NY futures reversed course this week, as December dropped 205 points to close at 68.11 cents.
December had gained nearly 500 points over the last four weeks, gradually climbing from an intraday low of 66.28 cents on July 14 to an intraday high of 71.20 cents on Wednesday, before today’s WASDE report sent the market tumbling again.
The USDA surprised traders with a rather bearish forecast, which was primarily due to a US crop increase from 19.0 to 20.55 million bales. Although the US crop has been doing well recently, we feel that it is a rather bold call to plug in record yields at this point in the season.
The USDA believes that the US crop will produce 892 lbs/acre, with just 8.3% abandonment. This would match the 2012 yield record, but back then 24% were abandoned. Typically a higher abandonment leads to bigger yields on the surviving acreage, because the abandoned acres consist mainly of dryland cotton.
The US crop had a relatively difficult start across the cotton belt, with a very rainy and overcast May/June in the Mid-South and parts of the Southeast, while Texas struggled for a while with dryness and damaging storms. July has allowed the crop to catch up, but the 30-day forecast calls for much cooler and wetter conditions for Texas and the Mid-South. While rain is generally good for crops, a lack of heat units could impact fiber development. Whether this all adds up to record yields in the end remains to be seen!
When we look at world numbers, the nutshell version is that the global production estimate (117.31 million bales) has been brought to the same level as mill use (117.4 million bales). But since China is primarily using its own stocks to cover the seasonal production shortfall of 14.0 million bales, most of the ROW production surplus of 13.91 million bales will be added to the ROW stockpile.
The rise in ROW stocks is really at the center of the bearish case. The USDA predicts that ROW stocks will increase by 9.15 million bales, from 41.59 to 50.74 million bales. This would be the highest ROW inventory ever! By comparison, over the last ten seasons it ranged between 32.9 and 44.8 million bales. If such a high stock level were indeed reached, it would be difficult for prices to stay where they are. However, there are several things to consider before we bury the market!
First of all, we don’t agree with the USDA beginning stocks of 41.59 million bales. Indian stocks are considerably overstated and there are a few other places that have slightly smaller inventories as well. We therefore feel that the starting point should be closer to 36 million bales. Second, crops are still not made yet, both in size and quality, and a lot needs to go right over the next 2-3 months for global output to reach 117.3 million bales. Third, the USDA assumes that China will import just 5 million bales, but if US prices decline further and the spread to Chinese prices persists, then there is a good chance that China might become more active on the import front.
US export sales slowed last week, as net sales amounted to just 73,100 running bales of Upland and Pima cotton. Shipments of 222,000 running bales were strong considering how low the current inventory is. Final exports for the 2016/17-season amounted to 14.9 statistical million bales, while commitments for the current season are at 6.35 million statistical bales, whereof a little over 0.1 million bales have so far been shipped.
So where do we go from here? The market came within 80 points of the 72 cents resistance level, but after today’s dismal performance the momentum has now clearly shifted to the downside again.
The trade was just 8.9 million bales net short last week, which compares to 16.7 million bales net short a year ago. In other words, the trade is nowhere near where it needs to be in regards to hedging, especially considering that global production is estimated to be nearly 11 million bales larger. We therefore expect the trade to become an aggressive seller on bounces from here on out.
Specs have no reason to cover any additional shorts at this point and some of the spec longs may actually opt out now. In other words, neither the specs nor the trade are likely to be net buyers of the market at current levels.
Support will eventually come from mill fixations, with 11.2 million bales in on-call sales currently open. But the bearish balance sheet will prompt mills to lower their fixation scales.
The only hope for the bulls is that the USDA numbers won’t play out as advertised. But even if the crops come in slightly lower and we take out the phantom stocks in India, it is still difficult to build a bullish case. It might just not be as bearish as these numbers suggest!