Supply Concerns Send Cotton ETF Surging Higher

Sep.20.10 | About: iPath Dow (BAL)

Although official inflation readings continue to remain flat or at comfortable levels around the world, a variety of important commodities have seen their prices surge higher in recent months. Thanks to rising demand in emerging markets and a host of supply problems, commodities ranging from industrial metals to staple crops such as corn and wheat are now approaching or have broken through their 52 week highs. These commodities have posted gains that have crushed equity markets in terms of total return, leading even more investors into this rapidly growing sector.

While corn and wheat have posted tremendous gains over the past three months, their surges pale in comparison to one often forgotten but extremely important commodity: cotton. Prices of this critical textile component recently exceeded $1 in New York Trading for the first time in 15 years. While this suggests an extreme level of appreciation, it is not to be underestimated how incredible the $1/lb level truly is for cotton; according to the Financial Times, the Cotlook A-Index, a benchmark for the physical cotton market with 44 years of history, has traded above the $1 level for less than 100 days.

David Watson, Senior Advisor, Markets, at FCStone Australia, said in an interview for Bloomberg:

There is a real shortage of raw cotton available to mills, be it India, Pakistan or China, ahead of new crop deliveries which obviously don’t come on line in any great volume, really, for another month. There has been a huge drawdown in stocks globally and you don’t have the buffer from the U.S. that you used to have.

This rapid price increase comes after severe flooding in Pakistan and an early frost in China, which has devastated crop yields in two of the world’s five largest users of the commodity. Meanwhile, India, the second-biggest producer and exporter, will limit exporters and impose ‘prohibitive’ duties on exports greater than 5.5 million bales, according to Bloomberg. This decrease in supply and further reduction of exports by India looks to push global cotton stockpiles to one of the lowest levels in close to two decades. USDA data shows that supply stockpiles will equal just 38% of demand, suggesting that further supply shocks could devastate the industry and send prices even higher.

One way to play this supply crisis is with the iPath Dow Jones-UBS Cotton ETN (NYSEARCA:BAL). The note tracks the Dow Jones-UBS Cotton Subindex Total Return, which is a single-commodity sub-index currently consisting of one futures contract on the commodity of cotton. BAL has been on an incredible run so far in 2010, posting a gain of 47.1% since the start of the year with an equally impressive gain of 10.1% over the past week. The fund charges an expense ratio of 75 basis points but has a beta of just 0.56 with the S&P 500 suggesting that in addition to solid returns, the fund has been able to provide valuable diversification benefits to investors who had bought into the fund before its recent summer surge.

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Disclosure: No positions

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