NY futures continued to move higher, as March gained another 248 points to close at 98.17 cents.

The market managed to extend its rally this week thanks to renewed spec buying. A week ago we felt that a correction was due once the index fund rebalancing was out of the way, but a constructive chart picture along with some bullish news out of China and an improving economic outlook brought some more sidelined speculators back into the fray.

Helping the bullish cause were rumors that the world’s two largest cotton producers, China and India, may have smaller crops than what is currently estimated by the USDA. The National Bureau of Statistics has the Chinese crop at just 30.3 million bales (6.6 million tons), which would be significantly lower than the USDA’s 33.5 million bales. This is not the first time we’ve heard news of a potentially lower crop in China, as about a month ago the Ministry of Agriculture pegged the crop at just 6.5 million tons (29.9 million bales). It is difficult to judge whether these lower crop estimates have any merit, but they have introduced an element of uncertainty that makes the shorts uneasy.

The story is similar in India, where slow arrival figures are prompting traders to lower their crop expectations, with many private estimates now at no more than 32.5 to 33.5 million local bales (25.4 to 26.2 million statistical bales). This would be some 0.8 to 1.6 million bales below the current USDA estimate of 27.0 million statistical bales.

In other words, the market is suddenly confronted with the possibility that global production may have to be scaled back, possibly by some 2 million bales or more. At the same time we may see global mill use recover from what we believe is an overly pessimistic number at 110.0 million bales. Therefore, the current estimate of a seasonal production surplus of 12.85 million bales may shrink in the months ahead, perhaps to as low as 8 or 9 million bales. Combine that with the fact that China’s Reserve has been aggressively siphoning off supply to the tune of 16.0 million statistical bales so far (of which 4.5 million are imports), and we may actually end up with an artificially tight market.

We have long held the belief that the huge price gap between China’s domestic market (135-140 cents) and the international market (A-index at 102.25 cents) would sooner or later have to narrow again. In order for this arbitrage to take place we need Chinese imports. Even though an official announcement is still pending, it now looks like an additional 1.1 million tons in sliding scale quotas will be issued shortly, which would be in addition to the 0.9 million tons Tariff Rate Quota (TRQ). Once Chinese buyers are armed with these additional 2.0 million tons of buying power, the idea is that they will take advantage of the much cheaper international offers and thereby bid prices up.

The market doesn’t seem to be fully aware of the fact that China has already been a very active importer in the first five months of the current season. Last month alone China imported 790’000 tons (3.6 million bales), which was a record for a single month, beating the previous mark of March 2006 by nearly 300’000 tons. Total Chinese imports between August and December are already amounting to 1.88 million tons or 8.6 million statistical bales. This means that China is well on its way to meet or exceed the current import projection of 16.5 million bales by the USDA.

It is difficult to get too bearish in the face of all this Chinese buying, but at the same time traders realize that the cotton China is lifting off the market has yet to be consumed. It therefore may be difficult for prices to break out of their current sideways trend. For that to happen it will likely take a sizeable imbalance between supply and demand next season, which doesn’t seem to be on the cards. Early indications are that global production will drop, most notably in China, where a 10 percent planting reduction is expected, while consumption should continue to recover. Therefore, if we were to see output drop to by let’s say 6 or 7 million bales and consumption were to recover by 2 or 3 million bales, we might end up with a more or less balanced position next season.

So where do we go from here? The cotton market has been able to attract new buyers lately, as the sharp rise in open interest indicates. Since January 9, open interest has increased by nearly 10’000 contracts, which validates the recent strength. Speculators have been net buyers, while the trade continues to sell into rallies. The technical picture and recent market action suggest that the uptrend may have further to go. However, eventually speculators will be done buying and it remains to be seen whether the trade will be there to take over. Based on what we know today that’s not likely, but if the statistical picture starts to tighten due to supply/demand revisions, the trade may change its view and cover existing short positions. For now we believe that the market will continue to trade sideways, albeit in a somewhat higher range.

Best Regards