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NY cotton futures remain on defensive this week

25
Oct '08
After weeks of trending lower, we finally saw a market that presented itself a little bit more two-sided this week.

December was at one point even mounting a rally of over 900 points before succumbing to renewed selling pressure. We believe that this jigsaw trading pattern has a lot to do with the certificated stock, which is causing some headaches for both longs and shorts of the December contract.

For December longs, as well as for the owners of the existing certificated stock, it does not make much sense to be long or to hold on to stock, both from a carry and a market point of view. Old crop certificated stock will be assessed a 200 point crop year penalty on January 1st and therefore the spread between December and March needs to be at least 200 points + plus actual carrying for three months, which should add up to over 450 points.

However, this week we saw the spread go below 300 points, which is a losing proposition for longs, although it has since widened back out to slightly over 400 points and is therefore getting closer to where it needs to be to entice potential takers. When we look at the certificated stock from a cash market point of view, if it is acquired at 49.00 cents it would need to fetch around 63.00 cents C&F Far East in order to break even, which is not realistic in today's tough market.

Conversely, for December shorts the calculation doesn't pencil out either at 49.00 cents, because the current cash price of US cotton renders certification more expensive than that. The basis for this calculation is the AWP (Adjusted World Price), which is the price at which US cotton can be redeemed from the government loan. Currently the AWP is at 44.64 cents and if we add about 5 to 6 cents for delivery charges plus something for 'equity', it becomes prohibitive to be December naked short at 49.00 cents.

The market is therefore having a tough time putting a value on the December contract, although it definitely has some support based on the replacement value of certificated cotton, which is tied to the AWP. This means that NY futures will probably not move lower unless the AWP allows that to happen, and this in turn depends on world prices as reported by the Cotlook A-index.

With governments in India and China stepping in to buy new crop supplies in order to support prices, it is unlikely that prices in these two origins will drop much in the short term and we may even see a quick bounce in prices stemming from some short-covering. We therefore don't think that the AWP will drop before the December contract heads into the notice period.

At the same time the upside seem to be equally contained since the outlook for cotton consumption remains gloomy due to the deepening recession. If we are correct with our assumptions, the spot month should trade in a relatively tight range in the foreseeable future and as a result we may see volatility drop from the current high readings of 52 percent in December and 41 percent in March.


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