NY futures retreated this week, as December gave back 396 points to close at 102.99 cents.

Although the market managed to rally all the way up to 109.00 cents on Wednesday, taking out the 108.62 cents resistance level and filling a chart gap at 108.88 cents in the process, there wasn’t enough momentum to sustain the advance and prices have since fallen by over 500 points. As we have pointed out last week, in order to validate the strong advance we have seen between August 9 and August 24, during which the market rallied by more than 15 cents, we need to see strong volume and rising open interest. There were a few bursts of decent volume, but not enough to support a bullish case, while open interest rose by only about 4’000 contracts overall, with the lead month December actually dropping by 1’654 contracts. Therefore, the attempt to break out of a ‘double bottom’ formation has failed and the market is now trying to regroup.

Today’s export sales report did not help the bulls either, since another 230’300 running bales net were cancelled for the current marketing year, bringing the two-week total of net reductions to 567’300 running bales. The 387’200 running bales that were reported for the 2012/13 marketing year last week were obviously a clerical error, since they were taken out again this week.

Merchants have apparently been busy trying to reduce their US exposure by switching to other growths, since ‘optional origin’ sales increased by 607’700 running bales this week, with 546’900 bales involving commitments to China. These US reductions are not necessarily as bearish as they may look at first glance, because they seem to be a move to bring US commitments down to a level that allows shippers to fulfill their contracts in light of all the problems the US crop is facing, with over 40 percent of the crop rated poor to very poor.

After this latest round of cancellations, or rather switches to ‘optional origins’, total outstanding commitments now amount to 6.5 million statistical bales of US cotton, plus 0.7 million bales in the ‘optional origin’ category. While this is still a fairly big number by historical standards, merchants are starting to get a grip on their US exposure. The bottleneck problem US shippers are confronted with is slowly but surely being addressed and if further reductions and switches to other growths follow over the coming weeks, it will disarm the potentially explosive December contract.

The way the global supply/demand balance sheet is shaping up, it is difficult to make a case for prices to go much higher from current levels. Production is expected to be comfortably higher than demand and unless there are some major problems at harvest, there will be no reason for mill buyers to chase prices higher over the coming months. What is particularly striking is that the foreign production gap is projected at only 5.2 million bales this season, which compares to 13.6 million bales last season and 25.7 million bales in 2009/10. We have to go all the way back to 2004/05 to find a smaller gap than this season. This is significant in the sense that it will render US imports less urgent. In fact, current US export commitments already more than cover this foreign production gap of 5.2 million bales, which may explain why the rest of the world is not too concerned about the dismal Texas crop. In a nutshell, there is enough cotton to go around this season and even to rebuild some of the depleted stocks around the globe.

While the upside looks contained, there is also reason to believe that prices won’t fall apart anytime soon. First of all, it will take until early next year to get enough cotton into the pipeline to relieve the bottleneck that currently exists and to rebuild stocks to more comfortable levels. Then there are several outside factors that act in support of cotton prices, like strong grain prices, the high cost of energy and the loss of the US dollar’s purchasing power.

This week December corn rallied to over US$ 7.40 per bushel and even December 2012 corn prices are already over US$ 6.50 per bushel. The same goes for soybeans, where current crop prices are near US$ 14.00 per bushel and November 2012 soybeans are at US$ 13.40 per bushel. This means that cotton has its work cut out if it wants to defend its current acreage next season.

So where do we go from here? We still believe that a sideways trend makes the most sense going forward. There is currently no reason to believe that prices will run away to the upside and there are also plenty of factors that offer support. The market seems to think so as well, because volatility readings have been dropping steadily, with December now below 39% volatility and March, May and July 2012 between 34 and 36%. However, while cotton fundamentals may predict an uneventful season, we need to be vigilant of developments on the economic and financial front. The lingering debt problems in Europe and the US have the potential to turn the financial markets upside down at any time, which could send commodities on another rollercoaster ride.

Best Regards