By Amit Agarwal

One word that aptly describes the situation in the cotton world over the last three years is volatility – on an unprecedented scale.

The usual business model of basis trading used by all of the merchants has failed. What has been thrown up out of the chaos – but not before some established cotton companies were forced into bankruptcy – is the “tweaked model” of hedging.

This model requires a rethinking of the “optimal hedging ratio” and the increased use of options as a hedging strategy against the plain vanilla hedging of selling futures against forward physical longs or against unfixed on call sales. This basis would eventually play out when the merchant made the physical delivery and bought back futures.

With intraday price swings of spot futures of about 15 cents/lb per day, and with the maximum daily limit of 7 cents/lb, have forced futures-hedged traders to look for increased working capital requirements for day-to-day margin calls . For example, a merchant with a 500,000-tonne global hedged position can face a whopping $77 million margin call the next day, while a movement of 47 cents/lb in a month -- which occurred between Feb. 4 and March 4, 2011 -- would require an extra $520 million of working capital just to meet margin call requirements! One would need to be a bank-owned hedge fund to run such an operation.

Clearly, traders need to decide how much they can undertake on futures trades. A daily stress test of the limit price movements on their positions should be checked to avoid surprises.

Swaps are one another way participants could weather intra-day volatility. By handing over daily margin requirements to their banking partners, they can free up daily provisioning requirements.

There is also an urgent need for greater participation by other supply chain participants -- growers, ginners, mills and retail brand owners -- in hedging mechanisms to protect themselves from volatility. They also need to keep tabs on the overall cost of the hedging, especially due to high costs for “at the market” options.

Multiple variables to track
Middle East politics have the potential to swiftly affect crude oil prices and can precipitate a “flight to safety” mindset, putting a bullish upside to oil and gold prices and having an inverse effect on the U.S. Dollar Index, which firms up the prices of commodities in the market.

These movements are further accentuated by a flood of investment dollars in the hands of speculators and various funds, which have access to superfast computing. They easily enter and exit the market, making huge returns from the movements for their investors but throwing the whole commodity complex into chaos. Inflation concerns, further tightening by banks on money supply, and hardening interest rates also create bearish sentiments on consumer demand for cotton products, thus creating periods of bearish price movements.

Meanwhile, manΆs greed for natural resources has pushed Mother Nature precariously close to the edge, and we all need to get used to such climatic events and the impact they can have on the supply side of various agricultural commodities.

Demand for textile products is increasing due to expanding middle classes in developing countries and a global population that is growing by 83 million people every year. Given the tight stocks-to-use ratio, the lack of an adequate buffer amplifies adverse weather impact on short-term prices.

Countries that have surplus cotton to export (and a strong domestic textile industry) need to create an adequate strategic reserve like ChinaΆs, thus eliminating the need to intervene midway through the season every time the supply position expands or contracts. Not only is it essential for the domestic industry to have ample access to raw materials, it will also bring stability in the global cotton market and keep away adverse price movements.

The world cotton trade should come together and push the agenda for modifying the ICE contract to become a global contract (such as the LIFFE Sugar or LME Copper contracts), which represent global cotton supply and demand, not that of the United States alone. Such a step would remove much of the basis risk from ICE hedging.

Last season saw the NY March 2011 cotton prices climb 175 percent from 78 cents/lb on Aug 5 to 215.15 cents/lb on March 4 -- a span of just 211 days -- followed by a precipitous drop of around 59 cents/lb from Mar 3 to May 12. That put great strain on the cotton supply chain by way of defaults -- initially from the growers , then later from the ginners and the trade, and then from the mills when prices tanked and they were left with high-priced contracts.

This emphasizes the need for a very robust and dynamic counterparty management requirement at all levels by trade participants. Adequate protection bands need to be created with automatic cutoffs of contractual obligations once those price band levels are reached, so positions could be closed or have reworked basis settlement levels in which participants have the capacity and wherewithal to perform on their contractual obligations.

The national associations for each cotton-growing and -exporting country should come out with stronger rules for contract performance, create adequate arbitration infrastructure, and ensure speedy settlements and enforcements. They should also create an alert list of defaulting participants. The threat of a strong trade rebuke and the potential sidelining those participants by the trade can create a fear factor among the defaulting parties and force them to meet their contractual obligations.

That will help maintain the sanctity of contracts, which is the fulcrum upon which the entire global cotton trade turns. Under the aegis of the International Cotton Association, our trade has been more organized and is widely respected, even among the other commodity participants.

There is a pressing need for greater cooperation and information sharing among supply-chain participants -- growers , ginners , merchants , mill owners , weavers , fabric processors , garment manufacturers and retail brand owners -- because the recent extreme volatility (and especially the inverted market structure of late) has created a great uncertainty and distrust.

This will help maintain an equilibrium between supply and demand at the level of each of participant in the cotton supply chain, facilitating an orderly flow of goods that doesnΆt inconvenience the end consumer of cotton products and maintains a healthy level of demand, which is good for everyone in the cotton trade.