October 11, 2010
December ’10 cotton futures have surged from 81 cents per pound on August 11th to over $1.10 two months later. Much of the near 30 cent run-up appears to be led by speculators, hedge funds, and relative currency values between the U.S. dollar and individual country currency, rather than physical demand.
Meanwhile, December ’11 futures have increased only 12.2 cents during the past two months. Weather conditions permitting, more cotton will be produced next year because of the higher price. But, demand is also likely to be sluggish and the shift to man-made fibers will accelerate. In addition, currency value between countries will adjust.
Assuming that the weak U.S. economy will stabilize and possibly improve slightly, the U.S. dollar has the potential to recover somewhat. The wild card is what will be the relative value of currency in China and other major countries buying U.S. Cotton.
While U.S. and foreign cotton supplies of last year’s cotton are tight, the U.S. cotton harvest is progressing rapidly, providing more supply for export and delivery on the futures contract. For the week ending October 7th, 2.8 million bales have been sampled with 59 percent tenderable for certification to be delivered on futures contracts. Cotton prices over $1.00 per pound should encourage delivery, provided the cash price does not follow futures prices minus delivery costs. In recent years, high futures prices have stimulated certification while price has been increasing. But, when the price starts decreasing, the certificated stock threatens delivery and the futures price adjusts in line with the supply/demand driven market.
In the past, when futures price ran away from cash price for a while, the chase stops and futures price drops sharply. The amount of price decline could be similar to the 20 to 30 cent recent run-up of price.
The bullish surge in futures price is supported by many traders that do not use cotton. Yet, the mathematical models driving electronic trading can turn bearish faster than they turned bullish.
Therefore, producers and other owners and textile manufacturers must rely on a strong price risk management program to maintain financial obligations. Because many market forces are not visible, hedging programs need to consider hedging futures positions with options to protect extreme margin calls. For example, short futures positions can be protected with purchase of calls at various strike prices at or out-of-the-money.
Given the combination of current extreme non-user market positions, producers of cotton need to consider fixing price or selling this season’s cotton soon and fixing a price on next year’s crop of 2011/12 cotton. Out-of-themoney put options on December 11th are viable.