|(United States Of America)|
Traders have remained rather indecisive, as they are torn between a tight supply situation nearby that justifies firm prices until new crop arrives and a potentially bearish outlook thereafter.
As a result we have a market that is stuck right in the middle of a 6-month sideways trend, marked by a low of 81.72 and a high of 89.56 in December. While the market hasn’t been able to generate any directional moves lately, the tight nearby supply scenario has forced the Dec/March spread out to an inversion of nearly 200 points.
Even though it may seem like there is not much going on, with December closing the last 27 sessions in a narrow range of less than 300 points, there are nevertheless a number of developments that have the potential to yank the market out of its comfort zone.
There is the certified stock for example, which has all but disappeared in July, dropping from 623’861 bales on July 2nd to just 71’848 bales as of this morning. When we combine this low availability of certified stock, or any cash cotton for that matter, with the massive trade net short position in NY futures, plus the fact that the US crop is late, we have the perfect set-up for a short-covering rally at some point between now and November.
According to the latest CFTC report, the trade net short position amounted to 13.6 million bales as of July 23, which was nearly twice as large as the 7.1 million bales net short of a year ago. Even though the US crop is estimated to be some 4 million bales smaller this season, which means that there are fewer bales to hedge, the trade has been on a tear to short the futures market. Merchants and farmers seem to adopt a ‘better safe than sorry’ attitude, seeking protection against a sudden change in China’s price support policy, which has the potential to turn the cotton market upside down.
For liquidity reasons most of these trade shorts have been put on in the December contract, considering that 85% of open interest belongs to the front month. By comparison, last year it amounted to just 76%, on a smaller position! So we have a rather substantial trade short in December, with hardly any certified stock left and not much cotton in the pipeline to replace it, since current crop cotton is nearly all spoken for and new crop may arrive a little late for delivery.
So far the shorts have kept their cool, waiting for a chance to roll their positions forward at something better than 200 points negative carry. The hope is that the 6.5 million bales net spec longs will blink first and liquidate, be it because of a bearish announcement out of China or some negative news on the macro front. Then there is always the Index fund roll, which will provide 7.0 million bales of liquidity, although that opportunity won’t arrive until late October/early November.
The worry is that in the meantime something spooks these trade shorts into covering. Weather is high on the list of potential catalysts, because it has been rather unusual so far this season, with many records broken on both sides of the spectrum.For example, in the US over 4’000 precipitation records have been tied or set in June and July, but there were also numerous records broken for heat, mostly in the Western US, while the Midwest set new marks for the coolest daytime highs in late July. For cotton it has been a mixed bag so far, with West Texas welcoming some much needed rain, while parts of the Mid-South and Southeast have been way too wet and cool lately, to the point that it is affecting crop development and yield.
Unfortunately the forecast calls for more unsettled and stormy weather as we head into fall, which has the potential to delay harvest and reduce quality and yield. In the arctic region, cooler than normal air masses are filled with volcanic debris from several eruptions in May and June, and as they find their way south they clash with humid air streaming in from the Gulf, which causes these excessive downpours and cooler temps. This set-up is not likely to change anytime soon and therefore poses a threat to crops in the eastern half of the US.
So where do we go from here? For now the market seems to be kept in balance by a friendly short-term outlook and a bearish longer-term view, with most of the action being confined to the Dec/March spread. China still holds the key to international prices in the coming season and traders are trying to assess whether China will indeed absorb the 10-11 million bales production surplus in the rest of the world as predicted by the USDA.
If China does import said amount, then the status quo is likely to prevail for another season, although the market nevertheless expects a bearish announcement out of China at some point during the season.
However, the trade seems to have already preempted a bearish outcome to some degree, judging by the large net short it owns in the futures market. By leaning too heavily on the short side, especially in the fickle December contract, the trade becomes vulnerable to an adverse market move, especially if there are going to be some weather related scares as we head into harvest. It ultimately comes down to properly timing the market and in that regard we avoid being exposed to December, using March and later deliveries for downside protection instead.
Plexus Cotton Limited
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