Revisiting the Cotton Trade

Directions in several key fundamentals portend strength in cotton prices as we move into the remaining months of the 2007/2008 season.

First, world production is expected to decrease 2.2% to 118 million bales in 2008/2009 and consumption is expected to increase 2.1% to 127 million bales. The market will enter a period where world consumption has exceeded world production for three consecutive years. This situation in 2008/2009 will reduce word ending stocks by an estimated 10%.

Second, despite a projected increase in Chinese production for 2008/2009, Chinese cotton imports are expected to rise by 25% to 15 million bales. This increase is likely to keep upward pressure on cotton prices as the total world trade in cotton is estimated to rise by 6.8%.

Third, this early season forecast for the fundamentals leaves little space for world production estimates to fall in the months ahead without an appreciable tightening in stocks and the fundamental strength reemerging for prices. As more reliable production estimates become available in July and August for an already smaller U.S. crop, the real uncertainty that awaits world prices lies in the production forecasts for China and India. Declines in either of these estimates, with even a modest forecast of 2.1% increase in world cotton use for 2008/2009, will leave the markets facing sharply declining stocks-to-use forecasts.

An article about the CFTC's examination of the cotton market sparked my interested in forward cotton prices once again. The following chart was used to argue that the recent volatility in the cotton markets is nothing new.

click to enlarge image

An examination into the cash price of cotton - that is the price which farmers are selling their cotton to merchants - shows that the the futures market had grossly overrun the true spot price.

What a good trader have realized from this, as prices rose to $.90 in the futures market while farmers garnered $.69 cents in the cash market, is a supply overhang that would soon bring future prices down. Having correctly called the 20% rise in prices in February/March, it's time to revisit the trade.

Let's start first with the market perception. June is historically a poor performing month for cotton futures, only to transition into late summer/fall rallies. Why? Because buyers typically come back to market around this time helping to remove supply from the market and allowing current production year stock-to-use ratios (inventory) effect forward pricing.

Put another way, supply builds in the early summer months only to be marketed in the fall and winter, when future prices are responding to current year harvest numbers. Currently future prices are off about 12% in the past few weeks.

At the same time, in recent weeks, names from major Wall Street banks to Byron Wein, the strategist at Pequot, have called cotton one of their favorite investments for the year. Could it be that these strategists called it wrong? Maybe. But we should care more about their logic. They have all pointed to a diminishing supply of cotton farms/acreage, as well as a 5 year low in stock-to-use.

Furthermore, if one looks at historic stock-to-use levels and pricing (unadjusted for inflation and dating back 30 years) forward cotton contracts are undervalued by roughly 9%. A quick, minimal and often unfair inflation adjustment (i.e. 1864 cotton prices would equal $36 dollars a bushel) would show fair value for October cotton at around $0.90 cents a contract.

Now lets move to the fundamentals - U.S. cotton supply is down this year, acreage is down and everyone expected that. Demand has risen but a bit slower then historical norms; blame it on the recession if you will. What people didn't expect is 6 million people in China needing to be relocated, cities being reconstructed, and massive foreign aid spend in the form of food and blankets. This article says a minimum of 3 million tents, made of canvass, which is low grade cotton, will be needed for Chinese refugees. We know from USDA reports that Chinese buying of cotton has been up year to date - maybe preparing for 2008 Olympic t-shirt sales. We also know that according to a pricing model built, cotton alternatives - rayon, polyester etc - these clothing producers all things being equal would rather be manufacturing clothe/clothing with cotton fibers then fibers made from petro products.

Additionally, we know that the WTO has ruled against US government cotton subsidies, meaning if enforced and accepted by the U.S. Department of Agriculture, cotton farmers in the future will not have a guaranteed floor of $0.72, making a further shift away from cotton acreage into wheat, beans and corn more likely.

As I mentioned above, having correctly called the 20% rise in prices in February/March, it's time to revisit the trade. Next week, the USDA will release a world supply and trade piece, which I believe will show increased exports. Since readers like actionable ideas, I will leave everyone with two suggestions to play the under valued future curve: outright long Oct '08 and Dec '08 futures or buy the COTN LON ETF. I've heard recent talk of a US based Cotton ETF being launched, which should help make the trade actionable for U.S. retail participants.