NY cotton futures display mixed reactions this week

A surprisingly large US export sales report of slightly over 1.0 million bales for both marketing years sent July shorts running for the exit this morning, which resulted in the spot month being locked the limit.

Since making a low of 66.10 cents on June 4, July has rallied an impressive 12 cents in just eight sessions. Short options positions - this time it was short call options – added further fuel to the fire. Before today’s session, with just two days to go until expiration, there were 16’818 call options open with a strike price of 81 cents or lower, which had a combined delta of 7’710 contracts. In other words, this position has the potential to generate an additional 9’000 contracts by tomorrow.

Most traders are quick to dismiss the market’s recent strength as nothing more than a temporary short-covering rally that’s confined to the July contract. The market is convinced that as soon as July goes off the board, new crop’s bearish forces will resume control.

Tuesday’s USDA supply/demand report has reaffirmed this belief, as global ending stocks in 2012/13 are projected to rise by another 0.76 million bales to an unprecedented 74.51 million bales. Although such a large ending stocks number is certainly a convincing argument for a bearish case, we believe that the situation is not quite as simple as it looks.

About a year ago, in early June 2011, the Chinese market and the international market were still sitting at around the same level, with both the CC-index and the A-index measuring a little over 170 cents/lb. Since then these two benchmarks have opened up a huge gap between them, with government sponsored Chinese prices still hovering north of 130 cents/lb, while the A-index is around 50 cents/lb cheaper than that. Therefore, when reaching conclusions about the USDA report, we need to take this two-tiered market into account.

Analyzing the latest USDA report from a Chinese versus a rest-of-the world perspective, the numbers look rather bearish for China but are actually quite supportive for the rest-of-the-world. While China is expected to see its ending stocks rise by 3.25 million bales at the end of next season, inventories in the rest-of-the-world are projected to fall by 2.5 million bales.

Of the expected 25.0 million bales rise in global ending stocks since 2010/11, 20.0 million bales are added in China and just 5.0 million bales in the rest-of-the-world. A 5.0 million bales increase in ending stocks outside China doesn’t look like an overly depressing number to us.

We feel that for proper price analysis we need to look at the world in three parts – China, the US and everyone else. China runs its own game with domestic prices in the stratosphere compared the international level and we should therefore primarily focus on China’s net imports of raw cotton and yarn.