As we enter a new year, we are confronted with one of the more bizarre and enigmatic cotton situations in recent memory. What makes price analysis currently so difficult is that we are essentially dealing with two entirely different markets – China versus the rest of the world. These two markets operate under markedly different price structures, with Chinese cotton and yarn imports creating an important link between the two systems.
The pace at which the Chinese Reserve has been procuring domestic cotton via its auction mechanism this season is simply mindboggling. As of this week the Reserve has already absorbed close to 5.2 million tons (23.5 million statistical bales) into its stockpile, which equates to around 75 percent of the Chinese crop. Total Reserve stocks are now estimated at close to 10 million tons!
With local cotton being prohibitively expensive as well as in short supply, Chinese mills have continued to focus on imports of raw cotton and yarn, thereby siphoning off cheaper supplies from the rest of the world. In the first four months of the current marketing year (August to November), raw cotton imports have already amounted to 5.3 million statistical bales, implying an annualized rate of nearly 16 million bales. Although that’s not quite as much as last season’s 24.5 million bales in imports, it would still be more than enough to neutralize the seasonal production surplus in the rest of the world, which according to USDA figures amounts to 14.4 million bales in 2012/13.
In addition to imports of raw cotton, China continues to be a keen buyer of foreign yarn, nearly doubling the pace of imports from the previous season to an annualized rate of around 6.5-7.0 million bale equivalents. This in turn is boosting mill demand in places like Pakistan, India and Vietnam, who are the main suppliers of this yarn. Given the rather dramatic shift in mill consumption from China to other markets over the last three seasons, it is quite possible that mill use outside China is being underestimated, with recent anecdotal evidence pointing in that direction.
There have been rumors over the past couple of weeks that the Chinese government may start to release some of its stocks by forcing mills to take three bales of Reserve cotton at a price of 19,000 yuan/ton (= 138 cents/lb) for every bale that they are allowed to import under a sliding scale duty. Although this price would be cheaper than the 20,400 yuan/ton the Reserve has been paying to farmers, it is still very expensive when compared to international values.
Some traders fear that such a 3:1 ratio scheme may have a negative market impact, but we don’t believe that to be the case. There may be an initial kneejerk reaction when the new policy is announced, but what matters in the long run is that imports are likely to continue, albeit at a reduced rate.
This is important in regards to international cotton prices, because if plantings in the rest of the world were to drop by 15 percent next season and demand increased by a modest 2 percent, then production and mill use would be at about the same level outside China. Therefore, if China continues to be a net importer, even if it is just 7-8 million bales a year (TRQ and sliding scale quota based on a 3:1 ratio scheme), then the balance sheet in the rest of the world would tighten quite considerably and prices would eventually be forced higher.
What concerns us is that hardly anyone in the trade believes that cotton prices have a chance of moving higher, with most traders subscribing to a perpetual sideways trend. Just look at the incredibly low volatility readings of just 20% all the way from March to new crop December! For example, the December 80 calls closed today at just 564 points, even though there are still over 10 months on the clock. This nonchalant attitude raises some red flags, especially when we consider the current spec/hedge position.
According to the latest CFTC report as of December 24, the long side was made up of index traders (66,362 net long), large speculators/hedge funds (27,740 contracts net long), and small speculators (5,793 net longs), while the trade was on the other side with a rather sizable net short of 99,895 contracts.
When we look at the changes in the individual positions over the last six weeks, or since the current uptrend began, we notice that the main feature was a swap of positions from spec shorts to trade shorts. Outright large and small spec shorts covered over 38,000 contracts over the last six weeks, while the trade short position grew by 41,000 contracts. By comparison outright large and small spec longs increased by just about 6,600 contacts during that time frame. These changes can be viewed as either bullish or bearish. The bears may say that this uptrend was entirely the work of spec short covering and will soon run out of steam, while the bulls will counter that the longs haven’t even started to buy yet and therefore still have a lot of money to spend!
So where do we go from here? Although upside momentum has stalled over the holiday period, the uptrend channel dating back to early November is still intact, albeit barely. Speculators have their sights on the 78.02 cents ceiling that marks a nearly 8-month sideways range, and if this level gets taken out, they will likely enter the market in greater numbers. However, getting there seems to be a difficult task right now and unless the market finds some sponsors relatively soon, momentum will shift to the downside and the market may once again have to regroup in the low 70s, like it did several times before.
Longer term we remain friendly for reasons mentioned above. Although there is still plenty of expensive cotton around, especially in China, cheap cotton is not overly abundant as mills will sooner or later find out.