NY Futures March contracts undergo steep correction

08 Jan '11

6 min read

The late sell-off seems to have been caused by Index Fund rebalancing. Earlier this week a news report claimed that nearly 14'000 March contracts would have to be sold between January 7 and January 14 in order to bring cotton's share back to the allotted percentages in the GSCI and DJ-UBS indexes, which are the two most widely tracked commodity benchmarks.

While we do not doubt there is some selling tied to Index Fund rebalancing, we don't believe that it is of the magnitude mentioned above. When we look at the latest CFTC report as of December 28, we notice that Index Fund related accounts owned 73'356 longs and 14'911 shorts for a net long position of 58'445 contracts, or 5.84 million bales.

As you may remember, Index Funds are by definition a 'long only' investment and it therefore strikes us as odd that there are 15'000 shorts on the books. We believe that most of these shorts were put on by swap dealers a while back in anticipation of the current rebalancing and to possibly take advantage of the huge backwardation that has existed for some time now. We therefore believe that the impact from Index Fund related selling is not going to be as severe as some analysts fear.

So where do we go from here? When we look at the latest net positions of the various market participants as reported by the CFTC, we have Index Funds (5.84 million bales net long) and Spec/Hedge Funds (5.22 million bales net long) vs. the trade with 11.06 million bales net short. Most of these trade shorts are against pending on-call fixations, since there is not really that much cotton left that needs to be hedged, at least not in current crop.

The on-call report shows that as of December 31 there were still 10.45 million bales in unfixed on-call sales, of which 2.7 million are on March, 1.9 million on May and 3.7 million on July. This presents a problem in our opinion, because there may be a lack of sellers to accommodate the 8.3 million bales of fixations that still need to be done over the next five months.

Once the current rebalancing is behind us, Index Funds are likely to remain invested on the long side and may even add additional long positions. This leaves Hedge Funds and other speculators as potential sellers, but with inflation fears flaring up, this group too is likely to stay long. So who will be there to take the other side if trade shorts want or need to cover?

With little cotton left to trade in the US cash market, the NY futures market could become quite thinly traded as we move further into the season and it may take elevated prices to entice potential sellers. We still feel that this is a dangerous set-up for the many trade shorts that remain in the game and they should take any opportunity that presents itself to get out of this predicament.

Plexus Cotton Limited

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