2 Reasons Why The Spike In Cotton Prices Should Concern Investors

Includes: BALB, DBA, RJA
by: Matt Schilling

On Wednesday, Cotton continued to rally as the commodity closed at 77.86 cents a pound due largely in part to the fact U.S.-based cotton supplies have reached a 17-year low. The iPath Dow Jones UBS Cotton Subindex Total Return ETN (BAL) was up 4.4% as of the mid-session on Wednesday and the RICI Agriculture ETN (NYSEARCA:RJA), which consists of about 12% cotton, was ahead by 1.1%. The more diversified PowerShares DB Agriculture Fund (NYSE:DBA), with only a few percent of the portfolio invested in cotton futures, was ahead by 0.3%.

One of the key catalysts contributing to the soaring price of cotton actually pertains to the quality of the cotton fibers already harvested. According to an article written by Ron Smith and featured on SouthWestFarmPress.com, "Quality continues to be the key for keeping U.S. cotton competitive in a global market and anything the industry can do to develop better varieties and better production techniques that reduce broken fibers and avoid contamination will increase potential for market share, says Michael Watson, vice president of fiber competition for Cotton Incorporated." The better the quality of cotton produced, the higher the price and since inventories are at multi-decade lows, the price of the commodity has been driven higher. Many of the key cotton harvests were delayed due to an unusual increase in moisture which directly affects the quality of the cotton harvested.

Why should the U.S. be concerned about the quality of its cotton? The answer is simple and that is to satisfy the demand of its largest buyer, China. Investors should note that although the Chinese have been purchasing less, they still remain a key component in the life cycle of U.S. cotton production. Aakash Doshi, of Citigroup, recently had this to say about the weakening demand for Chinese cotton consumption, "China remains the key global cotton consumer and in the absence of a reserve purchase program that the Middle Kingdom ended in 1Q'12 there is likely to be limited upside (during 11/12 China imported in excess of 23m bales but this figure is likely to drop by more than half in 12/13). To be sure, imports have been creeping steadily lower m/m since this past spring. As such the global cotton balance sheet appears bearish under most circumstances (unless there is a surprise stockpiling in Asia although the impetus with sluggish global growth and mills switching to synthetics from last year doesn't seem to be point to this development). Even with stronger consumption and lower U.S. production, China is looking to end up with nearly half of 12/13 carryout."

The second key catalyst which comes to mind deals directly with the staggering decline in U.S.-based inventories of cotton. The inventories, which consist of 500-pound bales of cotton and are currently stored at ICE-certified warehouses, are one of the key variables many traders use when to determining whether or not to establish a position. According to an article featured on WSJ.com, "inventories have been down significantly year over year." For example, October 2011 inventories held 18,447 bales whereas October 2012 inventories currently hold 7,802 bales, for those of you crunching the number that's a 136% decline year over year.

Given the data I've presented would now be the best time for investors to establish a long position cotton or for that matter any of the ETFs consisting of cotton-based investments? My concerns are clearly two-fold and although moisture will only hinder the quality of Cotton a tad, weakening Chinese demand strengthens my position to sit on the sidelines at least until April or May.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.