Eric Scholler
After witnessing record-setting cotton prices in the 2010-11 marketing year, cotton growers across the globe reacted to the sharp rise in prices by significantly increasing the world's cotton acreage during 2011-12. However, in spite of earlier expectations of significantly higher world output, the cotton market struggled with serious setbacks during the 2011 summer production cycle. Expecting a sharp output boost in the United States based on 7 million acres planted in Texas alone, U.S. merchants racked up significant early-season forward market sales, both domestically and abroad. Following the sharp price setback witnessed in July, with cotton futures losing more than 50 percent of value in less than three months, an unprecedented avalanche of contract defaults endangered the system contract sanctity that has served as the very foundation of the global cotton industry for 50 years. The level of contract defaults not only engulfed old crop values, but has aggressively continued well into 2011-12.
Textile mills, especially in Asia, have lost substantial amounts of working capital, leading to short-term financial distress. Not only has cotton been battling the financial balance sheet ramifications of these massive contract defaults, but the fiber has seen a substantial amount of substitution by other, alternative, fiber sources such as polyester as a result of the steep rise in cotton prices.
Despite the current negative market forces, foreign global demand continues to outpace foreign supply yet again this season. The United States is in the midst of rapidly expanding early-season forward market sales based on expectations of a 2011-12 U.S. bumper crop. Under the influence of a significant drop in U.S. output and sharply reduced forward commitments in the aftermath of record sales contract cancellations and commitment defaults, the anticipated foreign production gap — a driver of U.S. export potential — was simultaneously lowered with an increase in foreign production capacity.
Prices remain volatile even as raw cotton begins slowly to make its way to market. While world cotton production is expected to eclipse global consumption in the 2011-12 marketing year, several factors still remain that are expected to prevent cotton prices from dropping below the 90 cent mark for any appreciable amount of time over the next several months:
China's National Development and Reform Commission's procurement plan foresees replenishment of depleted Chinese strategic stocks to kick in below the announced threshold price of 19,800 yuan per ton, which equates to a New York futures price of $1.02 to $1.04 per pound. It is anticipated that the Chinese leadership will redress the strategic stock situation by accumulating a mix of foreign and imported cotton, resulting in creation of a new buffer stock able to bridge at least three months of consumption. This reramping of stocks should absorb 11 million to 12 million bales based on Chinese estimated 2011-12 usage of 45 million bales, which may be low depending on the extent and outcome of the Chinese economic slowdown during 2012.
Contrary to most market observers, analysts at Risk Management Group anticipate a significant reramping of the U.S. economy in 2012, which should lead to higher net textile consumption in the United States that could be the beginning of higher cotton consumption across Asia. Those consumption levels are expected to rise in spite of inflationary pressures across the region.
The level of real U.S. treasury market returns is negative when accounting for inflation as a result of the Federal Reserve Bank's monetary policy moves following the 2008 global economic crisis. Once the market senses the U.S. economy is gaining traction, an increase in risk-appetite and more aggressive funding of commodity markets is expected. This is likely to set the stage for a technical price rally, especially if the La Niña conditions in Texas garner elevated press attention. Speculation and high-frequency trading are likely to remain a driving force in the cotton market in addition to relative stock levels and fortunes of the global textile industry for the remaining months of 2011 and for the following year.
Current commitments for U.S. cotton offtake stand at 8 million bales of exports in addition to the anticipated 3.5 million bales of domestic usage. Given the outlook for U.S. production to tag 15.8 million bales and ending stocks to register nearly 3 million bales, there remain roughly 4 million bales to be marketed — a tall order given the current level of U.S. prices relative to the Cotlook A Index. Without accelerated imports by China to replenish its depleted stocks, it may be difficult to find the export channels to place these additional bales, unless global consumption rises from the U.S. Department of Agriculture's (USDA's) forecast level of 114 million bales to the expected 118 million-bale level.
According to the monthly cotton report issued by USDA on October 12, world ending stocks increased to 54.8 million 480-pound bales from 51.9 million bales in the previous month. USDA also raised its forecast for total world cotton output to 124.2 million bales from 123.0 million bales the previous month, and it reduced total global cotton consumption to 114.4 million bales from 115.2 million bales reported last month. The latest slide below the psychological dollar mark could be enhanced by an economic decline in China, given the current uneasiness in China's stock market. However, U.S. cotton futures appear to be well supported at the dollar mark, based primarily on Chinese buying in order to rebuild government cotton stocks, which were depleted in order to stabilize domestic cotton prices after last year's historic rally.
U.S. Export Sales And Eurozone Austerity
Not only was the market positively surprised by the U.S. gross domestic product (GDP) release on October 27 and the Eurozone's effort to contain its debt crisis, but the weekly export report brought a significant lift to the market, overshadowing any news out of Asia. U.S. export sales reached 385,100 bales in the latest month, beating market expectations and boosting domestic futures prices. But the fact remains that China's cotton export market is the only game in town. Without the Middle Kingdom, sales would have slumped to another disappointing number, as new sales outside China were confined to 31,200 bales against cancellations of 42,900 bales. This showing places shipments through week 12 still as the weakest over the past 11 marketing years, even though values are statistically nearing relatively more normal performance levels in comparison.
The European debt resolution plan hammered out at the latest round of summits — now totaling 14 over the last two years — has been hailed by markets as the cure-all and has led to a massive rally in all major currency and commodity markets.
Although this optimism in global financial markets is likely to be short-lived, the plan condemns Europe to austerity but toward certain recession over the long term, primarily in southern Europe including Italy, Greece, Spain and Portugal. Even though solvency has been saved, it will be at the expense of real growth. It is expected that European banks will be forced to accept a 50-percent cut on Greek sovereign debt, in addition to a forced recapitalization at the behest of the European Banking Authority. On top of already onerous austerity programs, this scenario will lead to even fewer loans from European banks and hamper any real growth potential for the flagging peripheral Eurozone economies that continue to struggle with tough economic times.
India And Pakistan
The cotton market was only too happy to take up the Hail Mary pass from politicians in Brussels with the latest round of debt resolution plans. On the heels of this development, managed money catapulted all major currencies to higher rates against the U.S. dollar, forcing commodity prices sharply higher — December cotton also among them. This activity was all but overshadowed by news India and Pakistan may be undergoing possible internal production revisions.
In late October, the president of the Pakistan Cotton Ginners Association asserted a 15 million-bale crop outlook, while the government body of the Cotton Crop Assessment Committee asserted a crop of only 12.2 million 375-pound bales. With politics in full play, Pakistani and Indian ginners currently enjoy free access to export markets, while mills continue to assert the need for a more restrictive export policy to protect access to cheap supplies of high-quality cotton. This debate on the subcontinent is likely to continue to rage as it has over the past marketing season. Given that India and Pakistan expect large production output levels of 35.5 million and 15 million bales, respectively, no restrictive export policies are expected to emanate from New Delhi or Islamabad unless global demand was to undergo a sizable shift toward higher demand during the first or second quarter of 2012. Risk Management Group anticipates the Pakistani crop to tag the 14 million- to 14.5 million-bale mark, which is expected to prove more than sufficient for the country's domestic textile industry at current usage rates. The same goes for India, where total exportable supplies of 8 million to 9 million bales are anaticipated after domestic demand has been satisfied.
A Look Toward December Cotton Futures And Beyond
The cotton market is poised to trade between 90 and 104 cents per pound through the end of December. Prices above the $1.00 mark are likely to place pressure upon mills to expedite their remaining fixations and squeeze supplies further up the supply chain. Given the ongoing malaise regarding the Asian cotton and textile markets, any rally going forward is expected to be largely technical in nature based on shorter-term outside market influences that will be overshadowed by increasing harvest pressure.
Even if the Indian and Pakistani crops see slight downward revisions, it will take a significant rejuvenation of the global textile business to support higher cotton prices at industry level. Overall, an allocation of managed money capital back into the commodity market is expected at the beginning of 2012 — especially if the nascent U.S. growth accelerates as the third-quarter GDP number suggests. This in turn will help support cotton prices through the first two quarters of 2012, especially if global demand recovers from the low expectations USDA has formulated in its October World Agricultural Supply and Demand Estimates report.
December cotton futures continue to gain significant attention as outside markets surged in a major relief rally over the Eurozone debt resolution plan. December contracts closed at the daily limit of +400 points, in the process cracking the 50-day moving average and allowing the Moving Average Convergence Divergence (MACD) indicator to close higher. With the MACD position under the zero histogram line, the jury is still out as to whether the market will see significant follow-through technical buying. The market is in major overhead resistance, with a downtrend not seen since 2008-09. The positive sloping stochastics is likely to support the board in the near-term. Overall, a price correction seems likely. In order for a significant price rally to take place, the market needs to break the 100-day moving average supported by rising volume and open interest.
Conclusion
Through year's end, cotton futures are expected to range between 90 and 104 cents per pound as cotton finds its way into the market. Over the subsequent months, technical indicators are expected to turn friendlier for cotton futures as speculative asset allocation into the commodity market will likely lead to higher prices. Growth in the U.S. economy is likely to boost domestic cotton prices over the first and second quarters of 2012, especially in connection with lingering supply problems amid another year of poor growing conditions expected in Texas, with the continued presence of La Niña. Over time, steady cotton prices are also expected to pass directly to the textile and apparel consumer, particularly at retail, which is likely to bring some price consistency to the apparel market, helping to boost sales. Price appreciation is anticipated through the end of 2011-12 on improved global consumption versus the current set of expectations and forecast. The 2012-13 new crop weather developments and global acreage competition will represent additional significant price inputs for cotton futures price discovery into the summer of 2012 that should not be underestimated. A repeat of the Texas drought will place additional upward pressure on prices to ensure large foreign supplies.
