Cotton Is the New King of Commodity Investments

Commodities are still on the run and just under their all-time high as the chart of the Goldman Sachs Commodities Spot Index [GNX] below shows. There are some signs which indicate that the longterm bull-market in commodities is not yet over:

• A sustained and strong world economy with China and India as its engines,
• Chinas and Indias unsatisfying appetite for natural resources and its result of rising dry freight rates,
• inflation fears which recently caused a bond sell-off around the world,
• and last but not least, huge capital inflows in passiv commoditiy investments.

A look at its sub-indices - GSCI Energy [GJX] (weight: 69,66%), GSCI Industrial Metal [GYX] 11,61%, GSCI Agricultural [GKX] 11,4%, GSCI Livestock [GVX] 4,94%, GSCI Precious Metal [GPX] 2,37% - reveals that the agricultural index recently broke out with a strong move to new highs.

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Inside the agricultural commodities group, Cotton looks the most promising commodity as it may be at the beginning of a sizable upward move as in the last 6 months Corn already exploded by 100% and Soybeans and Wheat each by 50%. Recently Art Samberg in Barron's Midyear Roundtable (2007) (subscription required) pointed out that:

Despite U.S. inventories are high at more than 10 million bales, inventories get depleted or added to based on Chinese demand and the timing of China's orders, and for several months China didn't place many orders. However, inventories are finally beginning to drop. Additionally, there is currently dry weather in Georgia and Texas, and according to the data 20% less cotton was planted this year.

As Chinese demand could be the catalyst, both factors could drive the price for cotton higher. The monthly chart of the cash price of Cotton below shows that Cotton has been trading in a tight trading range between $0.44 and $0.55 per pound for the last 3 1/2 years. However, the sharp increase in the last two weeks indicate, that Cotton might by ready for a strong move to the upside, which should lift cotton to at least $0.70 per pound.

As an investor the investment possibilities in Cotton are limited. You can by futures contracts on the NYBOT or you can by the Exchange Traded Fund issued by ETF Securities, which is listed on the LSE under the symbol COTN.L and is designed to track the Dow Jones AIG Cotton Sub-Index, a total return index. However, both investments will be influenced by the roll yield embedded in the term structure of futures contracts of Cotton. A comparison of the GSCI Spot Index [GNX] and the GSCI Total Return Index [GTX] reveals that the roll yield had been negative since the beginning of 2006 as most of the commodities are in contango and therefore the GTX has been lagging behind the GNX.

As Spencer Jakab recently pointed out in a comment in Barron's, given the huge sum of money which has entered the commodities market in the recent years, there could be a shift in the contango/backwardation situation of the commodities markets, which could influence future returns of passive commodity investments.