After three months of fighting a bear market with bullish fundamentals, the cotton market finally bottomed on May 22. Between then and mid-June, December had rallied 565 points.
“It's obvious the market is trying to plug in some weather premiums,” said Mike Stevens, an analyst with Swiss Financial Services, during the Ag Market Network conference call on June 13 (to listen, visit http://www.agmarketnetwork.net). “We may be starting to get stretched out. July, which rallied 485 points in the same period, has its own set of problems…And this is with the July delivery just nine sessions away on June 26.”
The daily volume has been “breathtaking.” On June 12, some 50,000 contracts went through. Several weeks earlier, when the Rogers Fund rolled July to October, the exchange set an all-time record of 55,000.
“That day, the October contract quadrupled its open interest in the last five minutes. Cotton is used to having an open interest — normally around 100,000 contracts. I continue to think things can't go on like this forever.”
Speculators are getting bullish in the market for good reason. December began showing signs of recovery before July did.
“For all practical purposes, December has detached itself. Yesterday, it seems July either held December back or December held July up — I'm not sure which.”
Normally the carrying charges from July to December are about 400 points (80 points per month).
“However, because of (ample) penalty cotton — and (Memphis-based cotton merchant) Billy Dunavant owns about 80 percent of the certificated stocks — some think it could take as much as 120 points to 600 points to carry this cotton from July to December.”
West Texas weather and the May supply demand report have furnished fundamentals. Once the technical pattern improved buyers showed up.
“That big dryland area south of Lubbock — with a (planting) cut-off date of June 5 for Lubbock and June 10 for most of the other areas (there) — is the fundamental. There's a 16-day window for crops to germinate and make a stand. Otherwise, the acreage will have failed and crop insurance will take over.”
Producers must wait 16 days after their final planting date before requesting an appraisal based on non-emerged seed. Plains cotton growers are estimating 1.7 million acres of dryland cotton at risk with a third in fair shape. Another third had just enough moisture to get started with nothing to sustain it. The remaining third was planted into dry dirt and is in “big” trouble.
But each third of at-risk cotton represents about 560,000 acres or 15 percent of the High Plains crop. The weather until June 26 (the June 10 cut-off plus 16 days) could “easily swell” abandonment to 30 percent of the crop.
“In my opinion, the June report…confirmed and reinforced the potentially bullish fundamentals that would support much higher prices…The stocks-to-use ratio is one that should be able to support new crops in the mid- to high 60s.”
Texas cotton is desperate for water, said Carl Anderson, Extension specialist emeritus, Texas A&M University. “It's a situation where, as of yesterday, 37 percent of the crop was labeled ‘very poor’ or ‘poor.’ That's pretty serious. Only 6 percent was rated ‘excellent.’
“As I look at the Texas cotton crop, we're far from last year's 8.44 million bales. We've already lost at least 500,000 bales.”
High temperatures have also added to the problems and could “easily” pull the cotton crop down to 5 million bales. That's 3.5 million fewer than last year, and it could go even a million bales lower if weather doesn't improve by late June.
Looking at last month's USDA numbers, the world crop was running about 6 million bales less than carryover from the previous year. “That's a significant drop. It shows very strong demand in the world of 121 million bales for a crop that runs around 115 million bales.
“That (world) number is still up for grabs. The weather isn't good in China or Pakistan. China is the key if it can maintain its demand at 51 million bales and produces only a 27 million-bale crop. (If that happens) there will be a lot of ‘fill in’ that will come to the United States for exports.”
Meanwhile, export business is slow.
“Last week's 275,000 bales looked good on the surface,” said Stevens. “But 200,000 bales went to China and they're probably on consignment…That means only 75,000 bales were sold to our traditional customers.”
While not a guarantee, between June 24 and the first “big” report of Aug. 10, the December contract has a tendency to trade lower. During that time, “we'll probably have some weather rallies, but that will be a good opportunity for producers to begin putting floors beneath the market.”
Last year, the United States had a 24 million-bale crop. Anderson said on the horizon is a crop that's nowhere near 24 million bales — more like 21 million. “That will cut our carryover down to a more reasonable level around 4.5 million bales.”
December 2006 futures, which made a recent 5-cent rally, “could hit the high 60s if (the crop) isn't a total disaster, but isn't nearly as good as last year. During the next six weeks, the market will be sizing up the fundamentals. We could easily see a rally in the 62-and-higher range. That would be a time to begin putting floors on the market…
“If we find the markets continue to rise, we could easily see the average U.S. price received go to the 58- to 60-cent range, depending on how short the crop is.”
That means the counter-cyclical payments are being squeezed.
“Last month, we said it was time to put on a 56-cent or 58-cent call. That was a good decision then. But today…the 58- or 59-cent strike prices on December calls are running about 4 cents a pound. That's a lot of money to spend to try and save counter-cyclical payments.”
What about the effect of the loss of Step 2?
“My guess…is a lot of merchants will be a lot tougher to deal with,” said Stevens. “Step 2 gave them a great deal of comfort. It could make it a bit more difficult for producers to move their equities because the merchants won't have Step 2 in their pocket.
“That means we must be more vigilant with marketing in the coming year. That's particularly true with educating themselves with the option market. Options are 100 percent better than futures for producers.”
If the market starts to slip, “we've got 102,000 speculative longs in this market. That could mean fast breaks so I encourage producers to use only options at this time. My preference is the use of September calls. Those are based on the December contracts but without the high premiums that sometimes run those off who should be using them.”