The market continued its correction and pulled back to a low of 80.05 cents in March and 81.35 cent in May, but there were plenty of buyers waiting to buy on dips. Volume was heavy all week long due to the Goldman roll, but overall open interest held up quite well considering that March is in liquidation, as it declined by only 9’520 lots overall.
While March open interest dropped by 61’670 contracts over the last five sessions, the rest of the board picked up 52’150 contracts, which tells us that specs longs and trade shorts continue to hold their line in this standoff.
According to the most recent CFTC report as of February 5, the trade increased its net short exposure to 15.5 million bales, while specs (8.1 million net long) and index funds (7.4 million net long) owned the corresponding positions on the other side.
The trade continued to increase the certified stock to 294’000 bales this week, including bales under review, which may keep the longs on the back burner for now. However, it is important to realize that over the next four months the trade will have to get out of its massive net futures short in current crop, either by buying it back or by rolling it into new crop.
That amounts to a lot of short covering in a limited time frame and spec longs are probably not going to be very accommodating. We estimate that around 13.0 million of the trade’s net short belongs to current crop, while the remaining 2.5 million bales are against new crop.
From a seasonal point of view this large trade short is a bit unusual. Typically the futures short position should be at its peak at harvest and then gradually decline as basis-long positions get sold over the course of the marketing year. This season the opposite has happened, as the trade net short position grew from 5.9 million bales in mid November to the current 15.5 million bales.
Traders may have become stuck on the idea that the market is a great sell above 80 cents and that prices can’t possibly go any higher in the face of these large global ending stocks. Assumptions like these have proven to be costly to traders in recent years, and we wouldn’t be surprised if history were to repeat itself over the coming months.
The market had three reports to look at since last Thursday and they weren’t really what the bears were hoping for. First up was the USDA report last Friday, which showed a familiar picture of increasing stocks in China (up 2.0 million bales) and declining inventories in the rest of the world (down 1.86 million bales).
Although projected ending stocks in China are at a record high of 42.61 million bales, they don’t really matter as much at the moment since they carry a hefty price tag of around 140 cents/lb and are therefore no threat to cotton that is priced in the 80s.
What does matter in regards to the futures market is that stocks outside China are getting tighter every month and are now estimated at just 39.25 million bales by the end of July. This is more or less the same level we had last season (38.85 million bales) and two years ago (38.40 million bales). What is important though is that in the previous two seasons the outlook for production in the rest of the world remained relatively high, whereas we are now looking at a significant decline in acreage next season.
While production outside China was still at 91.0 million bales in 2011/12 and at 85.3 million bales in the current season, we may possibly get no more than 76-78 million bales next season, although we realize that this is still very much a moving target.
The second report that traders had to digest this week was the NCC planting intentions survey, which came in at just 9.01 million acres (down 27%), the lowest number in 30 years! This number was well below trade estimates and what’s striking is that the Mid-South is expected to plant just 1.0 million acres, down over 50% from last season.
Another important factor to consider is that 5.23 million acres or 58% of the total is located in the Southwest (Texas, Oklahoma, Kansas), an area that has been struggling with drought conditions. With so many eggs in one basket it could spell trouble if the weather weren’t to cooperate and this should keep traders on edge throughout the growing season.
The third report that gave the bulls a reason to cheer was the US export sales report, which came in at a surprisingly strong 398’300 running bales for Upland and Pima, combining both marketing years. Participation continued to be broad-based, with 17 markets on the buyers list. For the current season total sales now amount to 10.7 million statistical bales, of which 5.6 million bales have so far been exported.
We believe that the majority of these sales were done ‘on-call’, since basis offers became more attractive once futures started to outpace cash prices. The most recent on-call report shows a big jump in outstanding on-call sales of 471’900 bales for fixations on May and beyond. When mills buy on-call, it creates deferred support in the futures market, since merchants often fix the sale right away by selling futures, and then buy these futures back when mills issue their fixation orders.
So where do we go from here? From a technical point of view it looks like the May chart is forming a ‘bull flag’, which is characterized as a brief pause in a bullish trend. More often than not, this pause is resolved in the direction of the move, which is up. Of importance here is that specs recognize this as a high probability pattern and are therefore likely to act on it. Additional spec buying could overwhelm trade shorts, since they don’t seem to have a lot of bullets left.
Even from a fundamental point of view there is currently no convincing argument against higher prices, since many mills are still wide open for shipment March/April onwards and cheap supplies are increasingly more difficult to come by. We therefore feel that it would make sense for the trade to exit short positions on pullbacks.
