NY futures extended their rally this week, as May gained another 304 points to close at 81.17 cents, while December advanced 63 points to close at 73.97 cents.

The market continues to run away to the upside almost uncontested, as the May contract has averaged gains of around 100 points per day over the last 13 sessions, rallying from 68.23 cents on February 5 to 81.17 cents today.

The most bullish factor in this ongoing rally is the expectation from some of a meaningful correction to enter the market on the long side. Mills continue to buy on-call May and July and are in no hurry to fix their already massive on-call position. Today’s on-call report showed that although mills were forced to fix 2’986 contracts that were on March last week, they increased their outstanding on-call commitments on May and July by a combined 2’740 contracts. This means that as of last Friday mills still had 3.3 million bales unfixed in current crop (1.3 million on May and 2.0 million on July). Overall unfixed on-call sales still amount to 5.6 million bales.

The trade has continued to sell into this strength according to the latest CFTC and ICE spec/hedge reports. The weekly CFTC report as of February 16 shows that the trade increased its net short position in futures and options by almost 1.3 million bales to 10.3 million bales net short. Since Index funds maintained their net long position at 7.3 million bales, it follows that speculators have started to rebuild their net long position, increasing it by 1.3 million bales to 3.0 million bales. The ICE report as of February 19 confirmed that specs are buying and the trade is selling, as speculators bought 10’257 contracts net (1.03. million bales) last week, while trade shorts were on the other side.

We believe we are currently in a bull market that is generating its own momentum and where outside markets do not seem relevant any longer, be it the stronger dollar or the weaker stock market. The same applies as to whether some mills may eventually shift out of cotton or reduce their production because the price is getting too expensive. These things will all matter again at some point down the road, but for the next three or four months all we need to focus on is how the various market participants will deal with their open positions in current crop futures.

Who is going to take the other side if trade shorts want or need to buy out of the market? Speculators follow trends and therefore typically buy strength and sell weakness. As we have seen in the spec/hedge numbers, speculators are currently jumping on the long side, so they are actually competing with trade shorts that need to get out. This leaves index funds, but as we have explained last week they will only be active for two more short periods in current crop, namely in late March/early April and then again in late May/early June when they roll their 7.3 million bale long position forward.

So there will be two opportunities where the market has enough liquidity to let these trade shorts out, but we are still about four or five weeks away from the first such rolling period. In the meantime sellers will probably be hard to find. At the same time, physical prices have kept up fairly well with the futures market, but we may now see spot futures accelerate at a much faster pace than the A-index, despite the tight physical situation.

We feel that the current bull market deserves even more respect than the one in 2008, because two years ago it was primarily a margin squeeze that fueled the market, while this time around we may have a margin issue coupled with a very tight fundamental situation. To have a strong taker for nearly 600’000 bales of certified stock despite an inverted market is something we didn’t see two years ago and it may just be a prelude for what’s to come in the May and July notice periods. There are plenty of rumors regarding the fate of the certified stock and it is certainly possible that a good part of this cotton has already been committed overseas.

Adding fuel to the fire today was a story out of China stating that the National Bureau of Statistics has the crop at just 6.4 million tons or around 29.3 million bales. This may prompt the USDA to lower its current forecast of 32.0 million bales in one of its next reports. The NBS also reported yarn output at nearly 24 million tons for 2009, up by 12.7 percent compared to 2008. Stories like these portend strong Chinese cotton imports for the remainder of the season.

So where do we go from here? We still feel there is upside potential on May and July since the specs want to be long, the trade will be a net buyer, mills will have to fix and there is not much cotton left to hedge. On Dec, we feel that the upside is more limited as a move above 75.00 is likely to attract some hedging of new crop. Therefore, we feel that the backwardation has the potential to increase over the next few weeks and we would advocate shorting May and July through long puts rather than short futures.

Best Regards