New York futures moved higher this week, with December advancing 209 points to close at 63.94 cents/lb, while March gained 174 points to close at 62.27 cents/lb.
“After posting a low of 60.83 cents two weeks ago, nearby supply worries have since lifted the December contract back into the mid-60s,” the latest Plexus cotton market report reveals.
Spec short covering was the main driver behind the strength in December this week, after an improving chart picture triggered a number of buy stops, while bearish options strategies by the trade hindered March’s ability to rally and thereby fuelled the inversion between the two front months.
The latest CFTC report as of September 30 reveals that large and small speculators were 3.3 million bales net short, which is the largest net short position in over eight years. Outright spec shorts amounted to a massive 8.4 million bales, which is just shy of the record 8.5 million bales set in 2006.
The trade on the other hand carries the smallest net short position in the last ten years at just 2.5 million bales short, which is the result of 8.4 million bales in outright longs and 10.9 million bales in outright shorts.
“This is rather puzzling considering how bearish the trade has been these past few months and a possible explanation is that merchants have been unable to cover their sales in the cash market so far and have therefore resorted to using long futures and options to protect against their commitments, while the short side consists of hedged grower positions that have yet to be sold,” the report says.
The futures market is a ‘zero sum’ game, which means that for every seller there has to be a buyer and vice versa. Therefore, speculators and the trade can’t both be going short at the same time.
Index Funds are the only net long at the moment with a position of 5.8 million bales, but since they are a passive form of investment they only buy or sell futures based on money flows or due to rebalancing. In other words, if the trade or the specs want to go short, they will have to find buyers amongst themselves.
Speculators have been a much more aggressive force since this bear market began in early May, selling around 9.6 million bales net since then, while the trade has bought 10.2 million bales net, with Index Funds making up the difference.
There are plenty of reasons why the trade has been such a strong net buyer in the futures market over the last five months. But in general, speculators seem to be the more disciplined bunch when it comes to recognizing and following trends, while the trade often tries to pick bottoms and tops, only to get hurt in the process.
While the specs sector is reaping the spoils of this bear market, producers have seen their profit potential evaporate as the market has dipped below the cost of production.
In some instances government programs are providing a backstop against further losses, which has taken away some of the necessity to hedge in the futures market. The four largest cotton producers in the world, which account for over 72 percent of production, all have some form of grower support kicking in at the moment.
In the US producers benefit from the loan mechanism, in India the government is buying cotton at a minimum support price, Pakistan just implemented a support price for seed cotton and China announced massive subsidy payments to growers, while its large stockpile is not available for export.
These government support programs combined with an empty pipeline that is only slowly starting to fill up has at least temporarily halted this brutal decline, during which December has lost over 20 cents since early May.
However, the supply bottleneck isn't going to last forever and government support won’t make these bales disappear and only delays their impact on the market.
Therefore, there is a need to look at the market in two time frames. The first one encompasses the next 2-3 months, during which it may prove difficult to buy attractively priced cotton, particularly high grades, which is the main reason why US export sales will continue to ‘disappoint’ in the foreseeable future.
Nevertheless, prices may still firm up, as shippers have no other choice but to pay up in order to cover nearby commitments. Weather plays of course a crucial role in all this, since it could further delay and/or reduce the availability of premium grades.
The second time frame starts around December or January, when the outcome of the Northern Hemisphere crops will finally be known, both in terms of size and quality. Assuming that there are no major weather related setbacks, supply pressure should eventually start to build and keep a firm lid on the market for some time to come.
Global supplies made up of beginning stocks and crop will amount to around 218.3 million bales this season according to the USDA, while global mill use is only a little more than half of that at 112.1 million bales.
Since China is no longer in hoarding mode, it is quite difficult to envision anything but a bearish scenario in the longer term.
The bear market has hit the ‘pause button’, as traders are waiting for new crop supplies to finally bail them out of this bottleneck situation.
Unfortunately the weather is not cooperating in the US, as another round of severe storms is expected to hit the Delta and Southeast early next week, which will not only delay harvest further, but has the potential to impact quality as well.
Combined with an improving technical picture this could extend the current counter trend move into the mid-to-high 60s.
However, the next USDA report will probably remind everyone that the longer-term outlook remains negative and that the trade should use rallies to bolster its short position.
