NY futures continued their relentless decline this week, as December fell another 318 points to close at 62.87 cents.
Since closing at 84.53 cents on May 5, or around three months ago, the December contract has now lost nearly 22 cents and it is still anyoneΆs guess as to where this slide will finally come to a halt. As explained previously, what drives the market from one contract low to another is the fact that we have both the specs and the trade in sell mode, with not enough bidders willing to take the other side.
The latest CFTC report as of July 22 showed an all-too-familiar situation, as the trade continued to reduce its net short position by another 0.4 million bales to just 5.2 million bales, while index and hedge funds were net sellers. This means that the trade is around 2.5 times less short than a year ago, when it owned 13.4 million bales in net shorts, with a much smaller US crop in the field.
By allowing its net short position to decline from 12.0 to 5.2 million bales since May 6, the trade has clearly misjudged the severity of this bear market and is now forced to engage in damage control. Recent action in the options market hints at sheer panic among traders, as they are desperately trying to put some price protection in place. This in turn has resulted in a vicious downward spiral, as the ensuing selling pressure leads to more of these desperate actions over the following sessions, turning the chart convincingly bearish and keeping any potential buyers away.
While basically all the fundamental, technical and structural reasons behind the marketΆs freefall are well known by now, we need to be on the lookout for any supporting elements that could alter this overwhelmingly bearish perception. While sellers seem to be determined to get shorter no matter what, we feel that they disregard the unwillingness of producers to let go of their crops, especially in the early part of the season.
With the forward A-index currently quoted at 73.25 cents and probably another 50-75 points lower after todayΆs sharp drop, the AWP (Adjusted World Price) is now getting very close to the US government loan level. To refresh our readerΆs memories, the AWP is calculated by subtracting roughly 20 cents (19.69 cents this week) from the A-index. Once the AWP calculates below the loan, it turns into a subsidy mechanism, since it allows owners of loan cotton to redeem it at a discount.
Even though these loan deficiency payments donΆt offer the same incentives as in the past due to much more stringent payment limitations (US$ 125Ά000 per entity), we still feel that a lot of growers will initially put their cotton in the loan and then adopt a wait-and-see attitude. This could temporarily withdraw a lot of cash cotton from the market and make it quite difficult for shorts to find coverage. This should soon be felt in a firming of the basis, as sellers are no longer willing to offer cash cotton below a certain level. We believe that it will only be a matter of time until this translates into support in the futures market as well.
This support should be most apparent in the December contract, as it may take some time to refill the nearly empty supply pipeline. If the futures market overshoots to the downside and becomes more attractive than the cash market, takers will emerge and this could get some shorts in trouble. The certified stock has been rapidly depleting, currently amounting to just 136Ά000 bales, and based on todayΆs futures price it would not be possible to profitably replenish this inventory.
The narrowing of the Dec/March spread to just 64 points today seems to recognize this fact! What this is telling us is that while the bear market may have further to go, there could be a bottleneck early on that forces December to appreciate relative to March, May and July. In other words, the bear market may have to take a breather in the fourth quarter before the floodgates open again in early 2015.
Although China and its massive Reserve stocks are the main reason behind this bear market, there have been a few rumors lately that could alter the marketΆs perception in regards to Chinese imports. According to some sources China may contemplate to allow imports at a 4:1 or 3:1 ratio against the purchase of Xinjiang new crop cotton and not resume further Reserve auctions until later in the season. If such a measure was passed, it could lead to more imports than currently anticipated by the market, which would be supportive to prices.
According to some estimates, China may still have some 3.5 to 4.0 million bales in unused import quotas at this point, most of which need to be imported before the end of December. If true, US cotton would be well positioned to capture a big share of this import demand, especially at current prices, as competitors like India and West Africa may either not be ready to meet the required shipping months or are not as competitive.
US export sales for the week ending July 24 amounted to a decent 260Ά400 running bales net, with 17 markets participating. China moved back into the top spot by taking 104Ά900 running bales, followed by Pakistan with 66Ά900 running bales. Shipments of 120Ά600 running bales were right at the pace needed to make the current USDA estimate of 10.5 million bales. With the 2013/14 marketing year ending today, we estimate that around 600Ά000 bales will be carried over and added to 2014/15 commitments, which should therefore rise to around 4.4 million statistical bales, plus whatever has been sold this week.
So where do we go from here? Looking at the chart there is nothing that would tell us that this wave of selling is about to end. The bullsΆ main hope therefore rests with the cash market, as producers may increasingly resist selling their cotton at these depressed levels, which could eventually translate into support for the futures market. However, since the next major delivery period is still nearly four months away, there is no immediate reality check for the futures market, which means that values could easily overshoot to the downside if the current selling panic continues.
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