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Commodities have been a major focus of the ETF world this year, as debates over the suitability of exchange-traded products and their role in increased market volatility have raged. Amidst this backdrop, many commodities have posted huge gains in 2010 as the dollar has stumbled and the raw materials appetite of emerging markets has proven to be insatiable. While the attention of many investors is pinned on gold’s historic run, price spikes in other commodities have flown under the radar. Many soft-commodities have seen hefty gains this year, including sugar, coffee, and most notably, cotton.

Cotton prices recently hit a 140 year high, with prices at levels that have not been seen since the post-Civil War era. December cotton contracts recently hit $1.5110, making it officially the highest price cotton has held since records began with the New York Cotton Exchange. Cotton’s recent peak–the commodity tumbled in recent sessions after new margin requirements were announced–marks a 56% rise in just three months, putting manufacturers and retailers on high alert. But why now, in a global economy riddled with uncertainty, has cotton emerged as one of the top-performing asset classes?

Several factors have combined to create the perfect storm for cotton prices. Four countries are responsible for a significant portion of global cotton production, with China leading the way, followed by India, the U.S., and finally Pakistan. Both China and Pakistan saw heavy rains and flooding that crippled cotton output this year. Though India and the U.S. reported strong numbers, it was not enough to overcome the losses endured by China and Pakistan, and consequentially, global production dropped more than 5% this year alone.

This supply bottleneck was met with a rising demand for cotton, as many manufacturers sought to restock their supplies with the economy showing signs of recovery, making the supply shortage all the more hazardous. The majority of the increasing demand comes from China, who continues to pay the rising prices due to a desperate shortage of the commodity. China’s domestic cotton output is predicted to be roughly 18.5 million bales less than what is demanded by the local markets–and this figure may only rise if adverse weather continues to batter crop yields.

Cotton investors are also picking the benefits of the movement in futures contracts. For the time being, the cotton market is backwardated, meaning that longer dated futures contracts are cheaper than those nearing expiration. At the same time, spot prices continue to rise, allowing investors to sell high and buy low month after month. Though the market seems to be betting on cotton prices to correct–as evidenced by the backwardated futures market–spot prices keep rising due to supply shortages, high demand, and a struggling U.S. dollar. Rising prices in a backwardated world allow for investors to make significant gains off of monthly contract prices.

Winners and Losers

As cotton continues its bullish growth pattern, several corners of the market will reap the benefits. Investments in cotton itself have paid off for many investors, who have enjoyed the strong gains from futures-based strategies this year. Also, agribusiness firms stand to gain from the cotton price spike. With a high demand, and a low supply, farmers from these firms can get away with charging more for the fluffy commodity, creating a unique opportunity for U.S. farmers, who have enjoyed strong yields this year. But, some farmers have warned that if prices climb too high, it will be difficult to sell their inventories. If prices climb too high, consumers will eventually refuse to pay for cotton-based products.

Manufacturers, retailers, and consumers fall on the other end of the spectrum, as a prolonged cotton spike could be an unwanted development. Manufacturers may be forced to raise prices on their products, as it may become too costly to produce items such as T-shirts with cotton. This price jump trickles down to retailers who then have to sell the item for more, which finally hits the consumers, who now have to pay more for cotton based products. The big fear is that recession-weary consumers are likely to cut purchases of cotton-based products if their prices rise. If consumers cut their spending habits, this then sends a shockwave back up to retailers, who will purchase less cotton from manufacturers, pinching this market sector as a whole.

Below we outline three ETFs that will be in focus if cotton continues its surge in the coming weeks.
iPath Dow Jones-UBS Cotton ETN (BAL)

This ETF is linked to the Dow Jones-UBS Cotton Subindex Total Return, a single-commodity sub-index currently consisting of one futures contract on the commodity of cotton. BAL has had an impressive year, posting gains of nearly 90%, as investors continue to bet on cotton [see BAL's performance charts here].

IQ CPI Inflation Hedged ETF (CPI)

The recent rallies in commodity prices, combined with the Fed’s move to pump even more money into the global financial system, has caused some concerns about an inevitable uptick in inflation in the not-so-distant future. This ETF seeks to deliver a real return above inflation (as measures by the Consumer Price Index) by building a core holding of short-term bonds surrounded by satellite positions in a variety of other asset classes.

SPDR S&P Retail ETF (XRT)

State Street’s XRT follows the S&P Retail Select Industry Index, which tracks all the U.S. common stocks listed on the NYSE, AMEX, NASDAQ National Market and NASDAQ Small Cap exchanges. XRT holds a number of large retailers, including J.C. Penney (JCP) (1.8%), Talbots (TLB) (1.7%), Ann Taylor Stores (ANN) (1.7%), and Guess Inc (GES) (1.6%) among others. The cotton spike will likely work against retailers, who may have to charge more for their apparel, scaring away a number of customers. If the fluffy commodity continues its rise, it will be interesting to see how these major retailers will react, in order to keep sales steady.

Disclosure: No positions at time of writing.
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Source: What Cotton’s Surge Means for ETF Investors