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Numerous commodities saw healthy bull runs in 2010, inspiring investor confidence for a strong 2011. Gold for example, has continued its historic run, breaking through the $1,700 per ounce mark and then some, while oil has been on more of a roller coaster ride as far as its prices are concerned. But while a number of commodities have fared well so far this year, others have not been so fortunate. Cotton in particular, was one of the best performing futures last year, only to suffer major blows through the first seven months of 2011 as well [see also The Ultimate Guide To Gold Investing].

Last year, cotton prices started a epic run that led to its historic high in early 2011, as a pound of the fluffy commodity went for over $2.25, meaning cotton futures were trading in the mid to upper $100′s. Now, prices have fallen off a cliff, as Cotton #2′s October contract is sitting around $100, with investors extremely skeptical as to whether or not cotton has further to fall, or is due to claw back some of the ground it has lost in recent months.

Starting with its meteoric rise, cotton futures skyrocketed for the first half of 2011 based on a number of factors. Perhaps the most important driver of cotton prices came from Chinese demand which has been steadily growing as their population continues to boom while other emerging markets exhibited similar patterns. Of course, inflationary concerns also played a part in sending cotton prices soaring, as many emerging markets are starting to feel inflation throughout their economies. With cotton reaching unheard of prices, producers and manufacturers scrambled to keep up profits as clothing companies took the brunt of the blow from cotton spikes, passing it on to individual consumers. But just as it seemed unbearable, cotton prices came tumbling back to earth in recent weeks, leaving some investors curious as to this major price swing.

Inside The Crash

Global consumption for 2011 was expected to surge, but unfortunately, the expected 120 million tons of cotton use was revised down to 113 million after issues in China and Pakistan led to lower demand. As the need for cotton began to cool down, supplies ramped up all over the world. In recent weeks, many countries have reported strong harvests, with India, the world’s second largest producer, leading the way. The emerging nation announced an increase of nearly 255,000 tons of cotton, putting a major damper on prices. Other regions like Nicosie, West Africa, and Turkey/Greece are expected to increase cotton supply by 10%, 17%, and 27% respectively.

Another major hindrance on cotton prices has been the looming debt crisis in the US. As our nation neared our debt ceiling deadline, equities, commodities, and bonds all took a downhill tumble, as investors around the world feared that the long-time safe haven in the U.S. and its greenback would soon be gone. Though a debt deal eventually went through, the S&P downgrade wreaked havoc on virtually every investment vehicle available, putting further pressure on cotton prices.

Furthermore, last year, as cotton prices soared, farmers scurried to cash in on the gains, leading to this year’s hefty supply. Yet, now the high supply figures are working in reverse as they are bringing cotton to more manageable levels. To understand cotton’s performance, we look to the Dow Jones-UBS Cotton Total Return Sub-Index ETN (NYSEARCA:BAL), which tracks cotton futures contracts. BAL has fallen over 44% from its March highs, and dipped over 14% on the year suggesting an incredible reversal in opinions for the fluffy commodity [see also see also Ultimate Guide To Cotton Investing].

Outlook

With cotton prices rising so high, many manufacturers and producers switched to alternative fabrics to keep their prices and profits in check. Now that cotton has become more reasonable, the question is whether or not it can win back its market share from those who stepped in during its historic spike. While it is unclear how consumers have responded to alternative fibers, or if demand for cotton will pick up, there seems to be one certainty in cotton’s near future; volatility. Chief Executive Joe Nicosia of Allenberg Cotton, one of the leading cotton merchants in the world, made a rare statement recently about the future of this commodity. He warned that while cotton prices are currently in free-fall, the next year will likely see extreme volatility in daily trading sessions.

Another possible issue on the horizon will lie on the farming end of cotton. If prices continue to dip, than acreage of this product may significantly decrease as farmers use their available land for more lucrative crops. This, of course, could cause a shortage and send cotton prices right back up to their high levels of late 2010 and early 2011. But while the long-term future of cotton may be hazy, traders will be delighted to take advantage of volatile sessions that have the potential to produce huge gains, as it is not uncommon to see Cotton #2 futures move by 3%-4% on any given day.

Disclosure: No positions at time of writing.

Source: Inside Cotton's Epic Crash