Futures prices continued to tumble this week, as negative fundamental and technical factors exerted additional downward pressure on the market. Abundant rainfall in West Texas over the Memorial Day weekend could potentially add 1.5-2.0 million bales to the ROW (rest-of-the world) balance sheet, which would help to alleviate the tight stock situation outside China in the coming season.
This bearish fundamental development exacerbated an already weak technical trend, which saw July drop from a high of 94.74 on May 6 to a low of 83.86 cents on May 28, before rebounding somewhat over the last two sessions. December fared only slightly better, as it dropped from a high of 84.58 to a low of 77.00 cents before regaining its footing.
Even though open interest in July futures remains stubbornly high at 102’092 contracts, there seem to be a lot of offsetting options positions according to the latest ‘Commitment of Traders’ report by the CFTC, suggesting that there has been plenty of liquidation in recent weeks. According to this data, the trade was just 4.7 million bales net short in the spot month on May 20, down from 6.8 million bales two weeks earlier, and this latest round of liquidation has likely reduced this position further.
Over the last three seasons the difference between the ROW production surplus and Chinese imports has been the main driver behind international cotton prices. This symbiotic relationship has worked rather well until now, as China has been willing to absorb all excess bales from the ROW, which in turn has kept ROW inventories fairly stable. As a result, ROW stocks have fluctuated in a relatively narrow range between 38.3 and 42.4 million bales for the last four seasons, with the current season representing the low mark.
Since the ROW production surplus has been steadily dropping over the last three seasons, declining from 27.8 million bales in 2011/12 to just 11.25 million bales in the current season, a corresponding drop in Chinese imports from 24.5 million bales in 2011/12 to an estimated 13.5 million bales this season didn’t have a negative impact on prices so far.
The market’s great fear is, once again, that China will no longer be able or willing to absorb the ROW surplus. This is nothing new, as analysts have been predicting rising ROW stocks and falling prices in each of the previous three seasons, only to be proven wrong by the strength of Chinese imports year after year. Nevertheless, with China shifting its policy from a high minimum support price mechanism to a target-deficiency payment, which leaves Chinese domestic prices exposed to market forces next season, there is definitely more reason for concern.
In its first supply/demand estimate for the 2014/15-season, the USDA predicted a ROW production surplus of 11.13 million bales, or about the same as in the current season. With Chinese imports expected to drop to 8.5 million bales, there would be 2.63 million bales added to inventories outside China. With stocks as tight as they currently are, this would not substantially alter the ROW balance sheet and therefore exert only minimal pressure on prices.
However, if a bumper crop in the US were to add two million bales to the ROW production surplus and if Chinese imports were to slow down more than anticipated due to internal price pressure, then we could suddenly find ourselves in a more ample ROW stock situation next season and this is what the market is getting worried about. So far this is all conjecture and while these worries may ultimately be justified, we feel that the market has overreacted in response to these Texas rains.
So where do we go from here? There is little doubt that we are at the beginning of a transitioning process in China, but we feel that it may not happen quite as fast as the market anticipates. ROW stocks are extremely tight at the moment and this situation will only get worse until new crop cotton finally brings relief, which won’t be until November. This makes it dangerous to be short July, as well as December, especially at these lower price levels. March is a different story, but only if the crops materialize as expected. In other words, a lot needs to go right over the coming months to justify the pessimistic outlook that currently prevails.
Technically the market looks ‘oversold’ and July has formed a bullish reversal pattern on the candlestick chart. Given the nearly ‘sold out’ situation in the US, we wouldn’t be surprised if potential takers had stepped in on this dip to 84 cents. We therefore don’t like the short side at these levels and would advise mills to fix their remaining on-call sales before the market changes its mind.
