The bear market in cotton was ugly. In March 2011, the price of the fiber traded to an all-time high of $2.27 per pound. As often happens in the world of commodities, a fundamental deficit in the cotton market developed but the price rose to a level that defied logic. As volatile market instruments, commodities often move a lot higher than they should during bull markets and a lot lower than they should during bear markets.
Following the dizzying highs of 2011, cotton proceeded to plunge to under $1 by July of that same year and it continued lower until reaching a bottom at 55.66 cents per pound on the active month ICE futures contract in March 2016. Cotton moved to a level that was too high in 2011 and it likely balanced that by moving to a level that was too low in March 2016. Since then, the cotton market has recovered and was trading at the 75.25 cents per pound level at the close on Wednesday, February 08. While a 20-cent move was nothing back in 2011, it represents a rally of around 35% over the past eleven months which is significant.
Last year as the price of the fiber reached its low, there was enough cotton in global inventories to produce two pairs of jeans for every man, woman, and child on earth. Almost 15 billion pairs of jeans take a lot of cotton to produce. However, there have been signs that inventories are on the decline over recent months and the price of cotton has responded by staging a recovery. Cotton is now in a position where it may be ready to take the price to another milestone as the 80 level is looking achievable sooner rather than later these days.
A bullish technical pattern
As the weekly chart highlights, cotton has been making higher lows since March and the price reached a peak of 77.80 cents on the nearby futures contract on August 5. A downside correction followed but the fiber was able to hold above 65 cents and since then it has been making a series of higher highs. The slow stochastic, a momentum indicator, continues to point to an uptrend although the metric has risen to overbought territory. Relative strength is in neutral territory while weekly historical volatility at around 15.6% indicates that the price appreciation has been slow and steady. Cotton was trading at a level close to recent highs on Wednesday and technical resistance at just below the 78 cent level on the weekly chart.
The possibility of a short-term correction rises
Like most commodities, cotton tends to take the stairs higher and the elevator down. Therefore, as the price climbs it becomes more susceptible to down drafts. Each month the U.S. Department of Agriculture releases its World Agricultural Supply and Demand Estimates (WASDE) report and cotton tends to be highly sensitive to this production, inventory and demand data. Therefore, sudden price moves in the fiber, higher or lower, tends to happen after the release of the WASDE report. The latest report comes out today at noon and the chances are we will see some price action in the fiber after the release.
A recent report from the International Cotton Advisory Committee said that Indian cotton production should increase by 7% during the 2017-2018 growing season versus the previous year. However, there are signs that inventories are moving lower and deferred buying for 2018 has provided support for futures prices. While each high in cotton increases the chances for a downside correction, cotton has found support at progressively higher levels for the past year. Another technical factor supports the current trading pattern in the fiber.
Open interest supports more gains
As the monthly cotton futures chart illustrates, open interest was at 283,531 contracts at the end of last week, the highest level since February 2008 when the metric reached its all-time high at 296,853 contracts. Rising open interest in an upward trending market provides technical support to the bullish trading pattern and supports more gains.
A bullish monthly chart
The longer-term monthly pictorial displays the uptrend as the slow stochastic continues to rise, an indication that price momentum remains higher. Additionally, relative strength is in neutral territory on a long-term basis which likely means that there is more room on the upside for cotton. Source: CQG
The daily chart highlights that cotton moved to a high of 77.40 cents per pound on February 2 before the latest price correction. Cotton got within 0.40 cents of the August 5 highs and 0.60 cents from the highs in the active month March futures contract as it works its way higher. The price trend supports an eventual test of the 80 cents per pound level, a price that cotton has not seen since June 2014. Moreover, the current shape of the forward curve in cotton supports further price gains in the weeks ahead depending on what the USDA tells the market above the fiber today.
Term structure supports higher price
Term structure is a great tool when it comes to understanding and monitoring market fundamentals. In glut markets where supplies are higher than demand, the forward curve tends towards contango, a condition where nearby futures trade at a discount to deferred futures prices. When markets tighten and demand rises to levels where a deficit begins to appear, the forward curve tends towards backwardation, a condition where nearby prices trade at a premium to deferred futures contract prices. Source: ICE
In agricultural commodities, the shape of the forward curve depends on market perception and the current state of inventories because deferred supplies are often estimates as farmers and producers have not yet planted the cotton and other crops that will be available in 2018 and 2019. However, the forward curve in cotton shows a small contango from March through July 2017 indicating ample current supplies. The short-term contango is likely a reflection of the current state of inventories in the U.S. and China.
Starting in July 2017, a backwardation has developed in the term structure for the fiber which is a sign of tightness as inventories are expected to decline in months where cotton is trading at the highest level on the curve; in this case in July 2017.
The current shape of term structure in cotton is supportive of the bullish trend in the fiber. I believe that cotton will trade at an 80 handle sooner rather than later. I remain long the iPath Bloomberg Cotton Subindex Total Return ETN (NYSEARCA:BAL) product which was trading at $49.70 per share on Wednesday, February 08. The 52-week range in BAL has been from $35.58 to $51.79 and I expect to see new highs in the coming months.
Cotton is approaching critical resistance at the 78 cent per pound level and given the technical trend, the shape of the forward curve and the fundamentals for the fiber, it will not be long until we see the highest prices since 2014.
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Disclosure: I am/we are long BAL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.