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When cotton supplies tighten next year, maintaining an effective threat to deliver will be more challenging because less certified cotton will be in position to deliver.

September 12, 2008

6 Min Read

Hedge funds found cotton in March. Their buying binge spiked cotton futures prices to a buck. Co-ops, cotton merchants and their lenders strained to meet margin calls. Forward cash cotton buying all but dried up. Bids that were offered were at horrendously weak basis levels.

Cotton's subsequent price collapse was equally dramatic. It shook the cotton industry to its very core.

Market participants began looking for ways to preserve the cotton futures market as both a viable price discovery instrument for cotton and an effective risk management tool for cotton growers, merchants and users.

Effective delivery mechanism crucial

Cotton needs a cost-effective mechanism to allow growers to sell cotton futures then deliver on those contracts. The ability to deliver will force cash cotton and cotton futures to converge when the futures contract becomes deliverable. Forcing price convergence during the futures delivery month is a necessary step to keep cotton futures a viable price discovery mechanism and a workable risk management tool.

Carl Anderson, Texas A&M University economist is more blunt. "The only control the cotton industry has over its market and prices is the threat to deliver cash cotton against futures contract sales. That's the new reality since cotton's breath-taking price spike and subsequent heart-breaking collapse."

Convergence needs cotton in deliverable position

When July 2008 futures topped 70 cents, cotton sales dried up. When futures retreated to 68 to 66 cents export sales bloomed. "That tells me supply and demand worked somewhere between 65 and 70 cents for July cotton," says Anderson. "As long as we can maintain an effective threat of delivery, I believe nearby futures will reflect the price needed to balance supply with demand in the market."

A huge 1.6 million bales of cotton certified for delivery helped make cash and futures prices converge when the July futures contract became deliverable. But when supplies tighten, as they will next year, maintaining an effective threat to deliver becomes more challenging because less cotton certified to deliver will be located where it can be delivered on futures contracts.

Why prices should converge

During the delivery month the futures price should not exceed the cash price by more than costs to deliver on the futures contract. If the futures price is higher than cash by more than costs to deliver, cash cotton owners will sell futures then deliver to those holding long futures contracts and get paid the futures price. Futures buyers, who took delivery, will have to figure out what to do with the cash cotton. If they end up selling on the weaker cash market, that's their loss. Other futures longs, seeing those who get delivered upon losing money, will offset their long futures positions by selling their futures positions. That will pressure futures prices lower.

Meanwhile, people seeing an opportunity to deliver cash cotton on futures contracts and turn a profit will buy cash cotton, sell futures then deliver the cotton. That will help lift cash cotton prices. Cash prices will advance and futures prices will give ground until the spread between cash and futures becomes no greater than the cost to deliver on the futures contract.

Costs to deliver include: transportation to a futures delivery location, paper work and cost to reclassify the cotton. Those costs factor into the basis.

Futures volatility also drives basis. Futures margin requirements also contribute. During the March price spike some merchants and co-ops had to find 12 cents a pound or $60 a bale for margin calls within a day.

Cotton basis used to be 4 to 6 cents. Extreme volatility and huge margin calls dramatically weakened basis to 12 to 15 cents on cash forward bids, if merchants would offer forward cash bids at all. Weaker and more unpredictable basis hinders growers trying to hedge their price risk. 

"The bottom line is I'm really concerned that we've hiked marketing and price risk management costs at a time when it's unnecessary to do that," says Anderson.

A costly alternative fix

"One risk management approach is a double hedge--sell futures and buy a call option somewhere near or slightly out of the money," says Anderson. "Selling futures would set a price floor. If the futures price suddenly shot up, the premium on the call would rise capping the grower's futures losses.

 "Let's say the cotton market is 90 cents. You sell futures at 90 cents. Buying the call may cost 10 cents. The basis may be another 10 to 15 cents. You may net 65 or 70 cents in a 90-cent market," explains Anderson. "We're trying to find ways to make the delivery mechanism effective so that if a grower sells futures for 90 cents, he can deliver it and get 90 cents, less delivery costs.

Any prudent way we see to manage price risk will up cost for the risk protection," says Anderson. "Growers need to expect that weaker basis levels will persist. Expecting weaker basis positions growers to make better informed assessments as to whether or not to short futures to price or make some other move.

Improve delivery mechanism

"We're urging the cotton industry to improve the futures delivery system," says Anderson. "An effective delivery mechanism requires:

  • An adequate number of delivery points where cotton is concentrated

  • A large number of bonded, certified warehouses to accept delivery

  • Growers and hedgers willing to go through the futures delivery process.

Most futures delivery locations are in the southeast. That made sense when the cotton market was predominantly a domestic market and most production was in the southeast and delta. Cotton production has moved west. Galveston and Houston are delivery points. But they're a long way from the main Texas cotton production area around Lubbock.

The industry needs to add more delivery locations west of the Mississippi River. Getting cotton into deliverable position will incur costs. But growers will end up with the price at which they shorted the futures.

"Agreed, selling futures then delivering on the contract is more cumbersome than selling futures, then later offsetting the hedge and moving cotton in normal cash channels," says Anderson. "However, an effective futures delivery mechanism gives the industry more flexibility. Plus it will assure that basis is no weaker than absolutely necessary. That works to the grower's advantage."

Why not prohibit specs?

Growers blame cotton's March price spike and collapse on hedge funds taking huge speculative positions. The futures market has limits on the number of contracts speculators can hold.

Hedge funds whipsawing prices renew calls to restrict or even prohibit speculators.

The market needs commercials who have interest in cash cotton. The market also needs speculators to have someone willing to take the opposite side of the trade when a commercial wants to establish or liquidate a position.

"We definitely need speculators," says Anderson. "But what we don't need is speculators controlling the market and price movements."

The futures market is designed for price discovery and price risk management, that's hedging. Cotton growers and merchants typically define cotton hedging as taking equal and opposite positions in the cash cotton market and cotton futures market. That's a far cry from the hedge fund's definition of hedging which is using cotton futures to "hedge" risk of positions taken in other financial instruments. The way hedge funds define hedging certainly muddies the water on what a hedge is.

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