A surprisingly large US export sales report of slightly over 1.0 million bales for both marketing years sent July shorts running for the exit this morning, which resulted in the spot month being locked the limit. Since making a low of 66.10 cents on June 4, July has rallied an impressive 12 cents in just eight sessions. Short options positions – this time it was short call options – added further fuel to the fire. Before today’s session, with just two days to go until expiration, there were 16’818 call options open with a strike price of 81 cents or lower, which had a combined delta of 7’710 contracts. In other words, this position has the potential to generate an additional 9’000 contracts by tomorrow.
Most traders are quick to dismiss the market’s recent strength as nothing more than a temporary short-covering rally that’s confined to the July contract. The market is convinced that as soon as July goes off the board, new crop’s bearish forces will resume control. Tuesday’s USDA supply/demand report has reaffirmed this belief, as global ending stocks in 2012/13 are projected to rise by another 0.76 million bales to an unprecedented 74.51 million bales. Although such a large ending stocks number is certainly a convincing argument for a bearish case, we believe that the situation is not quite as simple as it looks.
About a year ago, in early June 2011, the Chinese market and the international market were still sitting at around the same level, with both the CC-index and the A-index measuring a little over 170 cents/lb. Since then these two benchmarks have opened up a huge gap between them, with government sponsored Chinese prices still hovering north of 130 cents/lb, while the A-index is around 50 cents/lb cheaper than that. Therefore, when reaching conclusions about the USDA report, we need to take this two-tiered market into account.
Analyzing the latest USDA report from a Chinese versus a rest-of-the world perspective, the numbers look rather bearish for China but are actually quite supportive for the rest-of-the-world. While China is expected to see its ending stocks rise by 3.25 million bales at the end of next season, inventories in the rest-of-the-world are projected to fall by 2.5 million bales. Of the expected 25.0 million bales rise in global ending stocks since 2010/11, 20.0 million bales are added in China and just 5.0 million bales in the rest-of-the-world. A 5.0 million bales increase in ending stocks outside China doesn’t look like an overly depressing number to us.
We feel that for proper price analysis we need to look at the world in three parts – China, the US and everyone else. China runs its own game with domestic prices in the stratosphere compared the international level and we should therefore primarily focus on China’s net imports of raw cotton and yarn. In this regard it is interesting to note that even though China has a projected seasonal deficit of just 9.5 million bales next season (crop of 30.5 million bales versus mill use of 40.0 million bales), the USDA predicts that China will import 13.5 million bales, or 4.0 million bales more than its seasonal shortfall.
The US is the residual supplier to the world, with nearly its entire crop available for export. Theoretically the US has an exportable surplus of 13.5 million bales next season (17.0 million bales crop versus mill us of 3.5 million bales), but the USDA believes that only 11.8 million bales will ultimately be exported. When we look at the world minus China and the US, we have production at 67.8 million bales and mill use at 65.5 million bales, resulting in a small surplus of 2.3 million bales. This may seem comfortable, but since China is expected to import 4.0 million bales more than its actual shortfall and the US is believed to export 1.7 million bales less than it could, the situation may actually turn out to be a lot tighter than it appears.
We keep hearing and reading the argument that the new crop prices won’t be able to rally, because China would be there to unload its excess stocks and quickly cap any rally attempt. While this argument seems to make a lot of sense at first, it really doesn’t hold much water since it is highly unlikely that China would release any of its Reserve stocks. Or do we really think that if NY futures were to rally to 80 or 90 cents, the Chinese Reserve would unload inventory that it accumulated at 140 cents? For Reserve stocks to be released, Chinese domestic prices would first have to rise to a level well in excess of 140 cents. Only if that were to happen it would eventually put pressure on international prices, as the release of Reserve stocks would likely lead to fewer imports.
From a Chinese perspective the NY futures market at 70 cents must look like an incredible bargain, which means that given the opportunity, Chinese traders and mills will continue to import as much cotton as they possibly can, be it in the form of raw cotton or converted to yarn. Just look at today’s stellar US export sales report, which fits right into this scenario. Between September 2011 and May 2012, China has already imported 19.5 million statistical bales, which makes it very likely that the revised USDA estimate of 23.25 million bales will either be met or surpassed.
Also, as pointed out earlier, we feel that the current statistics are not accurately reflecting the impact of the recent shift towards yarn imports. While it makes sense for Chinese mills to use less cotton due to the huge price gap in relation to the international market, we feel that mill consumption in other parts of the world is picking up at least some of the slack. In other words, while Chinese mill use may have fallen from 50 million to 40 million bales over the last three seasons, this should not be counted as a net loss in global consumption.
So where do we go from here? While July is the midst of a short-covering rally that obeys its own rules, new crop is presenting growers with another opportunity to hedge an additional portion of their crop. Although we still feel that it is a good idea for growers to seek further downside protection, we would do so with put options rather than short futures. As we have tried to elaborate in this report, we believe that the market isn’t quite as bearish as generally believed and that the “Chinese cap” is not nearly as potent either, which may expose shorts to some fierce and unexpected short-covering rallies down the road.