Looking at a Bull Market in Cotton

| About: iPath Dow (BAL)

By Conley Turner

Cotton is by and large a ubiquitous and important part of the lives of much of the world's population. This is especially true in Asia where trio of China, India and Pakistan together consume just below 70 percent of all the cotton output in the world. The commodity has had an impressive run of late and given prevailing conditions, that move appears to be sustainable at least for the time being.

As the largest exporter of cotton in the world with approximately 80 percent of production allocated for overseas markets, the U.S. cotton industry is benefitting from a de facto bull market in the commodity. The price of raw cotton has been rising steadily over the past few months. The Cotlook A Index which is representative of the offering prices of raw cotton on the international market recorded a price of over $1.15 per pound at the end of September.

The significance of this must be appreciated in a broader historical context. Prior to this move, cotton prices averaged between $0.40 and $0.50 per pound. In fact, only three times during the period in which records were kept had the commodity traded above the psychologically important level of $1.00 per pound. These were during the American civil war, the cotton bull market of 1995 which ended with the onset of global economic crisis in 1998, and the present.

The factors attributed to the recent price move in cotton are various and sundry. First of all, there have been significant issues among the key producers of the commodity which in turn, resulted in severe supply constraints. As the world's largest producer, consumer and the biggest export market for U.S. output, China factors prominently in the cotton trade. Adverse weather related events in that country's biggest producing region earlier in the year caused substantial damage to the cotton crops there. The effect was a dramatically negative impact on the availability of the commodity.

Similarly, catastrophic floods in Pakistan severely compromised or destroyed as much as 15 percent of that country's cotton crop. As one of the world's largest producers and exporters of the commodity, this represented a critical loss of overall capacity. India, which is the world's second largest cotton producer was spared much of devastation and is actually anticipating a good yield from this year's harvest. Nonetheless, the country's government imposed a temporary tax on cotton exports in the wake of the supply issues. This measure effectively put a stop to cotton leaving the county thereby lessening the risk of any domestic shortages. The move also had the effect of contributing to the ongoing supply constraints of cotton in the world.

Although the U.S. is the world's third largest producer, it is important to recognize that American farmers have over the years been steadily redirecting acreage away from cotton to more profitable crops such as corn and soybeans. As such, there is a fundamental issue of issue of limited supply as production has eroded versus prior years.

These factors in aggregate proved to be a catalyst for cotton prices on China's Zhengzhou commodity exchange to rise to record levels. Locally delivered cotton traded at over $1.40 a pound. A corresponding rally in cotton prices occurred on New York's ICE futures exchange resulting in an over 35 percent gain for the year.

All of this is playing out at a time where there is an ongoing ramp in the demand for the commodity. The demand surge can largely be attributed to the improving economic situations of cotton consuming countries and a corresponding recovery in textile production. History has shown that there is a positive correlation between GDP growth in emerging economies and a rise in textile demand. As such, given the wave of prosperity engulfing many emerging countries, particularly in Asia, it is not unreasonable to assume that this demand trend will persist.

Looking ahead, a number of factors are already in place that portends higher cotton prices. Among these is the approximately 1.5 year cycle from the time at which crop plantings occur to when the harvest enters a textile mill. Given this timeline, it stands to reason that the prevailing condition of constrained supply is likely to endure for at least one cycle. Producers will attempt to recover from the aforementioned setbacks but there is no guarantee that their output can keep pace with the burgeoning demand. The same timetable will apply to farmers in the U.S. should they elect to increase additional acreage to cotton in the wake of the favorable pricing environment.

Another important factor vital to the price of cotton is the secular weakness of the U.S. dollar. Commodities, which are priced in dollars, tend to move higher when the value of the greenback declines. A weaker dollar encourages investors to buy commodities as a hedge against inflation. Exacerbating this weak dollar scenario is the fact that the U.S. Federal Reserve has conveyed its intention to pump more cash into the domestic economy through a process called quantitative easing. This form of monetary policy involves the pumping of trillions of dollars into the economy and keeping interest rates low in order to prop up a flagging economy. Invariably, such a move will have a debasing effect on the value of the dollar. Alternately however, it will be bullish for commodities and for cotton.