New York cotton futures rebound

Plexus Cotton Limited reported that New York (NY) futures rebounded this week, as May advanced 224 points to close at 89.58 cents, while December gained just 68 points to close at 88.95 cents.

In our last report we argued that cheap cotton may actually be a lot less plentiful than what statistics lead us to believe, because China has absorbed a lot of excess cotton into its balance sheet and a big chunk of the remaining exportable surplus is located in relatively expensive origins like Australia and Central Asia. Thanks to a depressed NY futures market, the US has been one of the more 'affordable origins' recently, which has allowed it to conclude a decent amount of export business over the last couple of weeks.

US export sales for the week of March 15 were once again above expectations at 200'400 running bales for the current marketing year, plus there were another 87'100 running bales sold for August onwards shipment. What's remarkable apart from the volume sold is that 19 markets participated in the buying, signaling that US cotton is currently one of the more attractive as well as one of the more reliable origins available. Commitments for the current season now amount to 11.9 million statistical bales, whereof 6.4 million have so far been exported.

When we look at the US balance sheet, we have supply at 18.3 million bales (2.6 beginning stocks and 15.7 crop), from which we need to deduct 3.4 million for domestic mill use and 11.9 million bales in export commitments. This leaves theoretically around 3.0 million bales of uncommitted cotton, but since our statistics are based on a snapshot at the end of July, we have to reserve around 0.9 million bales for domestic mills use between August and October and there are probably around 0.5 million bales in export commitments for August onwards that will be supplied from existing stocks. In other words, there are not much more than 1.6 million bales for sale at this point and some of these bales may already be spoken for, because there are still around 1.4 million bales in 'optional origins' sales on the books.

Typically one would expect to see price rationing and a slowdown in activity in a tightening supply situation like this, but what we are witnessing is actually the opposite, as US export sales have been accelerating in recent weeks and prices have been trending lower due to a bearish outlook for new crop. There is no incentive for anyone who is holding cotton to keep sitting on it, because the market offers no carry and the statistical picture for next season is still rather depressing. Therefore, old crop cotton gets pushed out the door as fast as possible, which in turn tightens the remaining supply even further and forces a steeper inversion, thereby creating even more of an incentive to let go of existing stocks.

As the US races towards a sold out position, the futures market could turn into a dangerous bear trap for the many shorts that remain in May and July. Based on our calculation above, the amount of uncommitted US cotton amounts to just 1.6 million or an equivalent of 16'000 contracts, while the open interest in May and July futures amounted to over 139'000 contracts or 13.9 million bales as of this morning. Although we realize that some of these open futures may have offsetting options positions against them, the amount of open interest remains rather high compared to what is left for sale in the US.

So what is this huge short interest in May and July futures against? For one, there are still over 30'000 contracts or 3.0 million bales in unfixed on-call sales on May and July, and merchants hold sold short futures or options against many of them. Then there are basis-long positions in foreign growths, such as Australia, Brazil or various African origins, where a physical long is being 'protected' with a short futures or options position. The last category involves speculative short positions, with large specs/hedge funds currently holding the largest short position in over three years, with 8000 contracts in net shorts and 44'000 contracts in outright shorts. Although some of these shorts may belong to December, specs typically play in nearby futures for liquidity reasons.

So where do we go from here? We don't like the current set-up in the futures market, where the trade and speculators are both leaning towards the short side, while inactive index funds are holding the longs. Since the US is almost sold out, we believe that it won't take much to spook these shorts into covering their positions in a less than orderly fashion. As we have pointed out last week, we don't think it is a good idea to be short nearby futures and would advise to do any short hedging in the December contract instead.