NY futures continued to advance this week, as July added 180 points to close at 71.44 cents, while December gained 312 points to close at 80.07 cents.
Weather worries, volatile outside markets and an improving technical picture were the driving forces behind this week's wild ride in the cotton market. On Monday morning, the December contract rallied over 700 points in synthetic trading before falling back to a gain of 'just' 279 points for the day. Since then we have seen a rather nervous, erratic market in search of its 'fair value'.
We believe that the market is set-up for such volatile trading because there is an imbalance between market driven long and short positions. As we have explained on previous occasions, the fact that index funds occupy such a large portion of the long side can lead to interesting dynamics.
Let's have a more detailed look at this! According to the latest CFTC report of June 10, which includes futures and options, the various market participants owned the following positions:
• Large speculators were 4.8 mio bales outright long and 3.0 mio bales outright short, for a net long position of 1.8 mio bales. In addition to that, they owned spread positions totaling 15.9 mio bales.
• The trade had 12.4 mio bales of outright longs and 24.9 mio bales of outright shorts, for a net short position of 12.5 mio bales.
• Index funds had had a net long position of 10.2 mio bales
• Small speculators, called 'non-reportable', owned 2.3 mio on the long side and 1.8 mio on the short side, for a net long position of 0.5 mio bales.
If we summarize these positions, we have on the one hand a large index fund long position of 10.2 mio bales net, to which we add the 1.8 mio bales net long of large speculators and the 0.5 mio bales net long of small speculators, for a total long exposure of 12.5 mio bales.
On the other side of the balance sheet we have the trade, which has an offsetting 12.5 mio bales net short position.
Now, since we know that index funds do not react to market movements, but only to the flow of money in and out of these index products, we really need to focus on the remaining longs and shorts, which do pay attention to supply/demand forces or to technical indicators.
This gives us just 2.3 mio bales of net longs of large and small speculators, and against that there are 12.5 mio of trade shorts, which is a rather stark imbalance. However, as long as the market outlook of these participants remains bearish, not much is likely to happen, because the longs see no reason to add to their positions, while trade shorts have no reason to cover, other than for liquidity reasons perhaps as we have seen in early March.
However, once these trade shorts change their mind about the market and decide to cover, who will be there to sell? Remember, there are not that many 'market driven' longs to begin with and many of them react to technical signals, which means that in a rising trend they want to buy, not sell.
We believe that these dynamics are responsible for the excessive upside moves we have seen in crude oil, grains and some of the other commodity markets that have bullish fundamentals. It really boils down to a lack of short sellers and with open interest rising so much in recent years, it takes an ever increasing amount of shorts to offset the huge block of these 'long only' index funds.
The question in regards to cotton is whether the supply/demand situation is finally switching to a bullish scenario as we head into the coming season. We already know that we have a much smaller US crop than in recent years, the question is just how much smaller it will be?
West Texas seems to have lost quite a bit of potential, with acreage losses estimated at 0.5 to 0.8 mio acres. There has been some scattered rain over the last few days that brought some relief and more may be on the way tonight and tomorrow, but after that a high pressure ridge is supposed to bring above average temperatures.
If we calculate with a 14.0 mio bales crop for the US, which may be generous at this point, we will end up with total supply of 24.2 mio bales next season. Since export sales for the current marketing year have already reached 15.5 mio statistical bales, we will carry-in at least 1.6 mio bales in sales, plus there are 0.8 mio bales of new crop sales on the books.
This means that out of this 24.2 mio bales supply next season, 2.4 mio are already committed for export and 4.5 mio bales will be taken up by domestic mills. This leaves just 17.3 mio bales of US cotton for sale to overseas markets between now and the end of 2009.
The fact that we still have plenty of inventories to get mills comfortably into new crop may give buyers a false sense of security. Sure, right now there is no shortage of cotton and once new crop arrives, there will be enough for a while longer.
But once we get into the second and third quarter of 2009, the situation may not look so accommodative, especially if grain prices remain high and next year's cotton acreage shrinks further. The futures market is a discounting machine and it will not wait until the middle of next year to 'discount' a much more friendly market scenario.
One may argue that December has already discounted a higher price, because its current price of 80 cents is substantially higher than the cash market. It will therefore be interesting to see what gives, whether mills will have to pay up this summer or whether new crop futures will eventually trade down to the level of the cash market. Perhaps they will meet somewhere in the middle.
However, this is all based on a relatively benign market outlook, without any bullish surprises. If the Texas crop goes further downhill, it may very well be that the shorts see an urgency to cover their positions and this could trigger a rather explosive move higher.
