplies. Yet the USDA numbers hardly reflect this huge drawdown in government stocks, thereby implying that free market stocks must have increased rather substantially.
When we look at ending stocks in China over the last 4 seasons, we have 20.5 million for 06/07, again 20.5 million for 07/08, 22.4 million for 08/09 and 18.25 million on August 1, 2010. But would Chinese prices really have rallied to over two dollars a pound if available stocks were at more or less the same level as in the previous three seasons? Probably not!
So where did the statistics go wrong? We can’t really disagree with the production and consumption numbers the USDA shows in its balance sheet, which are in the ballpark of most private estimates. However, what seems to have gone largely unnoticed by the marketplace is that the USDA has been adding ‘phantom stocks’ back into the Chinese balance sheet year after year. It has done so via so-called ‘negative loss adjustments’, which the USDA has been adding to Chinese ending stocks since 2005. Back then these stock adjustments may have been justified, since the USDA correctly felt that Chinese stocks were underestimated at the time. But what started out with good intentions and a relatively minor adjustment of 0.4 million bales in 2005, has since grown into rather substantial annual add-ins of 2.0 to 2.25 million bales.
Just over the last three seasons, the USDA has added 6.25 million bales to the Chinese balance sheet that way, at a time when the government was getting rid of nearly all its stock. Therefore, if we were to disregard all these add-ins over the last 3 seasons, Chinese beginning stocks would be at a more realistic 12.0 million bales instead of 18.25 million bales. This would explain why the Chinese market has been acting with so much desperation lately.
But lower stock levels are just one element of the bullish China story. A smaller than expected crop (likely below 30 million bales) and stronger than expected mill use (based on recent yarn statistics) have been widening an already large seasonal output gap to potentially more than 20 million bales. Since China can’t run stocks a whole lot lower than they currently are, its only remedy is to either import in excess of 4 million tons or reduce demand via high prices. We believe that we are going to see a combination of the two, as imports will likely be some 2 million bales higher than the 13 million the USDA currently estimates, while demand destruction should take care of the rest.
However, it may be difficult for China to find all these necessary imports. Today’s US export sales report, which was again stellar at over 600’000 bales for both marketing years, tells us that there are already 11.8 million statistical bales committed at this point. Therefore, assuming beginning stocks of 3.0 million bales, a US crop of 19.0 million bales and domestic mill use of 3.6 million bales, there are currently no more than 6.6 million bales left for sale. Since China has so far bought ‘just’ 3.7 million statistical bales from the US, it may have a difficult time finding all these extra bales it needs until the end of the season, which is why we continue to see Chinese mills scramble for imports, even at these elevated levels.
Another factor that has helped to fuel this rally is the trade’s shortage of available cash. This rally has come at the worst possible time for merchants with large basis-long positions (long physicals/short futures), because not only did they have to send billions of dollars in margin money to New York since July, but they also have to pay growers for their crop now. Money will eventually come back once cotton gets shipped and invoiced, but a the moment the cash drain is tremendous and in some cases it has forced traders to make defensive moves in the futures market by buying calls or call spreads, which has further fueled an already hot market.
The third ingredient to this bull market is the pronounced shift in investor sentiment that we have been witnessing since early summer. More and more investors are convinced that all this money printing by central bankers, here and elsewhere, will eventually debase fiat currencies and lead to severe inflation. Commodities are therefore seen as an attractive way to store value. It is no longer just precious metals that are seen in this role, but the commodity complex as a whole.
So where do we go from here? It is still anybody’s guess at what point this freight train will finally run out of steam. Although many import markets have started to back off, China is still actively pursuing cotton at levels that justify December futures at 140 cents and based on its huge import potential this season, China may be able to singlehandedly support an elevated market for months to come. Demand destruction is definitely occurring at these levels, but how much and from what baseline is still up for debate. Statistics may have underestimated demand over the last 24 months as result of the financial crisis. What if end-user demand was running at an annual pace of 124 million bales? And if so, would an 8-10 million bales drop in demand be enough to right the ship? Only time will tell, but for now we don’t see the dynamics in place to reverse this powerful bull market just yet.
Best Regards