New York futures were able to halt the decline this week, as December advanced 115 points to close at 64.02 cents.
After speculators had sold nearly 8 million bales net since early May, they finally seemed to move to the sidelines, allowing the market to recover some of its losses this week. The latest CFTC report as of July 29 showed speculators (including non-reportable positions) at 1.6 million bales net short, whereas the trade was 4.1 million bales net short, leaving index funds currently as the only group on the long side with 5.7 million bales net long.
When December dropped to a low of 62.02 last Friday, it traded more than 10 cents below the A-index of 72.15 cents, which is about 2-3 cents above the traditional spread between these two measures. This meant that the futures market was either getting too cheap in relation to cash prices or vice versa. Since the AWP (Adjusted World Price) is near the loan level and growers are refusing to sell their cotton at these depressed levels, we believe that the former is the case, as cash prices are holding steady for now, which in turn stabilizes the futures market.
Another element of support comes from the current relationship between ROW (rest of the world) and Chinese prices. The bearish case is to a large extent built on the expectation that China is not going to import enough cotton to absorb the ROW production surplus this season, which would lead to higher ROW ending stocks at the end of the season. But what if China were to surprise the market once again by importing more cotton than anticipated?
Under the current system there are a number of ways for Chinese mills and trading companies to import cotton. So far the market has been under the assumption that Chinese imports next season would be tied to specific quotas only (TRQ, Sliding Scale and Processing Trade), while little or no consideration has been given to the possibility of China importing cotton outside the quota system by paying the full 40% duty. However, since ROW prices have fallen by nearly 25 cents in just three months, they are getting close to the level at which 40% duty imports become feasible.
For example, at 70 cents CIF landed and a US dollar/RMB exchange rate of 6.15, the equivalent cleared customs price (including 40% duty, VAT and port charges) calculates at roughly 15Ά200 RMB/ton. For the lower duty Tariff-Rate and Sliding Scale quotas the numbers work out to around 11Ά000 RMB/to and 13Ά600 RMB/ton, respectively.
The current CCI index still calculates at around 17Ά100 RMB/ton, but forward prices as measured by Zhengzhou futures or the CNCE trade between 15Ά400 to 14Ά700 RMB/ton for November to January deliveries. This means that ROW prices are getting competitive vis-à-vis Chinese domestic values, even at the full 40% duty!
Of course Chinese domestic prices could fall further and thereby open the door for lower ROW prices, but we donΆt believe that growers will relinquish their cotton without putting up a fight, at least not in the early going. Last year Chinese producers got 20Ά400 RMB/ton from the government and now they are looking at forward prices below 15Ά000 RMB/ton. Although the government will offer producers some price support in the form of direct subsidies, it will probably not be enough to put a smile on their faces.
We therefore feel that the marketΆs bearish outlook may find itself at odds with growersΆ resistance to let their cotton go, not just in China, but in India, the US and many other origins as well. Also, letΆs not forget that there are support mechanisms in place, like the US loan program or the Indian MSP, which will help growers to buy some time. While we donΆt doubt that large crops may eventually force prices lower, we wouldnΆt be surprised to see some of the early short positions get squeezed.
US export sales for the week ending July 31 amounted to 250Ά100 running bales net, with ChinaΆs 73Ά600 running bales leading a pack of 19 different buyers. The final export figure for the 2013/14-season amounts to 10.57 million statistical bales, which is slightly higher than the latest USDA estimate of 10.50 million bales. For the current marketing year, i.e. the 2014/15-season, total commitment currently amount to 4.6 million statistical bales, which compares to 3.4 million bales a year ago.
So where do we go from here? We feel that the futures market is currently boxed in by strong support in the low-60s and massive overhead resistance in the high-60s/low70s. The support comes from growersΆ resistance to sell and the possibility of Chinese imports outside the quota system, while overhead resistance results from the tradeΆs need to increase its price protection in the futures and options market. The drop in volatility this week seems to indicate that the market has started to discount the above scenario.
With the certified stock disappearing (just 112Ά000 bales as of this morning), we still feel that December is a dangerous month to be short at these low levels. The brunt of this bear market will probably not be felt until early 2015 when growers start running out of money or patience and for this reason we believe that March, May and July offer a much safer bet for short hedgers.
Best regards
