The March contract traded to an 8-month intraday high of 78.18 cents, although it settled shy of the 77.98 cents closing high of August 31. Also, while March was able to briefly break above its 8-month sideways range, May, July and December have yet to do so. Nevertheless, the move in the futures market this week was impressive, considering that most traders are still rejecting the idea of higher prices on grounds of massive global ending stocks.
The USDA supply/demand report, which was released last Friday, certainly did not disappoint the bearish camp in that regard, as it boosted global ending stocks to an unprecedented 81.72 million bales, or nearly 77% of current mill use. However, despite a kneejerk reaction that forced the spot month temporarily below 75 cents following the release of the report, the price action has since been bullish. So what is the reason behind this strength?
The answer would be quite obvious to traders if they had two separate USDA supply/demand reports to look at – one for China and one for the rest of the world (ROW). What they would see is a rather depressing, very bearish situation in China, while the balance sheet for the ROW looks quite friendly. For example, while the stocks-to-use ratio in China is at a ridiculous 114%, it is at just 58% in the ROW. In fact, the stocks-to-use ratio in the rest of world is only the 3rd highest over the last five seasons. Furthermore, while Chinese mill use has fallen by 14.5 million to just 35.5 million bales since 2009/10, the ROW is actually enjoying the highest mill consumption in five years at 70.6 million bales.
In other words, when we talk about the “cotton market”, we really need to talk about two markets, namely China and the ROW. The Chinese cotton market is clearly bearish, with Chinese prices nearly double of what they are in the ROW. For example, the March futures contract in New York of around 78 cents/lb compares to a March futures contract in Zhengzhou of around 144 cents/lb. Since prices in the ROW are relatively cheap, they continue to attract a lot of buying interest, including import demand from China.
The latest US export sales report once again surprised positively, as no less than 372’400 running bales of Upland and Pima cotton were sold to 19 different markets last week, bringing the total for the current marketing year to 10.0 million statistical bales, of which 4.1 million bales have so far been exported. According to our calculation, there are only around 6.5 million bales of US Upland cotton left for sale at this point, assuming that US domestic mills have already booked their requirements for the season. In other words, if US export sales were to average around 225’000 running bales a week through the end of July, every last bale of US cotton would be committed!
Chinese imports maintained an impressive pace during December at 2.4 million statistical bales, with Indian, Australian and US cotton leading the pack. For the first five months of the marketing year (Aug-Dec), China has already taken in 7.7 million bales of foreign cotton, which means that for the remaining seven months it only needs to import another 4.8 million bales to get to the current USDA estimate of 12.5 million bales.
There simply exists too wide of a gap between prices in China and the ROW and we therefore believe that over time this gap will narrow, maybe not in the very near future, but certainly over the next couple of years. The most likely course of action is for Chinese prices to trend lower and for world prices to move higher.
This week the Chinese government started to auction off some its huge stockpile to local mills starved for cotton, at weighted average prices of around 137-140 cents/lb, or over 60 cents above where NY futures are currently trading. Some analysts see these Reserve sales as a bearish omen, but we would argue that unless China drops its prices considerably and thereby manages to throttle the flow of imports down to a trickle, it is not going to impact world prices negatively.
In fact, it doesn’t take a lot of imagination to make a ‘glass half full’ case in conjunction with these Reserve sales. For example, the Chinese government could easily arbitrage this huge gap that exists between local and imported prices by auctioning off stocks at 137 cents and importing cotton 50 cents cheaper. In doing so, it would be able to achieve two objectives: a) average the price of its inventory down and b) close the price gap to the ROW, thereby erasing the competitive disadvantage that Chinese mills face vis-à-vis foreign competitors. We are not suggesting that the Chinese government is actually intending to do this; we simply try to point out that there isn’t just one possible (bearish) outcome when it comes to Chinese reserve stocks.
So where do we go from here? The market has arrived at a crossroads , closing near the upper boundary of an 8-month trading range. The technical picture looks supportive and if the 78 cents support level is taken out, we would probably see a lot of new spec buying enter the scene. With the trade already 10 million bales net short, we wonder how much resistance it could muster to oppose any new spec buying. There is a decent chance for the market to explode to the upside and such a move would definitely carry it a lot farther than just a cent or two. On the other hand, if resistance holds over the next couple of sessions, we may get a ‘double-top’ formation and prices may retreat towards 75 cents. Regardless of what happens in the very near term, we still see higher prices ahead down the road.
