Cotton Prices Hit Record Levels

| About: iPath Dow (BAL)

By Tony D'Altorio

Cotton prices have surged beyond $2 a pound, the highest level they’ve ever hit. The fiber didn’t even go that high during the Civil War’s cotton embargo.

It is now up 170% since a year ago, and more than 40% since the beginning of 2011.

Short-term squeezes have definitely contributed, as mills scramble to buy futures contracts to fix physical supply prices. But there are solid fundamentals to blame as well.

Demand for textiles, especially from China, has rebounded sharply from lows set in the global financial crisis. Meanwhile, on the supply side, flooding has led to very poor cotton crops in Pakistan and Australia.

In short, cotton prices aren’t going down anytime soon.

The Cotton Supply Shortage

A shortage really is the problem in the cotton market right now. This has been building up since 2007, with no signs of stopping anytime soon.

India, the world’s second-largest cotton exporter, is imposing export restrictions to help its domestic textiles industry. That has led to severe shortages elsewhere, with everybody turning to the U.S., the biggest – and currently most reliable – cotton exporter for help.

As a proportion of world demand, cotton inventories are expected to fall to their lowest levels in over 15 years, according to the U.S. Department of Agriculture. Its chief economist, Joe Glauber, points out how consumption exceeded production for five years running.

As a result, “there was a draw-down in world stocks. There’s very little cotton out there.” Going forward, the USDA estimates that global demand will outstrip production by 1.3 million bales in the marketing year to July.

U.S. farmers plan to plant more this spring, boosting global production, but those efforts won’t pay off for 8-9 months. And coupled with the situation in India, it could mean higher prices ahead regardless.

The Dutch bank Rabobank says the world needs a record cotton crop this next season just to maintain the current tight fundamentals. It reports: “An inadequate harvest would likely result in continued record highs.”

Cotton’s Price Increase Adds to Global Commodity-Driven Inflation

Cotton’s move past $2 adds further pressure to global, commodity-driven inflation. At the least, it could lead to sharp price hikes in clothing, from jeans and evening dresses to t-shirts and socks.

Runaway cotton prices have sent the clothing industry reeling. They used to be very stable, rarely trading above $1 a pound for any length of time over the last three decades. In fact, from 2000 to 2010, the commodity traded between 40 and 80 cents a pound. But now the clothing industry is warning that the prolonged spell of price deflation is over.

Some U.S. clothing brands have started passing on an initial wave of price increases in their spring collections, after last year’s initial escalation in cotton prices. But they expect even worse as commodity shortages make their way through the production process and onto store shelves.

Manufacturers certainly tried to reduce costs by switching to alternative materials. But the sharp demand increase led to significant price hikes in those as well.

Hence the reason why Wesley Card, CEO of Jones Group (NYSE:JNY), which encompasses Nine West and Anne Klein, has bad news. He says to expect inflation across the board by the end of the year, with potential double digit rises.

Other companies, such as Levi Strauss, echo that warning. And Polo Ralph Lauren (NYSE:RL) and JC Penney (NYSE:JCP) say the same.

Now they just have to wait to see how consumers react to all that. Remember, the U.S. has grown accustomed to prices falling for years due to low fiber prices and the emergence of low-cost overseas production.

Investing in Cotton with ETNs

Sophisticated investors may want to try shorting some of the clothing companies. But that isn’t the only way to profit off of the situation.

Investors should look to buy into a specific exchange traded note on any short-term price drops: iPath Dow Jones-UBS Cotton Subindex Total Return (NYSEARCA:BAL). Backed by Barclays, the ETN reflects the return of cotton futures traded on the InterContinental Exchange.

Even in the best-case scenario, cotton prices should continue to stay strong until the next U.S. cotton crop is harvested. And if it’s not a good crop, $3 or even $4 a pound isn’t out of the question.

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