Over the last ten-and-a-half weeks relentless spec and trade selling has pushed the December contract nearly 1700 points lower and it still remains to be seen where this decline ultimately leads to. From a technical perspective we are now approaching the June 2012 low of 66.10 on the weekly chart and beyond that we’ll have to go all the way back to October 2009 to find lower prices.
However, there is a glimmer of hope that we might at least get a rebound in the next week or two, since the market has been able to move sideways over the last five sessions, holding the low of 67.10 cents that was posted right after the release of the USDA report on July 11.
Although the USDA report offered plenty of shock value with its projection of 105.68 million bales in global ending stocks, the market is currently trading only slightly below its pre-report level, indicating that the brunt of the bearish news has already been discounted.
Taking a deeper look into the USDA numbers, one could even conclude that the market has been a bit too pessimistic lately. For example, the projected ROW surplus of 12.1 million bales in the coming season would actually be the lowest in four years. By comparison, in 2011/12 the ROW surplus amounted to over 27 million bales and in 2012/13 it was still over 17 million bales.
The reason the market is so bearish at the moment despite this relatively low ROW surplus is that China is not expected to absorb it to the degree it has in the past. Over the last 3 seasons the ROW surplus amounted to a combined 57.1 million bales and China imported a total of 58.4 million bales, absorbing the entire ROW surplus as well as some stocks.
This is not likely to happen again this season, as China is currently expected to import only 8.0 million of the 12.1 million bales the ROW produces in excess, which will result in ROW stocks growing by 3.75 million bales according to the USDA, from 39.67 million at the end of this season to 43.42 million at the end of 2014/15.
Considering that ROW ending stocks have been relatively tight in recent years, to the point that there was hardly any available cotton left at the end of summer, does a 3.75 million increase change the situation so dramatically that prices have to fall into an abyss?
The bears’ response is that Chinese policy is changing from supportive Reserve buying at highly elevated levels to a ‘target deficiency’ scheme, which is forcing Chinese cotton to trade at significantly lower price levels this season. As Chinese cotton becomes more competitive, it will slow down cotton and yarn imports considerably, which in turn leads to higher ROW ending stocks.
The market seems to believe that the latest USDA numbers are not properly reflecting this bearish scenario yet and that ROW mill use will likely drop more than currently anticipated and/or cotton imports are going to be lower than 8 million bales. This may well be the case, but the way the USDA numbers present themselves today, the ROW situation isn’t quite as depressing as the market perceives it to be.
This brings us to Chinese ending stocks, which are expected to grow to over 62 million bales by the end of next season. That’s a massive amount of cotton, which equates to over twenty months of Chinese mill use! How the Chinese government is going to deal with this gigantic inventory overhang is in our opinion the key to international cotton prices over the next few years.
We can rule out with a great degree of certainty that these Reserve stocks will be exported in the foreseeable future. We therefore need to focus on the rate at which these stocks are going to be reduced, since this will determine the amount of Chinese cotton and yarn imports going forward. A drastic move to reduce these Chinese inventories would translate into rapidly rising ROW stocks and sharply lower world prices, while a measured and drawn out approach would likely act in support of the market.
So far we have yet to hear from China how it is going to implement its policy changes. Exactly what kind of price support will growers get and in what manner is the de-stocking going to take place? We believe that China is still struggling with these issues, since there are limits as to how much price support can be paid under the WTO framework and we feel that the market may be underestimating this factor.
Currently everyone expects China to act as the proverbial wrecking ball in the cotton market, but what if it doesn’t? In each of the previous three seasons the market has made the mistake of underestimating the strength of Chinese imports and only time will tell whether this year is indeed different.
So where do we go from here? Although the statistical picture has certainly turned more bearish than in the previous three seasons and the market therefore deserves a lower price outlook, the speed and degree with which the market has crashed has another explanation.
We need to remember that the futures market is a zero sum game, meaning that for every seller there has to be a buyer. There are essentially three main groups playing in the futures market – index funds, speculators (from small specs to hedge funds) and the trade (growers, mills and merchants). Index funds are by design always long, but they are a passive form of investment and react to money flows in and out of a fund rather than what happens in the market. Speculators are typically on the long side of our market, while the trade is almost exclusively operating from the short side.
When both the speculators and the trade want to sell the market, in reaction to a bearish chart or bearish fundamentals, then the market has a problem, because it can’t accommodate two potential sellers without having willing buyers on the other side. In such situations prices often tend to drop precipitously in search of ready buyers. This is what has happened in the cotton market during this sharp decline.
