The market hasn’t been kind to anyone betting against July, be it outright shorts or those ending up on the wrong side of the July/Dec spread, as the spot month exploded for a gain of over 1200 points in just nine sessions.
July closed at its highest level in nearly three months, just 114 points shy of the March 15 high close of 92.86 cents.
There was a lot going on this week between the Goldman roll, July options expiration and the USDA supply/demand report. The Goldman roll, which concluded today, has provided plenty of liquidity and offered an opportunity for July shorts to exit or roll their positions, although it seems that quite a few traders continued to procrastinate, considering that there were still 58’643 contracts open as of this morning.
Tomorrow’s options expiration will offset a big chunk of this open interest, but we nevertheless feel that there will be some 25’000-30’000 contacts still open at the beginning of next week, with First Notice Day lurking on June 24.
This may not be a big deal in a season with plenty of cotton available, but in a year like this, where we are down to the last million bales of unsold inventory, a short position can turn into a dangerous trap. Although the certified stock keeps increasing and currently amounts to around 560’000 bales, or 5’600 futures contracts, it may not get the shorts out of their predicament.
Even if the current owners were willing to give up the certified stock, new owners may already be waiting in the wings. When the market dropped below 80 cents a couple of weeks ago, it provided a huge incentive for traders to take possession of the certified stock and then either sell it when the market rallied or apply it against existing commitments.
Therefore, if most of the certified stock is already spoken for, it will become very difficult to replace it, since there is simply not much supply available anymore. With little cotton left to back up short bets, the only way out for most traders is to buy back their position. While this was relatively easy to do when the Goldman roll provided liquidity and options offered protection, the shorts may be in for a wild ride next week.
No market maker or trader in his right mind will want to take on a new July short at this point, so the shorts will be mainly at the mercy of existing longs to let them out. However, some of the longs may be intent on taking delivery, while others hang in there for a move to loftier levels. We shall keep a close eye on July open interest for clues regarding a potential short squeeze!
While until a few days ago it could be argued that new crop was simply pulled higher by the strength in the spot month, Wednesday’s USDA report helped to build a bullish case for December beyond the July expiration.
As long as Chinese stocks remain expensive and locked away, the two numbers that matter most in the USDA supply/demand report are a) the ROW (rest-of-the-word) production surplus and b) Chinese imports. The more China imports, the tighter the stocks in the ROW get, which in turn supports world prices.
For the 2012/13 season, the USDA continued to lower ROW stocks from 36.5 to 34.9 million bales, mainly due to a rise in Chinese imports from 18.25 to 20.00 million bales. The pace of Chinese imports has been the big story this season! Just seven months ago, in November 2012, the USDA had Chinese imports at 11.0 million bales, or 9.0 million bales less than its current estimate!
For 2013/14, the USDA predicts the ROW to produce 8.99 million bales more than it consumes, down from a surplus of 13.87 million bales in the current season.
Although Chinese imports are expected to be quite a bit lower next season at 11.0 million bales, they are nevertheless 2.01 million bales larger than the production surplus outside China, which adjusted for some other changes means that ROW stocks are expected to fall to just 33.56 million bales by the end of July 2014. This would be the second lowest inventory in ten seasons, after 32.41 million in 2009/10.
US export sales continued to surprise positively, as a combined 201’900 running bales net were sold for both marketing years, with 15 markets participating in the buying. Total commitments for the current season now stand at 13.7 million statistical bales, whereof 11.8 million have already been shipped.
In addition to that there are currently 2.0 million bales in export commitments for shipment August onwards. According to our calculations the unsold inventory is now less than a million bales, not counting the certified stock of a little over half a million bales. This means that export sales will likely drop off considerably over the coming weeks, not because there isn’t any buying interest, but because there won’t be much cotton on offer anymore.
So where do we go from here? The fate of the July contract depends to a large degree on how the remaining open interest gets dealt with. The odds favor a short squeeze and a continuation of the rally as we head towards First Notice Day. Once most of the shorts are out, there may be a last minute selloff when the futures market reconciles with cash values.
New crop has been pulled up by July, but the tightening statistical picture in the ROW is providing strong underlying support for December in the low to mid-80s. As long as China continues to reduce supplies in the ROW, prices are likely to stay on a firm footing.
Traders are aware that at some point in the future these massive Chinese stocks will come back into picture and are therefore reluctant to get too friendly on prices going forward. But until China changes its current modus operandi, the market will likely continue to climb the proverbial "Chinese Wall of worry”.
