NY futures rallied this week on short covering, as May gained 396 points to close at 93.54 cents, while December advanced 177 points to close at 90.72 cents.
In a little over two weeks the May/Dec spread has gone from 179 points carry to an inversion of 282 points at today’s close, a swing nearly 500 points! This is due to tightening supplies for nearby shipment, after China has been aggressively restocking all season long, while new crop still promises to produce more cotton than there is demand for it.
Although there is no shortage of cotton when we look at the global balance sheet, the problem is accessibility. Despite reports of a struggling textile industry in China, imports of cotton and yarn have been rather brisk in recent months, which has led to a tightening of supplies in many origins, most notably in the US and India. The Chinese government has sidelined over 14 million bales of high priced domestic cotton through its auction system this season, while at the same time opening its doors to cheaper imports. We believe that China has been using these measures in an effort to balance the needs of farmers and mills. The high domestic price should ensure that not too many farmers will walk away from cotton this spring, while relatively cheap imports of cotton and yarn should allow mills who export finished goods to remain competitive, although the high duty structure poses a big obstacle in that endeavor.
Since only about two-thirds of Chinese cotton products are sold domestically, mills that manufacture textile products for export cannot afford to pay substantially more for cotton than their counterparts overseas, especially in an environment of rising wages and energy prices. More and more mills are getting squeezed and a number of companies have already gone out of business over the last twelve months. However, while Chinese mills are struggling, other markets such as Vietnam and Cambodia seem to be picking up the slack.
China’s current strategy of absorbing expensive domestic cotton into its strategic reserve while allowing cheaper imports to replace it is not a sustainable model in our opinion, because it raises stocks to unmanageable levels over time. This season China is expected to import nearly twice as many bales (18.5 million) as it needs based on a production deficit of 10.0 million bales. We feel that over the coming years China won’t be able to add much more to its stockpile and that imports will therefore be limited to the size of the annual production shortfall.
In other words, there may soon be an abrupt end to the fierce Chinese buying we have become so accustomed to since last fall. Not only is the auction program going to end this week, but we also feel that most of the import quotas have been filled by now and that the release of additional quotas is unlikely. Once China turns quiet, so will the cotton market, although it is still possible that current crop futures will go out with a bang due to the many spec and trade shorts that remain in May and July.
US export sales were once again above expectations last week at 157’500 running bales, with broad-based participation of 16 markets, while shipments were impressive as well at 352’100 running bales. For the season we now have total commitments at 12.0 million statistical bales, whereof 6.8 million have so far been exported.
Some traders seem to be waking up to the fact that it may be dangerous to be short futures in a nearly sold out market. Over the last five sessions open interest in May has dropped by 13’712 contracts, as some shorts obviously decided to either roll or cover their positions. However, overall open interest dropped by only 1’500 contracts, as July picked up around 7’000 lots, while December added about 5’000 contracts. Although the reduction in May open interest is certainly a step in the right direction, there are still a combined 13.2 million bales open in May and July, which seems disproportionately high compared to the amount of cotton that remains uncommitted in the US. Also, unfixed on-call sales have barely changed last week, as there are still over 3.0 million bales open in May and July!
So where do we go from here? After nearby futures rallied more than 600 points in the last ten sessions, we may see some consolidation in the days ahead, but the drivers that have fueled this advance are still largely in place. The upcoming index fund roll will provide plenty of liquidity for spec and trade shorts to get out of harms way, and we feel that whoever stays in the game beyond that point is playing with fire. In particular we would advise mills not too wait until the last minute with their fixations!
While current crop looks well supported to us at the moment, new crop is a different story. Although there will be planting reductions, we may still end up with a global crop that is several million bales larger than mill use. Unlike in the current season, there is very little cotton sold forward and as explained above, we expect China to be a lot less active on the import front next year. Therefore, unless weather causes trouble on the supply side, we don’t see much upside potential for December and feel that growers should use options strategies to protect themselves against a potential drop in prices.
Best Regards
