Cotton: A Better Way to Play Oil?

| About: iPath Dow (BAL)

I am currently exploring cotton as an alternative (better?) way to play a long-oil position. I admit there are many variables at play here so I write this hoping for an interesting debate.

Before reading on, remember that commodities are priced on supply and demand. All things equal, reduce supply and prices will rise…increase demand and prices will rise. In fact, demand for a commodity could shrink but if supply falls at a faster pace prices should still rise.

How might cotton be an oil play?

When oil prices rise, and people start looking for bio-fuels substitutes, farmers start diverting land to grow corn and sugar to make ethanol. This means that less land is available for growing cotton, which means lower cotton supply and higher prices.

Oil prices probably need to rise above a certain threshold before this becomes economical, so in a way cotton is a call option on oil.

Also, higher oil prices will increase costs across the entire agricultural production and supply chain. (Oil is used in transportation, harvesting, fertilizing, and treating crops.) This will cause the high-cost agricultural producers to drop out of the market thus shrinking supply until prices rise above marginal costs of production. This is probably bullish for most agricultural commodities – including cotton.

Non-oil factors also support cotton prices:

  1. For US producers, cotton appears to have been an unprofitable crop for at least six seasons. Ideally, I’d like to see a crop-by-crop profitability comparison, but I’m assuming that soybeans and corn are more profitable. If this is true, farmers will divert land away from cotton production, shrinking supply.

    It appears that US farmers are already doing this. 2009 prospective plantings in the US is down 7%. US production is forecast to be lowest in 14 years. US supply forecast is lowest in about 8 years. (Of course, this is a world market so we must pay attention to other regions.)

  2. 2009 world cotton production: 106.5 million bales…2009 world cotton mill use: 113.5 million bales. This will cause world cotton stocks to decline from 62.31 million bales to 57.77 million bales. (The numbers don’t add up precisely but the general trend is supportive.)

    2009 world cotton stocks (inventory) to use ratio expected to fall below 50% for the first time in 5 years. Lower inventories are supportive of prices going into 2010. Moreover, a return of global growth will shrink stocks even further as Chinese clothing exports pick up.

  3. There are 70 million new mouths to feed on the planet each year. Crop yield improvements have slowed dramatically – the big marginal yield gains from the ‘green revolution’ have already been made. Regardless of costs, simply growing enough food to feed the planet will require more land to be diverted to edible crops (and away from cotton). Again, this shrinks cotton supply, supporting prices.

There you have it…cotton appears to be an oil play, a global growth play, and an agriculture play. Thoughts?

Source for all data: National Cotton Council of America