NY futures came under renewed pressure this week, as December fell 507 points to close at 113.52 cents.
The bearish mood in the market prevailed, as traders remain fearful that the drop in demand may more than offset US crop reductions. Mill demand continues to be only of sporadic nature and certainly not sufficient to absorb all the foreign stocks that merchants and growers would like to get rid of.
The huge inversion between July and December, which at one point back in March had widened to as much as 90 cents and only briefly traded below 20 cents a few weeks back, deserves at least part of the blame for the comatose market we are currently experiencing. As long as the market went up and mills were chasing after cotton, basis-long positions were fine because the basis was strengthening. The only issue was the availability of credit to pay for margin calls, which prompted some merchants to lift short hedges, thereby exacerbating the up move.
However, once the tide started to turn, owners of physical longs would suddenly find themselves greatly exposed, because there were hardly any buyers in the cash market, while the futures market proved to be a less than perfect hedge due to the steep inversion. For example, even if a merchant would have been smart enough to anticipate the turn at the top and to hedge his long position by selling July futures a few months back, he would still have to give up 20, 30 or more cents in roll losses to transfer his short hedge to December a few weeks ago – a huge difference he would never be able to make up unless the basis were to strengthen substantially. Realizing this predicament, physical longs were suddenly offering aggressively, but with only a few buyers not too many longs were able to escape. This sequence of events has turned into a downward spiral with apparently no end in sight.
There is a striking difference when we compare the balance sheets of the US and the rest of the world. The US is actually in a deficit situation, which is why the certified stock was able to find a strong taker in the last two delivery periods despite the relatively high price. Here is the latest snapshot for the US (in million statistical bales):
- Total supply on August 1, 2010: 21.0
- Exports until June 30, 2011: -13.8
- Domestic mill use until June 30: -3.5
- Unshipped/unused inventory:3.7
Against this inventory, we have the following export commitments and domestic mills requirements:
- Outstanding exports 2010/11: 1.5
- Domestic mill use July-0ct: 1.3
- Outstanding exports 2011/12: 6.0
The 1.5 million bales in current crop export commitments and the 1.3 million bales that domestic mills require until October are fairly solid numbers, although they may get somewhat reduced by additional cancellations. What’s more difficult to assess is how many of the 6.0 million bales in export commitments for the 2011/12 season are for the July to October shipment period.
For the purpose of this exercise let’s assume that a third, or 2.0 million of these 6.0 million bales were sold for shipment before November, i.e. before new crop arrives in volume. This would bring total export and domestic mill requirements for the July to October period to 4.7 million bales, against which there are just 3.7 million bales in inventory, plus whatever little new crop cotton starts trickling in. Nevertheless, it seems quite obvious that there is not nearly enough US cotton to meet existing obligations over the coming months.
Since merchants can’t ship what they don’t have, we will probably see additional cancellations or switches to other growths over the coming months. Based on the above numbers it wouldn’t surprise us to see another 0.5 – 1.0 million US bales canceled. In contrast, there is still plenty of cotton available in the rest of the world, starting with the vast unsold supply in Uzbekistan and Turkmenistan, followed by positions in India, Brazil, Australia, Argentina and various African countries, which is where the current price pressure is coming from.
So where do we go from here? It has only been four months since the spot month (May contract) posted a synthetic high of around 227 cents, which is roughly double of what today’s spot month (December contract) is currently worth. December closed today right at important long-term support near 113 cents and given the oversold conditions we wouldn’t be surprised to see a bounce of 5-10 cents from here. The market has gotten a bit too negative too soon for our taste and as we have pointed out last week, in the case of US cotton there is currently a rather large physical short position and a big short in futures against foreign cotton, with a US crop that is getting smaller every week, which is a dangerous constellation.
Best Regards
