NY futures lost further ground this week, as December dropped another 583 points to close at 98.63 cents.
It was sheer capitulation last Friday and Monday, when December caved in 1000 points without much opposition, as traders were dumping positions in panic-like fashion and sentiment turned exceedingly bearish. It looked like a typical exhaustion move in a market that saw December fall from a high of 140.90 cents on June 3rd to a low of 94.46 cents on July 18, a drop of over 46 cents in a matter of just six weeks!
The price collapse is even more dramatic when we look at how much the spot futures contract and physical prices have fallen since March. On March 7, spot futures traded to a high of 219.70 cents (synthetically reaching as high as 227 cents), while the A-index was quoted at 243.65 cents the following day. Due to a lack of quotes there is currently no A-index published, but the forward A-index, which includes quotes for shipment October onwards, stood at just 116.10 cents this morning, which is less than half of where prices were a little over four months ago.
How was such an epic collapse possible? Once the parabolic rise in prices had run its course and mills began to withdraw back in March, the momentum shifted into reverse, which created some very powerful bearish dynamics. Suddenly it was the longs that were feeling nervous, as they desperately tried to find a home for their remaining inventories, many of which were acquired at fairly expensive levels. With buyers in hiding, many traders turned to New York as a buyer of last resort and this started to weigh on the futures market. But even that offered only limited protection, because there was this huge, unprecedented inversion between July and December, which posed a big problem for anyone carrying a basis-long position. As the July contract was nearing expiration, these basis-longs were facing a 30-40 cents ‘roll loss’ to keep their positions hedged. This dilemma prompted some traders to dump their inventories into a dead market at huge discounts, just to escape this no-win situation.
But this dump and run strategy created a new set of problems, as the big price drop led to an increasing number of defaults at steep market differences. So on one hand merchants were trying to reduce their longs at throwaway prices, while on the other hand defaults and cancellations kept refilling their books with expensive cotton. With most mill buyers still in hiding, merchants once again resorted to the futures market for some price protection. The lower the market went, the more momentum this self-reinforcing process gathered and the more traders panicked.
What will it take to stop this brutal downward spiral? We believe that sooner or later we will either see mills return to the market as prices begin to look attractive to them or all these long positions that needed protection are finally hedged, which should take away the selling pressure. We don’t know whether we have reached that point just yet, but we are probably not too far from it.
In the grand scheme of things the amount of long positions that were caught in this downtrend is not that huge in absolute numbers, even with all the recent defaults and cancellations added back in. World stocks are still relatively small by historical norms and even at reduced global demand there will not be a lot of cotton left in October. Take the US for example, where stocks will just about run out by the time new crop starts coming in. We estimate that the US will have about 3.0 million statistical bales left when the new marketing year starts on August 1, which is about the same amount we had a year ago. Against that export commitments will be in the neighborhood of 7.5 million statistical bales (including the carry-in from this season), which is a record. In addition to exports we also need to account for about 0.32 million bales of domestic mill use per month.
We figure that about 60% of next season’s supply of around 18.5 million bales (3.0 beginning stocks + 15.5 million crop) is already spoken for. We therefore don’t expect to see any price pressure from the US for months to come, at least not until this struggling crop is safely in and existing commitment have been applied.
The situation in the rest of the world looks a little more comfortable, but not by much. The reason why mills are not too worried about tight stocks this fall is that crops in the rest of the world promise to be quite a bit larger than in the previous two seasons, which should guarantee enough availability after we pass the bottleneck.
So where do we go from here? The physical market is finally becoming more active, although so far it has been mainly China who accounted for the recent buying interest. Nevertheless, after dropping about 120 cents in a matter of just four months, the market looks oversold and we expect prices to stabilize. If mill buyers were to return in greater numbers, we could even see a bit of a rebound in the weeks to come. However, in order to rekindle any kind of a bull market, we either need a crop problem other than Texas or stronger than expected demand. In our opinion the most likely scenario at this point is a sideways trading range and a pronounced drop in volatility.
Best Regards
