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Huge investments: Outside forces stirring up cotton markets

Cotton prices should strengthen early next year as the world cotton industry comes to grips with a dramatic change in world fundamentals and huge investments into the market by commodity funds, said Peter Egli, analyst with Plexus Cotton Ltd., speaking at the Ag Market Network's December teleconference.

The changes started five years ago, “when we had a monumental jump in world production of nearly 27 million bales in just one season, going from 95 million bales to 122 million bales, a jump of about 30 percent in a single season.

“In the four seasons since, we have seen a leveling off, but production was able to stay near record levels of somewhere between 117 million and 122 million bales, with the current season in the range of 118.8 million bales.”

Egli noted that because of the huge jump in production in the 2004-05 season, “mills really never had to worry too much about supplies. Stocks were plentiful and as a result, mills were patiently adhering to a hand-to-mouth buying pattern, which has pretty much continued to this day.

“Consumption, on the other hand, is much more linear and it's taken a while for it to catch up to this new production plateau. We have seen a gradual increase in consumption from about 98 million bales five years ago to the current USDA estimate of 128.3 million bales, which if correct would be about 9.5 million bales above production.”

Egli believes USDA's consumption number “is a bit overstated, that the real number is closer to 122 million to 123 million bales. But the important thing to remember is that even at the reduced number, consumption would still be above production.

“Statistically, we have an inflection point as we're moving from a production surplus of ample stocks into a seasonal production shortfall which will require some de-stocking to take place. This scenario is likely to continue into the foreseeable future.”

A gradual decline in the production surplus outside China is also a factor, noted Egli. The world outside China produced 21 million more bales that it consumed in 2004-05, 17 million bales in 2005-06, 13 million bales in 2006-07 and for the current crop, 10 million bales.

“If you believe that China will continue to have significant production gaps, it needs to import large quantities of cotton from the rest of the world. We are now at an important point. The world has to either start producing larger surpluses, or demand has to be suppressed by higher prices.

“How much China will import the rest of the marketing year remains to be seen, but even if they were to take only 10 million bales, they would still absorb the current seasonal surplus from the rest of the world. USDA is a little more optimistic, predicting that China will import 14.5 million bales in 2007-08. That means the rest would have to come from foreign stocks.”

If more and more money continues to be allocated to commodity index funds, which seems likely, and if open interest continues to rise over time, Egli noted, “it's going to be more difficult for the trade to maintain its ever-increasing short position, especially when there is not that much cotton to be hedged anymore. By springtime, when supplies have been worked down considerably, it will become easy for spec longs to push past trade resistance, similar to what we saw last summer.”

With competing crops rocketing higher, “cotton prices will have to start to rally soon to defend their acreage, or they will rally again next spring or summer because they lost the acreage.”

Egli noted with a weak dollar, and with inflation expected to pick up considerably, “just about anything denominated in U.S. dollars will go higher in nominal value, and I don't think cotton will be an exception. All these factors point to a fairly optimistic outlook for cotton prices as we move into next year.

“The only negative factor would be a complete collapse of demand, which would have to come as result of a collapse of the financial system. I think this is an extreme view and the liquidity pumping should avert at the cost of dealing with higher inflation and lower currency.”

Carl Anderson, Extension professor emeritus, Texas A&M University, advises growers with cotton from the 2007 crop, particularly in the loan, “to be very alert to getting cotton out of the loan when any kind of equity is possible. With these short-run technical moves up, there's always the possibility to pick up 2 to 3 cents above loan value.

“On the 2008 crop, with the uncertainty we're dealing with, we have to get into more complex strategies using options — and possibly futures to some extent — in setting prices.

“This kind of a market puts a whole new dimension on protecting your price. We are export-driven with uncertainties that we cannot predict. Prices for the new crop are likely to move up, yet I have trouble pushing numbers for an A-Index very much above 76 cents. It's going to take a sudden shock like less production in a big-producing country, or some shock with the outside funds.”

Egli projects December 2008 cotton futures at between 71 and 85 cents; Mike Stevens Swiss Financial Services, 71-80 cents; economist O.A. Cleveland, a maximum of 75 cents; and Anderson, 72-78 cents.

“I like using the 72-cent floor on new crop,” said Stevens. “But try to keep the upside open as much as you can.”

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