NY cotton futures loses previous week's upside momentum

Plexus Cotton Limited reported that New York (NY) futures dropped back to reality this week, as December fell 499 points to close at 72.73 cents.

As anticipated the market was unable to sustain last week’s upside momentum and started to run out of buyers when December traded around 78 cents. Shorts were for the most part done covering last Friday after 3 days of heavy turnover and the trade helped to cap the rally by putting on a fair amount of bearish options strategies, most of which were in the March contract.

Friday’s sharp drop in volume was the first sign that this ‘flash rally’ was running out of steam and when traders returned from the weekend, sellers started to take control of the market, with hedge selling and sell stops by speculators pressuring values. Over a period of just ten days we saw the market rally from a low of 70.41 to a high of 79.19 cents in five sessions, only to see it collapse back to a low of 72.06 cents in the following five.

The market is once again near the 71-72 cents support level, from which it had launched last week’s rally. We believe that this price level represents more or less ‘fair value’ when we compare spot futures to the physical market. In other words, if a trader were to buy certified stock at around 71-72 cents, he should be able to compete in overseas markets, where prices for high grades are currently in the low to mid-80s on a CIF Far East basis, depending on the origin. Conversely, for someone considering shorting spot futures at the current level, it may be difficult to procure cash cotton at a cheap enough price to deliver it profitably to the board.

The above ‘line in the sand’ is of course a moving target and depends on how much price pressure there is going to be on US high grades. The fact that the US crop has seen fewer deliverable grades than usual at the beginning of harvest and the lack of pressure from outside growths has allowed the futures market to hold above 70 cents for now.

Many traders feel that this will eventually change as crop pressure builds both in the US as well as in foreign growths, with India probably posing the biggest threat in that regard, both from a price as well as a volume point of view.

Today’s US export sales report confirmed that US cotton is still among the cheapest at this point, based on the fact that there were no less than 16 markets on the buyers list. Even though the headline number was disappointing, as just 49’000 running bales of Upland and Pima were sold for the current marketing year, new sales of 151’200 bales were actually quite good considering that prices rallied last week. What spoiled this otherwise decent number were cancellations of over 100’000 bales, most of which belonged to Bangladesh.

Shipments were also lagging behind at just 67’700 running bales, but this has to do with the fact that old crop stocks are exhausted, while new crop supplies are just entering the pipeline.

Based on the global balance sheet we should sooner or later see some price pressure, but things are not quite as simple as that, as China continues to surprise traders by a) importing a lot of cotton and yarn and b) stashing plenty of domestic cotton away in the Strategic Reserve. Even though Chinese imports are expected to be less than half of what they were last season, we have yet to see this big drop in imports.

For the first two months of the 2012/13 season, August and September, China has already imported 568’000 tons (2.6 million bales), which is over 100’000 tons more than at the same time last season. In addition to that China continues to import yarn at double the pace of last year, with August and September yarn imports combining for about 250’000 tons (1.1 million bales).

At the same time the Chinese Reserve continues to siphon off domestic cotton at a rapid rate. Last week alone the Reserve procured 1.8 million bales, which brings the total since the beginning of September to about 6.8 million bales. Total Reserve stocks are now estimated at around 26 million statistical bales. This begs the question as to what China’s intentions are in regards to its cotton policy? By stocking away high priced cotton and continuing to let cheap cotton and yarn come in, China is acting in support of world prices.

But to what end? We feel that China will eventually surprise us with a major policy shift that steers farmers towards food crops at the expense of cotton. This can be achieved by lowering the support price for cotton while at the same time increasing it for food crops. Just recently the NDRC announced a nearly ten percent increase in the support price for wheat, a clear indication as to where China’s priority lies!

So where do we go from here? With the spot month once again approaching ‘fair value’ and with tenderable grades still in somewhat limited supply, it will take pressure from the cash market to open the downside in the futures market. This pressure may come from the US crop itself or from outside markets like India, but we are probably still several weeks away before the weight of the crops gets big enough. Many traders feel that while the December contract may escape this pressure, March may later on turn into a bottomless pit.

For this to happen we would need to see December’13 fall apart, which is not likely given the already extreme ratio to new crop soybeans and corn. We believe that any price analysis needs to start with December’13, from which we can deduce the price for current crop futures by allowing for a maximum discount of full carry.

For example, if December’13 were to hold at 75 cents, then March would probably not trade much lower than 67/68 cents, and so on. We therefore feel that the market will remain in its broader trading range between 65 and 77 cents, with the 71-72 cents level as the current center of gravity.