NY futures had a mixed performance since our last report two weeks ago, as March traded down 690 points to close at 141.22 cents, while December rallied 517 points to close at 100.97 cents.
After making an all-time high of 159.12 cents just before Christmas, the March contract fell for a few sessions thereafter but has since transitioned into a sideways pattern, closing the last 9 sessions in a relatively tight range between 140.43 and 145.76 cents. With the spot month calming down, the extreme backwardation has started to reverse as well, as the March/July inversion retreated from over 3300 points to currently around 1300 points, while the March/December inversion went from over 6200 points to a little more than 4000 points today. In fact, while March has been going through a steep correction, December closed today at a new contract high of 100.97 cents.
Bearish commentators have been pointing out that export business has slowed considerably in recent weeks. While this is definitely the case, the bullish camp is quick to counter that this is mainly due to a lack of available supplies and that sellers are in no hurry to discount prices on their remaining inventory.
We believe that both sides raise valid points and that’s probably why the market has been relatively steady over the past two weeks. While most consuming markets are currently well supplied with cotton, as they are able to draw from their own crops as well as imports, it doesn’t change the fact that from a statistical point of view we are in one of the tightest seasons ever and that many origins have already committed the bulk of their crops.
Take the US for example! At the end of December, export commitments for the current marketing year amounted to 14.5 million statistical bales, which combined with the 3.6 million bales that US domestic mills require adds up to 18.1 million bales. In other words, the 2010/11 US crop – currently estimated at 18.27 million bales by the USDA – has basically been committed! This means that statistically speaking, any additional sales will have to come out of the relatively small beginning stock of 2.95 million bales. Since there are already 2.0 million bales committed for next marketing year (beginning on August 1) and domestic mills will need around 1.0 million bales between August and October to tie them over to new crop, the US is for all practical purposes sold out.
Although mill buying is currently very sporadic and selective, offers nonetheless remain at elevated levels and there have been no noticeable price concessions on recent sales. The A-index was still at over 173 cents this morning, while the China Cotton Index converted to 188 cents. In other words, these two physical price measures are still at a considerable premium over NY futures. Until about six months ago, the A-index traded at a 5 to 8 cents premium over spot futures, while it is currently at a 30 cents premium, reflecting the tight situation in the physical market. Therefore, unless we see a significant drop in cash prices, it will be difficult to envision a much lower NY futures market.
Today’s late sell-off seems to have been caused by Index Fund rebalancing. Earlier this week a news report claimed that nearly 14’000 March contracts would have to be sold between today and January 14 in order to bring cotton’s share back to the allotted percentages in the GSCI and DJ-UBS indexes, which are the two most widely tracked commodity benchmarks.
While we do not doubt there is some selling tied to Index Fund rebalancing, we don’t believe that it is of the magnitude mentioned above. When we look at the latest CFTC report as of December 28, we notice that Index Fund related accounts owned 73’356 longs and 14’911 shorts for a net long position of 58’445 contracts, or 5.84 million bales. As you may remember, Index Funds are by definition a ‘long only’ investment and it therefore strikes us as odd that there are 15’000 shorts on the books. We believe that most of these shorts were put on by swap dealers a while back in anticipation of the current rebalancing and to possibly take advantage of the huge backwardation that has existed for some time now. We therefore believe that the impact from Index Fund related selling is not going to be as severe as some analysts fear.
So where do we go from here? When we look at the latest net positions of the various market participants as reported by the CFTC, we have Index Funds (5.84 million bales net long) and Spec/Hedge Funds (5.22 million bales net long) vs. the trade with 11.06 million bales net short. Most of these trade shorts are against pending on-call fixations, since there is not really that much cotton left that needs to be hedged, at least not in current crop. Today’s on-call report shows that as of December 31 there were still 10.45 million bales in unfixed on-call sales, of which 2.7 million are on March, 1.9 million on May and 3.7 million on July. This presents a problem in our opinion, because there may be a lack of sellers to accommodate the 8.3 million bales of fixations that still need to be done over the next five months.
Once the current rebalancing is behind us, Index Funds are likely to remain invested on the long side and may even add additional long positions. This leaves Hedge Funds and other speculators as potential sellers, but with inflation fears flaring up, this group too is likely to stay long. So who will be there to take the other side if trade shorts want or need to cover? With little cotton left to trade in the US cash market, the NY futures market could become quite thinly traded as we move further into the season and it may take elevated prices to entice potential sellers. We still feel that this is a dangerous set-up for the many trade shorts that remain in the game and they should take any opportunity that presents itself to get out of this predicament.
Best Regards
