The October USDA crop report for cotton was a bear’s fantasy. The forecast for global 2012-13 output was revised up by 2.3 million bales, while consumption was lowered by 680,000 bales from the September estimate. Crop estimates for just about all major producers – including the world’s four largest, China, India, the U.S. and Pakistan – were raised. The net effect was an increase in the estimate for ending stocks to 79.11 million bales, 2.6 million bales above the already-record-high ending stocks estimate reported in September. Ending stocks as a percentage of consumption will jump to 74%, up from the September estimate of 71.1%. That compares with 67.4% at the end of 2011-12. That would be the highest inventory level of any major internationally-traded commodity that we know of – this year or any other year.
This, of course, explains why cotton prices have fallen from the $2.15-per-pound peak set in early 2011 (Chart 1). Are we headed down even further, back to the 2009 lows?
The first matter that requires explanation, though, is why, after selling off on Oct. 11 immediately after the release of the USDA report, the market rallied from 70¢ per pound to close to 80¢ per pound over the following few sessions, if the market is in fact as bearish as the global balance sheet implies.
It seems to have been a temporary problem. Certified stocks in the U.S., which can be delivered at the exchange, have fallen to historic lows. This ignited fears that a squeeze will follow on the December contract. Some early-harvested cotton has been of poor quality, and traders are concerned that it may not meet deliverable grade. The December/March spread, which had been in a moderate contago since the summer, quickly spiked to a 2-cent backwardation (Chart 2).
The U.S. harvest is 38% complete, in line with the five-year average of 39% for this time of year, and the tight stock situation should be alleviated soon enough. The first small increase in certified stocks, indeed, ended the panic. Prices and spreads reverted.
The demand side has not been particularly supportive. The USDA forecast is calling for U.S. exports of 11.6 million bales, down only 1% from 2011-12. Commitments for the 2012-13 marketing year, which began on Aug. 1, however, stand at 5.6 million bales, down 16% from the same time last year.
A closer look reveals a bit of a silver lining, though. At 1.55 million bales, or 27% of sales to date, shipments are stronger than last year at this time when shipments were only 1 million bales, or 15% of sales to date. That could mean that the demand is there, but buyers are confident of lower prices down the road.
We’re not actually bearish, though, and we have no interest in being short this market. The market could drift lower with harvest pressure, but the downside is limited. As we’ve pointed out in the past, production costs have increased significantly to around current price levels, which is generally not a great incentive to grow cotton when you can grow alternative, more profitable crops.
To illustrate, November 2013 soybeans, which represent the crop that will be planted next spring and harvested in the fall, are trading at $13.35 per bushel, $2.30 per bushel below spot November. December 2013 cotton is trading at 77¢ per pound, 4.5¢ per pound above spot December. And yet soybean prices are still near their historical highs vis-à-vis cotton (Chart 3). In fact, in an early forecast for 2013-14 acreage, Informa Economics estimates that soybean acreage would climb by 2.7 million acres, to 79.9 million acres. Cotton acres, on the other hand, are estimated to fall by 2.36 million acres, to 10 million acres. It’s not much of a stretch to assume that a similar pattern will emerge in other producing nations as well.
Prices would have to rise substantially within the next couple of months to incentivize increased cotton plantings, in the US and abroad, and precisely because global inventories are so large, that is not a likely scenario. The decision to plant much less cotton could be misguided if demand exceeds expectations and we eat into the monster stockpiles at a faster rate than anticipated.
We are long December cotton, with a stop at 69¢ per pound. We recommend rolling to December 2013, placing initial stops at 72.5¢ per pound, close only.