A Woolly Market For Investors

By Tom Vulcan

 

Beginning with thee, O Phoebus, I will recount the famous deeds of men of old, who, at the behest of King Pelias, down through the mouth of Pontus and between the Cyanean rocks, sped well-benched Argo in quest of the golden fleece.

--Apollonius Rhodius: The Argonautica

As far back as the mid-3^rd century BCE, when Apollonius of Rhodes gave us the classic tale of Jason and the Argonauts, the story of the golden fleece had already been around for a number of centuries. It would have been known to Homer some five centuries previously and was known even before that.

If you think that's ancient history, then think again: Wool and sheep (albeit not now the winged ram Chrysomallos (Χρυσόμαλλος) had been around for many thousands of years before that. In fact, after dogs, sheep are probably the oldest domesticated animal!

Does the story of the golden fleece still hold sway for today's investors? 

A Very Short History of Wool

If the domestication of sheep goes back as far as 10,000 years, an international trade in wool, by Sumerian merchants in southern Mesopotamia, is recorded as far back as 2500 BCE. And during the period 3000-1000 BCE, the great empires of the day - Greek, Roman and Persian - were all distributing sheep and wool throughout their empires and, in particular, Europe.

Wool remained the primary fiber in Europe until the Middle Ages, when the introduction of linen undergarments challenged that primacy. With wool came enormous wealth, particularly through raw wool exports. In the 12th century, for example, wool was England's greatest asset, and indeed, wool production hits its peak in that country in the 13th century.

In Spain, the wool trade helped finance the expeditions both of Columbus and the Conquistadors. Constituting their fiefdom as it did, the Spanish royal family and its nobility kept tight control of the means of production, i.e., the sheep themselves, especially when it came to those producing the finest-quality wool.

Having exercised close control for many hundreds of years over its flocks (not least through the use of the death penalty for any illegal exports of sheep), it was only in the 18th century that Spanish Merino sheep, famed still for the quality of their wool, started to be exported from Spain, not least as gifts of the Spanish king. The rulers of England, France and Saxony all received their Merinos in this way. Now Merino flocks are to be found all round the world.

Until the late 18^th century, when the use of cotton in clothing started to become increasingly prevalent, wool was the most commonly consumed fiber. Since the turn of the last century, however, which saw the introduction of man-made fibers, wool's position in the global fiber market has been on the slide.

Global Fiber Production 1970-2006 (000 kg)

(a) Production of a seasonal basis (i.e., 2006 = 2005/6)

(b) Excluding olefin production

Sources: International Wool Textile Organisation (IWTO) (from The Woolmark Company, FAO of the United Nations, International Cotton Advisory Committee, Fiber Economic Bureau and International Silk Association) 

Wool now represents only about 1.9% of world fiber production. 

World Fiber Production: 2006 (% share)

Sources: International Wool Textile Organisation (IWTO) (from The Woolmark Company, FAO of the United Nations, International Cotton Advisory Committee, Fiber Economic Bureau and International Silk Association) 

However, despite the growth in the production both of synthetics and cotton, the wool industry remains an important one, especially in countries such as Australia, China and New Zealand. The International Wool Textile Organisation (IWTO) quotes a figure of $80 billion yearly (source: Woolmark) as the total retail value of sales of wool products. 

Why Use Wool?

Apart from being the quintessentially natural fiber, wool, amongst its most important characteristics, is:

• Absorbent: It keeps you cool in hot climates and warm in cold climates - wool sheds water.
• Durable and Resilient: Since it is so elastic, it is remarkably resistant to tearing and, as a multipart fiber, it resists wear.
• Flame Resistant: Wool is self-extinguishing, it does not support combustion.
• Versatile: Its uses range from clothing to carpets.

Source: Australian Commonwealth Scientific and Industrial Research Organisation (CSIRO)  

And For What?

Wool is used for a vast range of purposes. 

Source: Australian Commonwealth Scientific and Industrial Research Organisation (CSIRO)

 Counting Sheep

In 2006, according to the IWTO, there were certainly enough sheep in the world to send you to sleep by counting - 1,023,496,000! Of these billion sheep, China had by far the most, followed by Australia. 

Note: Includes wooled and nonwooled sheep

Source: IWTO (from FAO of the United Nations/The Woolmark Company)

 But, out of a total of 2,146,524 tonnes, it was Australia - followed by China and then New Zealand - who produced the most greasy raw wool. (World clean equivalent wool production in 2006 was 1,228,670 tonnes.) 

World Wool Production - 2006: Greasy^‡

^‡ Wool in its natural state, after removal from the sheep and before any commercial processing

* Production on a seasonal basis (ie 2006 = 2005/6)

Source: IWTO 

Over the last 16 years, while New Zealand has maintained its position in the market, Australia's percentage share has fallen as China's has risen. And all signs are that it looks set to fall even further, especially as growers continue to seize opportunities in the market to sell lambs for meat instead of keeping them for wool. 

Source: IWTO (from FAO of the United Nations/The Woolmark Company) 

Grading Wool

Historically, while native sheep in various regions developed into particular breeds, it was only in the 18th century that definite breed descriptions were actually ascribed to sheep. In 1800, there were around 20 different defined breeds; there are now at least 200 different breeds of sheep worldwide.

Together with other characteristics (for example, habitat), sheep breeds are defined by the type of wool they produce. The wool fibers from each breed are unique in terms of color, density, diameter, strength and length of staple (cluster or lock of wool).

At one extreme, there are fine wool sheep; for example, Merinos and Rambouillets. Their wool is used to make the most luxurious woolen apparel; for example, suits made from Merino wool cloth. At the other, there are carpet (coarse) wool sheep; for example, Cotswolds, Lincolns and Navajo-Churro, whose wool may, appropriately, be used to make, amongst other things, carpets! Their coarse wool is also used to make blankets, upholstery and yarn.

There are three different systems for grading wool, the least subjective of which is the micron system, a system that grades wool according to the micron thickness of the wool fibers - a micron is 1/25,400 of an inch.

(The American blood count system is based on the percentage of Merino in a sheep's ancestry. It includes six market grades. Originally these grades referred to the amount of Merino blood in the sheep. Currently, the names refer to the diameter of the fiber. With this standard, "fine" refers to the diameter of the fiber, not the quality of the wool.

The numerical count system divides the wool into 14 grades, designated by a number. This originated in the 18th century in England and is based on the number of 560-yard skeins that can be produced from one pound of clean wool top (semi-processed wool that has been washed, combed and sorted). With this system, the larger number will be a finer wool. The problem is that there were too many variables involved and a pound of the fiber rarely produced the implied yarn.)[1] 

Grading Systems

American Blood Count	Numerical Count	Micron	Breeds*
Fine Wool	80	17.70-19.14	Merino
Fine	70	19.15-20.59	Rambouillet
Fine	64	20.60-22.04	Targhee, Southdown
Half blood	60-62	22.05-24.94	Corriedale, Columbia
Three-eights blood	56-58	24.95-27.84	Panama, Romeldale
One-fourth blood	50-54	27.85-30.99	Suffolk, Dorset, Hampshire
Low one-fourth	46-48	31.00-34.39	Romney
Common	40-44	34.40-36.19	Cotswold, Lincoln
Braid	36-40	36.20-40.20	Cotswold, Lincoln

*According to average grades

Source: United State International Trade Commission (USITC)

Of the world's clean equivalent wool, the majority of production in 2006 was coarse wool, followed by fine wool. 

Estimated Wool Production by Micron Range: Clean Equivalent

um = micron (micro meter)

Source: IWTO (from The Woolmark Company) 

Where Does All The Wool Go?

In addition to having the largest number of sheep on Earth (and being the second-largest producer both of greasy and clean equivalent wool), China is also the world's largest importer of raw wool (greasy, scoured and carbonized). In 2006, it accounted for 39% of global imports and over 60% of Australia's wool exports. The country also accounted for 47% of the world's wool top production in 2006.

Despite pressure from China and other low-cost countries, Italy remains the world's second-largest wool processor and manufacturer with 8% of the market in 2006. It is also Europe's major processor and manufacturer of fine wool textiles and apparel. Italy was closely followed by Uruguay with 6% of the market in 2006.

At the manufacturing stage in 2006, China accounted for 29% of world wool use, followed by India (11%) and Turkey (4%).

Finally, at the retail stage, in 2006, China, the world's largest wool apparel retail market, accounted for 17% of all wool use, followed by the U.S. with 12% and Japan with 7%.[2] 

Opportunities In Wool - Long Term

Although the U.S. is such a huge country, it actually produces comparatively little wool. Somewhere about the 17th/18th place on the list of producing countries, the U.S. produced approximately 35 million pounds of greasy wool in 2007 - about half its production of 10 years ago. (The country did, however, import some 20 million pounds of raw wool during 2006 - mainly from Australia and New Zealand.)

Seventy percent of U.S. raw wool production was exported in 2007. China remained the country's main export market, taking 67% of all wool exports - up from 44% in 2005-2006. Such an export level stands in stark contrast to how it stood in the late '90s when raw wool exports averaged 35% and more of the country's production was used domestically.

So, for those of you who may be both somewhat wary of the sustainability of such import and export levels, and attracted to wool as a niche play, then perhaps getting your hands dirty on a sheep farm in Texas, Wyoming or California is something worth considering.

Even though you may be a little late to supply the wool for the 10,200 blankets, "Bed, Wool, Olive Green" recently requested by the U.S. army - they needed them delivered on October 15 - I am sure there will be other such opportunities. More interesting, however, and possibly a very attractive niche, could be the production of organic wool - to be sold at a premium to traditionally raised wool. Not only does the Organic Trade Association already have organic fiber standards for processing such wool, these standards cover all post-harvest processing from storage to labeling.

And while the U.S. Farm Security and Rural Investment Act of 2002 provided marketing assistance loans and loan deficiency payments to wool producers only for the crop years 2002-2007, there is a good chance that such government support may again be available in the future.

Or, for the even-more adventurous, Argentina and/or Uruguay could be places to look for a sheep farm. Much of Argentina's wool production, and its wool exports, are of fine wool with a micron range 18.5 - 22.9. As supplies of fine wool from Australia diminish, and demand for such wool is maintained, particularly from China, Argentina and Uruguay (with its mid-micron wool) could both become attractive propositions on the growing front. 

Opportunities In Wool - Shorter Term

And for all the rest of us, there are wool futures. Well, there are wool futures, but it is not a market I would rush into posthaste - whether you are wool bull or wool bear.

The Australian Securities Exchange (ASX), and Sydney Futures Exchange (SFE), with which it merged in July 2006, both offer a number of wool futures contracts. However, trying to gain exposure to the wool market through either exchange is not ideal.

The three ASX China Type contracts are excellent contracts, reflecting, in their scope, probably 80% of the physical wool trade transacted in Australia. Unfortunately, none of them is traded, not least because of issues with the platform on which they are traded.

There is, however, trading activity in the three SFE contracts, despite certain issues with the age of the trading platform (surprisingly the SFE and ASX do not share the same trading platform for wool futures) and the delivery process.

Unfortunately, though, this activity is restricted mainly to the SFE 21.0 Micron Greasy Wool (Mid Range Wool) contract, which itself reflects probably only about 6-7% of the physical wool trade transacted in Australia. On October 15, open interest across all delivery months was some 1,370 lots, with the predominance - some 1,273 lots - in the December contract. 

There is some activity in the 19 Micron (Fine Wool) contract - total open interest on October 15 was 32 contracts. But currently there is no open interest in the 23 Micron SFE (Broad Wool) contract, and it has not traded in months. While all the other wool futures contracts are deliverable, these two contracts are cash-settled - with all that can imply when it comes to price convergence toward contract maturity and market efficiency.

Despite all the above caveats, though, international investment funds have been in the Australian wool futures market for at least the last couple of years, and still are.

While their participation in the market probably constitutes just a tiny proportion of their overall commodity exposure - exposure to provide them both with diversification and, hopefully, an inflation hedge - in terms of the totality of the wool futures market's business, their participation is not so tiny. According to one market participant, it is currently "significantly larger than the industry acknowledged: 20%." Any untimely exodus by these funds would, therefore, certainly be felt by the market. So, another reason for avoiding a precipitous dive into the market.

Quite apart from all the above, wool futures just haven't been doing that well recently: 

SFE 21.0 Micron Greasy Wool Futures Contract

 

Source: ASX 

Conclusion

Wool is an incredible natural fiber. It is the environmentally friendly fiber - from how it is grown, through how it is processed, to the products it is used to make. And, not least, when you have done with it, it is biodegradable!

That being so, if growing wool appears attractive, you should certainly look at niches within the wool industry that capitalize on its unique qualities. For example, the production of organic wool, or super fine wool or wool with a rare characteristic, such as a particular color, are all areas that have already proven, and will probably continue to prove, attractive.

The same, I believe, is true in wool apparel. Keep your eyes open for opportunities amongst the niche players, particularly at the upper end of the market. If, for example, any one of John Smedley in the U.K., Loro Piana in Italy or Icebreaker in New Zealand were to go public, I would certainly peruse the prospectus with great interest. Word even has it that Icebreaker's products are now so popular that the company is having difficulty keeping up with its order book.

In the meantime, in the absence either of a clearer indication of direction for the Australian wool industry and wool prices, except inexorably down, or some sort of resolution to its wool futures contract issues, I would just enjoy wearing some real woollies this winter. They would constitute a fine investment. 

Afterword

If you are still interested in wool, just remember that 2009 has been declared by the United Nations the International Year of Natural Fibres. With any luck, this should help rekindle interest in this phenomenal fiber.