Sharp correction ensues in NY cotton futures

July 31, 2009 - Global

NY futures have retreated since our last report on July 16, with December dropping 335 points during this two-week period to close at 60.11 cents.

After the market had advanced by more than 1000 points in exactly a month, reaching a high of 64.98 cents on July 21, the rally finally ran out of steam and a sharp correction ensued.

In order to keep this steep uptrend going, the market needed a continuous supply of fresh buying, but after open interest had increased by nearly 25'000 contracts during the course of this rally, it became increasingly difficult to find buyers once the market approached the 65.00 cents level. Markets are sometimes able to extend a rally thanks to short-covering, but that was not the case here because speculators had hardly any shorts left to cover, while trade shorts consisted of stubborn hedges against physicals and on-call sales. As we have learned last year, large trade short positions can be vulnerable to cash flow issues, but this time around there was no panic discernible among traders.

Once there was a void of buying, the market quickly fell by nearly seven cents in just five sessions, but it encountered decent trendline support above 58.00 cents. The uptrend line we are talking about extends back about 5 ½ months to early March, which is where the current trend originated at around 46.00 cents.

This correction certainly made sense from a fundamental point of view, because futures prices had advanced about three times as much as physical prices in this spec-induced rally. This sharp drop in the futures market should allow merchants to profitably sell some of their recently established basis-long positions, which in turn would act in support of the market as futures are being bought back.

US export sales have slowed down considerably in recent weeks owing to these higher prices, with today's report showing net new sales of just 103'700 running bales of Upland and Pima for both marketing years. This brings total sales for the current season to 14.3 million statistical bales, of which 12.9 million has so far been exported. The pace of shipments has been slower than expected over the last few weeks, which means that we will probably fall about 0.2 million bales short of the current USDA projection of 13.3 million bales.

Of note is that total outstanding commitments for both seasons are currently at just 2.6 million statistical bales, which is 1.3 million less than at the same time last year. Mills are obviously not willing to extend coverage in these uncertain economic times. This can be interpreted as friendly, because by running tighter coverage mills can't stay away from the market for too long.

The demand side of the equation is always the more difficult to get right, especially in tough economic times like these. When the financial crisis hit last fall, analysts were quick to substantially scale back demand numbers, but they may have overreacted! When trying to gauge the level of demand, we prefer to look at production and then add or subtract the change in stocks. Based on this methodology we feel that the USDA world demand number of 110.3 million bales is close to reality; it may even be a bit conservative based on what we are seeing with stock levels.

In China, ending stocks are estimated to be about the same at the end of July as last year according to the USDA, namely around 4.3 million tons or 19.9 million bales. Stocks in private hands seem to be mostly exhausted, with supplies currently coming from government reserves and imports. The current government auction has been a success, as it is estimated that all 1.5 million tons will have found a home by the end of August, at prices that average above what the government paid for it. Based on circumstantial evidence we feel that the USDA ending stocks number for China may be a little on the high side and that there is absolutely no price pressure to be expected from these inventories.

The same goes for India, where the USDA believes that stocks will amount to 10.7 million statistical bales, which equals about 13.7 million local bales. The bulk of these stocks is owned by mills and is needed to tie them over to new crop, which will arrive late this year. Neither these mill stocks nor the few million bales still held by the government are expected to exert any price pressure on the market over the next few months.

The next on the stock list is the US, which will end the season with around 6.2 million bales, of which less than 3.0 million remain unsold. As in the case of China and India, these US remnants are not expected to put much pressure on the market over the summer months. Number four is Brazil, which transitions to the next marketing year with about 5.0 million bales in inventory. But here too we do not foresee any bargain prices to show up anytime soon.

What we realize as we move down this ending stocks list is that there is very little cotton that itches to be sold. Central Asian, African and Australian cotton is still available in some volume, but quantities are not burdensome enough to lead to any major price pressure.

So where do we go from here? The market has found decent technical and fundamental support near 58/59 cents. Whether this support will hold remains to be seen! We are a bit uneasy to see the market so close to this 5 ½ months trendline, for if it were broken we could see spec longs bail out of their recently established positions. For now we shall give the market the benefit of doubt and expect it to establish itself in a range between 58 and 64 cents.

The longer term outlooks points to a sideways trend as well. Most of the crops around the globe seem to be in good shape and we will probably see the USDA raise world production in its August report. We would not be surprised to see world output at 108 to 109 million bales (currently 106 million), which would cut the current production gap of 6.7 million bales by a substantial margin and lead to a fairly balanced supply/demand situation in the coming season.