Does cotton rally have legs?

Cotton prices have been trading in a relatively narrow trading band over the past year. Recently they’ve rallied to the top of that range against a mixed bag of bullish and bearish developments.

As U.S. production has dwindled over the years, so have inventories. This has left the market vulnerable to temporary supply squeezes. There have been shortages in mills in the Southeast where specific varieties are required, which is at least partially responsible for the strength in prices.

Estimates have begun to trickle in for the new crops to be planted this coming spring. Still in the bull camp, early forecasts for 2014-15 Chinese acreage call for a sharp drop in planted area of close to 11%. That would be the equivalent of about 3.5 million bales less than in 2013-14, which would in itself shave about 3% off global production.

That is about where the bullish case ends. On Feb. 20, the USDA released its preliminary forecast for US 2014-15 crops. Planted cotton area is expected to increase by 1 million acres, or close to 10% more than in 2013-14. Output, however, is estimated to jump by 23%. Yields were poor and the abandonment rate high in 2013-14. With normal weather the output target should be achieved.

The main issue has been, and continues to be, China’s burdensome inventories. Short-term regional tightness in the US and a new crop that might be a couple of million bales smaller are mere diversions.

The February USDA crop report revised the size of the 2013-14 Chinese crop harvested this past fall down by 1 million bales, which resulted in a 1-million-bale downward revision in ending stocks. But it was a drop in the bucket. Chinese stocks still represent 160% of domestic consumption – a statistic unheard of in the annals of internationally traded agricultural commodities.

Moreover, the era of massive Chinese imports that fed that stockpile for the past three years could be over. On January 19, the government announced that it will end the stockpiling program for cotton and soybeans (see Focus on Futures, January 31). Instead, it will offer a direct subsidy to farmers if prices fall below a certain level. The goal is to provide an incentive for farmers to grow cotton to keep prices in line with international prices.

It remains to be seen if the new policy, currently being tested in one province, will work.

Even before the announcement was made, Chinese purchases from the US for 2013-14 had already fallen off sharply from 2012-13. For the 2013-14 marketing year to date, Chinese commitments stand at 1.722 million bales compared with 3.976 million bales at this time last year. The USDA estimates Chinese imports from all sources for the season at 11 million bales, down from 20.33 million bales last year. So it was no great surprise that the market did not immediately react more negatively to the January 19 announcement.

 Smaller Chinese imports had been discounted for some time now. Sooner or later, the Chinese will sell cotton from the monstrous buildup of stocks. We were stopped out of our short position at 86¢ per pound, basis March, as per our Dec. 19 recommendation. Old-crop contract months are flirting with the 90¢-per-pound level, while new crop cotton is priced at 78¢ per pound (Chart 2), reflecting the reality that once short-term supply issues are out of the way, the market should settle back to the low end of the range. We advise reestablishing short positions in July cotton, currently trading at about 88.5¢ per pound. Steer clear of the front month where maximum pain will be felt if a bona fide – albeit short-term – squeeze develops. Place initial stops at 94¢ per pound, close only

 

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