Editor’s note: According to Joe O’Neill, former president of the New York Cotton Exchange, three big events shaped the cotton market over the last 35 years, beginning oddly enough with the lack of anchovy fishing off the coast of South America and ending with the loss of the futures markets as a viable long-term pricing tool for producers. O’Neill recounted these events recently at an Ag Market Network teleconference.

How could anything as benign as an anchovy change the structure of the cotton market? According to Joe O’Neill, former president of the New York Cotton Exchange, that’s exactly what happened after an El Niño dried up the anchovy fishing market in 1973, and cattle producers lost the main source of protein for cattle feed — fish meal.

“Cattlemen moved to the second-best meal, soybeans,” O’Neill said. “Soybean prices started to rise, and the slogan was, ‘beans in the teens.’ Since soybeans and cotton were competing for acreage, cotton prices started to rise and in September, it hit a high of 99 cents.”

O’Neill says one cotton merchant didn’t want to see cotton prices go over a dollar “because he was afraid we were going to lose market share. So he came in and started selling at 99 cents, which caused the market to go down.”

But cotton had reached a new price plateau. “Prior to this event, the highest cotton price of all time on the futures market was about 44 cents and often ranged from 20 cents to 30 cents. Now we were looking at cotton in the 50-cent to 60-cent range. It really changed the pricing of cotton dramatically.”

The second event was the introduction of cotton options, which O’Neill helped develop in the mid-1980s along with Carl Anderson and O.A. Cleveland, then Extension economists at Texas A&M and Mississippi State University. “We went around and talked to every farm group that would listen about how we had finally developed a product for the cotton producer.

“The grower could use the futures market (to price cotton), but the futures market is really a tool for the merchant. The merchant really doesn’t care what the price is. If it’s 60 cents and he can sell it at 62 cents, that’s great. If he can purchase it at 70 cents and sell at 72 cents, that’s great, too.

“But absolute price does matter to the grower. So we were trying to develop some option strategies that would allow the grower to maximize his price.”

The third event, and one that is still unfolding, began in Brazil in 2006. Brazil had used ethanol as a substitute for gasoline for many years, and Brazilians had developed automobiles with the ability to use any percentage of gasoline and ethanol. As the price of petroleum started rising, ethanol became the leading provider of fuel in Brazil.

The success of ethanol in Brazil prompted the United States to embark on its own ethanol program — based on ethanol from corn. “Agricultural markets with large U.S. production were dramatically altered by this government push to develop alternate energy sources,” O’Neill said.

Corn prices increased 135 percent; beans, 107 percent, and wheat, 174 percent. But cotton prices increased only 28 percent. The result was cotton losing a lot of its acreage to other commodities.

“Then, in early October 2007, we saw the stock market hit all-time highs. The Dow went over 14,000 and we saw the S&P top 1,500. The whole world was looking at rising prices and commodities were up.

“Speculators figured they needed to invest in a commodity that had not started to really move up,” O’Neill said. “Cotton was it. We saw open interest move from 83,000 contracts in December 2004 to 231,000 contracts at the end of December 2007. By February 2008, open interest was over 300,000 contracts.

“Also at the end of January, the Dow, which had been at 14,000, was down to 12,000, and money was moving out of the stock market and into the cotton market. Everybody was talking about cotton moving to a dollar. The economy was not doing well, but that did not dampen the spirits of the speculators.

“During the last two weeks of February 2008, we saw the market move up 11 cents. We saw the trade become a major seller. The index funds and hedge funds were all long over 300,000 contracts and the trade, mostly the merchants and the co-ops, were short because they didn’t believe cotton prices were going to keep going up. On the first day of trading in March, the market moved up the limit. A lot of the trade guys got nervous. They couldn’t get out using futures, so they got into the options market to get out.

That first day of trading, March 3, 2008, also marked the first day of all-electronic trading in the cotton futures pit, ending 138 years of floor trading in the cotton pits at the Intercontinental Exchange, formerly the New York Board of Trade. “Without the locals being there buying and selling, nobody knew how to react,” O’Neill said.

“On March 3, we saw the options market move 12 cents above the previous night’s close. The Exchange had to follow existing policies to margin futures to the option’s synthetic margin, which was 12 cents higher.

“That was a significant margin call, and it tested the financing and credit ability of many of the merchants. On March 4, it got even worse. Synthetically, prices rose to about $1.10. On that day, they had a 25-cent range in the options market. That 25 cents equaled the average move for the last 20 years.

“Over two weeks, we saw a move, synthetically, of about 40 cents a pound. The cotton industry just shut down. The futures market was not reflecting what was happening in the cotton world. Cotton was out of control.”

The result was that many of the domestic and international cotton merchants were forced out of business or forced to merge, and the remaining merchants had to change the way they did business. Long-term forward contracting became almost non-existent.

“Merchants began living hand-to-mouth, mills began living hand-to-mouth.

“Now, even when the market rises, we see reluctance on the part of the trade to sell into the market because they’re afraid.”

O’Neill sees similarities in today’s cotton market. Although open interest is a little less than half of what it was in early 2008, “we still have seen a significant growth since June, from 105,000 contracts to 145,000 contracts.

“The growth mirrors 2008 in that it’s largely spec longs in the form of managed money funds. It’s interesting that index funds remain relatively unchanged. The short side is represented by the trade.

“From the Oct. 6 report of index and managed funds, we see that funds are 76 percent of the long positions. If we add other specs, the spec community holds about 90 percent of the long open interest. The trade holds about 6 percent of the long open interest. On the short side, 80 percent of short positions are held by the trade.

“What we have potentially is a very volatile situation. If the market starts to run up dramatically, will the trade have to again run for cover, which will cause prices to go up dramatically? Or — as we saw in September 2008, when we had a recession — will we see the market moving down dramatically when all the specs had to exit because they needed the money to service other needs?

“To handle this situation, I think we’re going to have to go back and look at some of the tried and true philosophies, like hedging through options.”

O’Neill’s favorite option strategy is to sell cotton at harvest and buy a July call.

“You eliminate your basis risk, prices now are okay and you can guarantee a price. Plus if the market moves up between now and June 10, you’ll participate without any risk. Over the last 10 or 11 years, about half the time, the market moves up dramatically after harvest. In 1995, it moved from 72 cents to $1.13. It’s also moved dramatically down, like in 2001, where we saw it move from 62 cents to 39 cents.”

O’Neill says the options market “is going to provide some interesting opportunities. But remember, volatility is going to be higher and that is going to affect options prices.”

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