Tight stocks in the U.S. cotton market coupled with a heightened awareness of potential weather risks due to La Nina at the start of 2011 signal incereased volatility for traders and manufacturers in the months ahead. We talked about some of the effects on commercial agriculture stemming from the current La Nina in a post last week, and cotton will be a key commodity to keep on the radar, at least through the first half of the year. The USDA table below shows says it all ... despite a rebound in world cotton production in 2010/11 over the 2009/10 crop year (115.5 MM bales v. 101.5 MM bales), the U.S. domestic Stocks-to-Use ratio is now under 10%; this measure of market tightness was above 50% just a few years ago.
(Click to enlarge)
(Click to enlarge)
The chart above shows the March 2011 contract reaching a high of nearly $1.60/# in late December; it has since retreated back to the $1.40-$1.50 range, which is still a significant rise over what manufacturers were expecting when planning their spend in 2011. Although global consumption is down slightly from last year, demand for fiber remains strong and we so anticipate this support to remain in place during a slow but steady recovery (China has increased the y/y import quota by more than 33% for 2011).
Prospective acreage will also come into the equation in spring. According to a recent Financial Times article, the USDA is estimating that the mid year stocks-to-use ratio for U.S. corn will be around 5.5%, the lowest in 15 years. The potential for low corn stocks supporting prices may have some growers who would be planting cotton this year diverting a portion of their acres to corn, expecting a premium in this tight market. This scenario has the potential to further exacerbate the cotton situation, and these high prices in the $1.20+ range could be sticking around for awhile.
With the expectations that a tight S-D balance will remain in place and that cotton futures will likely be in a firm market, higher sustained prices will start to cut into the margins of manufacturers who hold a significant cotton exposure. Even if additional U.S. acres are devoted to cotton (at this stage this is unclear), it is unlikely that the added production volumes will put enough physical supply on the exportable world market to keep up with rising (or sustained) demand, so we are advising clients to look for opportunities to enter positions using the cotton hedge as a base. Fiber-based manufacturing companies who have an active hedging and risk management strategy in place are likely to fare better during this period; those who are less proactive may start to see negative results with a clear impact on earnings.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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