The Rise of Cotton, the Decline of Supply

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Includes: DJP, RJA
by: Kenard Grant

Think for a moment as a cotton farmer. You have a fixed amount of acreage, which you typically divvy up accordingly: 50% to cotton and the other 50% to a range of three different crops: corn, soybeans and wheat. Due to planting seasons – we’ll get into the specifics of this in a moment - and the climate of the region, you have constrained yourself to the national average of growing 3 types of crop on your farm. Remember, as a farmer, you look to the futures prices to determine how to allocate acreage so you can harvest the most profitable crop next year.

Now imagine for a moment that out of your normal crop of corn, wheat and cotton (a typical Texas cotton farmer's farm make-up), two of your crops have futures trading at record highs. When you factor in the average costs and yield for each of the three crops to determine your profitability, it would take a rise in your third, lonely, crop of roughly 35% to be on profitability par with the other two. This is the pricing incentive causing farmers in the Southwest and Texas to allocate more of their farms land to soybeans, corn and/or wheat then in past years. As a result, America is witnessing a decrease in planted acres of cotton for next season.

As a result of tight global stock-to-use ratio and America’s position as the world’s exporter of cotton (40% comes from our farmers), a decrease in next year’s acreage devoted to cotton planting in America will result in a price spike from today’s prices. The world’s current cotton inventory (55 million 480-lb bales) would provide about 5.5 months of the world’s demand (according to 2007/2008 yearly demand of roughly 120 million 480-lb bales). Further, at today’s levels, soybeans, corn and wheat remain attractive alternatives for farmers until cotton reaches $0.90-1.00.

Recent legislation moving through Congress threatens to take away a critical farm subsidy, which has provided cotton farmers with a price floor guaranteed through the Federal Government. If successful, the risk/reward for farmers planting cotton given the current pricing environment for wheat, corn and soybeans may force farmers to swap more cotton acreage at an increased rate.

China (30%), India (20%), and Pakistan (7%), who along with the U.S. (16%) make up 73% of 2007/2008’s cotton production, are all net importers of cotton and have shown in recent weeks a very protectionist regime when it comes to other soft commodities related to food. As an export driven market, and with anticipation of the argument that the rest of the world is going to slow down, similar to what we’ve seen in the U.S., you should know the per capita consumption of cotton averaged 35 lbs in 2007; and in 2001 (a year of recession), we saw cotton retreat 2.4 lbs per person, only to raise back to previous levels in 2002.

If you don’t believe me, just ask Professor Carl G. Anderson. Texas A&M’s renowned professor on cotton reported that:

The big question is how much cotton acreage will be planted in the U.S. next season. Alternative crops continue to offer favorable prices compared to cotton. Cotton acreage might slip below 10 million acres. Texas is the only state where 2008/09 acreage may remain stable. The Delta states have the greatest flexibility to reduce cotton acreage. The Southeast and Western regions will also reduce cotton plantings. Two seasons of sharp cuts in cotton acres will tighten U.S. carryover stocks substantially for the 2008/09 crop.

Looking at previous rallies in soybeans, corn and wheat over the past 15 years, we see cotton prices lag their rallies by about a year’s time. As November and December represent planting times for wheat and corn in the south, we can expect the upcoming data to be a catalyst for a price move in cotton.

Factoring a conservative 20% increase in projected costs of corn, soybeans and wheat, in given future levels today, 2008 and 2009 cotton planting acreage should decrease to 6.5 million acres. When factoring the regions accounting for these acres and their historic yields, America will produce 12.8 and 11.6 million bales, respectively, forcing pressure on international growers – some of which have already seen full penetration of Bt seeds – to make up for America's shortfall, resulting in a low of 10% stock-to-use ratio in 2009. A quick comparison of price and stock-to-use ratio (unadjusted for inflation) shows that cotton could trade up to $1.00 per contract. When adjusted for inflation, cotton’s high in the 70s reached $2.40 per contract.

I will leave you with this thought (a new approach to blame China): everyone who attends the 2008 Olympics will want to buy two cotton shirts – given expected attendance, that’s a lot of extra cotton.

If you’re thinking of investing in cotton via futures, note that May is soon to be the new front month contract.

If futures aren’t for you, take a look at the Cotton ETF listed in London [COTN]. Additionally, the iPath Dow Jones-AIG Commodity Index Total Return ETN (NYSEARCA:DJP) and the Rogers International Commodity Index – Agriculture ETN (NYSEARCA:RJA) both provide exposure to cotton along with other agriculture commodities. I’m always a believer of buy what you know best.

And don’t forget to buy an extra cotton shirt after making your purchase!

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