NY futures continued to rally this week, as July jumped 270 points to close at 84.82 cents, while December gained 130 points to close at 77.19 cents.

After several failed attempts, the July contract finally managed to break out of its 7-week sideways range and it did so in convincing fashion. July literally exploded to the upside, as it rallied from a low of 80.52 on Monday to a high of 86.80 on Wednesday in heavy volume. It has since given back about two cents but has so far been able to hold above the breakout point.

We believe that there are quite different dynamics at work in the July and the December contracts, so let’s take a closer look at what is driving these futures months. July is the last contract of a season that has seen the biggest foreign production gap ever at 23 million bales. Even if the US manages to export 12 million bales, it will only cover a little over half of this huge deficit, while the balance has to be supplied from existing inventories. Due to this tight statistical situation we had a strong physical market all season long, leaving mills with little negotiating power.

Although mills did not hesitate to secure their needs from shippers, many of them left the price open by buying ‘on-call’, waiting for some breaks in the market to cheapen their deals. While this strategy may have worked well in recent years, it has backfired this season, as unfixed on-call sales have increased from 2.6 million to currently 7.0 million bales since the bull market started back in March 2009. This bigger than usual ‘on-call’ position, combined with the fact that large basis-long positions were established early in the season, has given the trade a fairly substantial net short position to contend with. According to the latest CFTC report, the trade’s net short still amounted to 12.1 million bales last week, of which about two-thirds were in current crop.

As long as this net short position can be rolled forward at more or less full carry it does not really pose a problem, but July seems to be the end of the line in that regard, since it is currently trading at an invert of nearly 800 points to December, which is about 1300 points shy of full carry. Merchants have tried to combat this inversion by boosting the certified stock to about a million bales, but so far the market has been unimpressed.

Rather than waiting for this inversion to collapse, many owners of basis-long positions have decided to aggressively sell their physical longs into the current strength and to get out of short futures. Combined with fixation related buying this is keeping the July contract well supported at the moment. Many traders seem surprised that the certified stock has not been able to put a lid on the market. While it has forced out the May/July spread to more than full carry, it hasn’t prevented the board from moving higher.

We believe that it is all a matter of timing. Right now the certified stock doesn’t pose a threat to the market because the wide May/July spread is facilitating another roll forward. In other words, the market has just bought itself another two months to deal with the problem. In the meantime we have trade short-covering and new spec buying leading the front end higher. We once again have a situation in which there are more traders wanting or needing to buy the July contract than others willing to sell it. The trade is getting out of shorts and speculators like the long side based on the market’s strong technical performance. There will be dips resulting from occasional voids of buying or from momentum players trying to scalp a cent or two on the short side, but the tide will only turn once this massive trade short in July has been greatly reduced. At that point we could very well see the July contract collapse, but it may be another six to eight weeks before that happens.

The dynamics in the December contract are entirely different. The outlook for a much bigger crop next season, not just in the US, but globally, is going to provide a lot of hedge selling over the coming months. Even though it is a tall order for world production to catch up to global mill use (estimated at 118 million bales), we may see it happen. Growing conditions in the Northern Hemisphere seem to be ideal after a very cold and wet winter, promising low abandonment numbers and high yields. West Texas growers are particularly enthusiastic after receiving up to 10 inches of rain since the beginning of the year. Once the seed is in the ground, growers and coops will want to lock in at least part of their expected crop at the current high price level or use bearish options strategies to seek downside protection. Mills on the other hand are not expected to book a lot of forward cotton at these prices, at least not on a fixed price basis, which means that there is not much to counterweigh grower selling until prices move lower.

So where do we go from here? July looks well supported at the moment as trade shorts are covering, while December will face a lot of resistance from grower selling from here on up. This should keep the steep inversion alive for the time being, although we would not be surprised to see the spread collapse as we approach the final days of July. Again, it is all a matter of timing and with so many open positions yet to be dealt with it promises to be a very volatile affair.

Best Regards