NY futures came under renewed pressure this week, as July dropped 968 points to a synthetic level of 68.41 cents (official close was 78.17 cents), while December dropped 289 points to close at 67.71cents.

First, let us explain the math regarding JulyΆs value, which seemed to confuse some traders. Although July spent most of this weekΆs session in ΅locked limitΆ mode and July options were no longer available after they had expired last Friday, it was still possible to trade July via the July/Dec spread. On Tuesday the July contract traded to a high of 90 cents based on spreads, followed by a regular trading high of 89.48 cents on Wednesday, after which the bottom fell out as values collapsed all the way down to around 68 cents this morning, with the July/Dec spread trading as low as 12 points ΅July overΆ, going out on a 70 points ΅July overΆ trade. Therefore, the real value of July at the close of toady was 68.41 cents and not 78.17 cents. This implies that we will likely see at least another limit down move in July on tomorrow and possibly on Monday as well.

The big story over the last couple of weeks was obviously the extreme swing in the July contract, which first rallied from a low of 66.10 cents on June 4 to a high of 89.48 cents on June 20, before collapsing by over 21 cents to a synthetic low of around 68 cents today. This erratic price swing reminds us of the events in early March 2008, when the spot month rallied from around 72 cents on February 20, 2008 to a synthetic high of 109 cents on March 4, 2008, only to collapse back down to around 74 cents by March 20, 2008, wiping out several members of the cotton trade in the process. Although this most recent episode did not involve nearly as many contracts as four years ago, it was nevertheless a painful experience for the traders who got caught in it.

It would be easy to dismiss this 30 percent price swing as nothing more than a good old-fashioned short squeeze, but we believe that the problem is rooted much deeper than that. The primary role of a commodity futures market is to provide a hedging mechanism for the trade, and in order to maintain a high correlation to the cash market, the futures exchange allows for physical delivery of the commodity. This is where we see a problem with the current ICE cotton contract, since it only allows for delivery of US cotton.

Other soft commodities like Coffee and Cocoa allow the delivery of a wide variety of origins from around the globe, which of course makes sense since the US does not have any significant local production of these commodities. In regards to cotton the argument has always been that its domestic crop is large enough to ensure an ample supply of tenderable grades. Until about ten years ago this notion may have been justified, because the US crop represented a much larger percentage of global output. In the early 2000Άs the US crop still accounted for some 20-25 percent of global production, but over the last decade US production has been trending lower, while foreign production has been rising substantially. This seasonΆs US Upland crop of 14.5 million statistical bales amounted to just 11.8 percent of global output and if we look at tenderable grades only (66.4 percent tenderable), the number shrinks to just 9.63 million bales or 7.8 percent of global output.

Considering that a growing number of origins and consuming markets are trying to use futures and options to hedge their exposure in this increasingly volatile world, we believe that the current ICE contract no longer meets the criteria to be an effective hedging tool. The events of March 2008, the unprecedented inversion in 2011, the squeeze of July 2011 (which has caught the attention of the CFTC) and the latest short squeeze of July 2012 would probably not have happened to the same degree if the pool of tenderable grades had been at least 25% of global output, composed of a variety of origins and global delivery points, rather than just 8% comprised of US cotton only. We therefore believe that it is high time for ICE or another exchange to come up with a revised futures contract that serves as an effective vehicle for the global cotton industry.

Apart from the excitement surrounding the July contract, we got another very constructive US export sales report this morning, with total sales for both marketing years amounting to 491Ά900 running bales of Upland and Pima. Once again it was China that showed the biggest appetite, accounting for 459Ά100 running bales. For the current season, export commitments are now at 13.5 million statistical bales, of which 10.3 million bales have so far been exported.

Outside markets had a negative influence on cotton prices this week, as the Federal Reserve disappointed the markets by not announcing another QE (Quantitative Easing) just yet, instead extending its “Operation Twist” (swapping out short-term for long-term bonds) by 267 billion dollars. The markets reacted like a bunch of pouty teenagers who didnΆt get their allowance and money managers reverted to a ΅switch offΆ position, dumping stocks and commodities in the process. However, the commodity that is most relevant to cotton, soybeans, was able to buck the negative mood and closed the week substantially higher at 13.72 dollars/bushel, up 0.64 dollars on the week. This means that the ratio between December cotton and November soybeans amounted to over 20-to-1. At this ratio soybeans are likely to steal away a lot of acres next season, starting with Southern Hemisphere plantings at the end the year. Although this may not be an immediate market factor, traders need to be careful not to get too negative at these already low prices.

So where do we go from here? The spike in December provided growers with another opportunity to put on additional hedges in the 73-75 cents range and the subsequent collapse below 70 cents has provided mills with a chance to extend their coverage at an attractive level. With July now basically history, the December contract will likely trade in a range between 65 and 75 cents, as the lower end is being supported by mill buying and a lack of grower selling, while the opposite is true when the market heads towards the mid-70s. Weather, competing crops, outside markets and China are all factors that could alter this balance of power and need to be watched, but for now we feel that the summer doldrums will take some of the volatility out of the market.

Regards