Like a high-stakes craps player in Las Vegas, some marketers and merchants have put their money on the table, betting on the futures market with certificated stocks, and then sullenly watching as the shooter rolls a seven and the dealer sweeps their chips away.
The certificated cotton stocks hanging over the market apparently are, at least in part, the result of marketers, merchants and others betting that futures prices would move out of line with cash prices. That would, in turn, provide these gamblers with the opportunity to deliver cotton against the futures contract at a profit higher than that offered by the cash market.
Certificated cotton stocks perform very valid, legitimate functions in the cotton market, according to Kent Lanclos, assistant director of National Cotton Council's economic services in Memphis. “Certificated cotton stocks maintain a proper relationship between futures prices and cash prices, and maintain carry in the market,” he says.
But, some market observers, including William B. Dunavant Jr., president of Memphis, Tenn.-based Dunavant Enterprises Inc., have said certificated stocks have had a negative impact in recent months, driving down prices.
Dunavant and others have called for changes in the quality factors for certificating cotton for delivery on the New York Cotton Exchange to make it more difficult to certify lower grades of cotton. Those changes, which must be approved by the Commodity Futures Trading Commission, could take at least 18 months to enact.
Certificated cotton stocks are bales of cotton that are eligible for delivery against contracts on the New York Board of Trade, but have not yet been delivered to a buyer. As of April 5, certificated cotton stocks numbered 325,844 bales.
“Cotton that has been certificated has been re-graded by USDA's Agricultural Marketing Service and has been deemed as meeting the quality standards necessary for delivery against contracts on the New York Board of Trade. It's cotton that is trying to find a home,” says Lanclos. “When someone certificates cotton, they may be betting the futures price will pay a premium over the cash market price.”
Then, if the futures basis, which is the simple difference between the futures price and the cash price, exceeds what is normal, and the futures price for cotton gets out of line with cash prices, the owners of certificated cotton can start delivering actual product on the futures contracts. Delivering actual product on futures contracts can drive futures price back in line with the cash price for cotton, whether through a decrease or an increase in futures prices.
One possible result of this scenario is that the owners of futures contracts end up owning cotton they don't want. Despite the fact that there is a mechanism for physical delivery through futures contracts, in truth these contracts are not intended as a mechanism where cotton is actually physically traded.
Basically, traders of cotton futures contracts are often speculators or hedgers who are interested in the risk-reducing or money-making opportunities the futures market may offer, they don't exactly want any cotton. But, Lanclos says, a high number of certificated stocks can increase the likelihood of having cotton actually delivered on futures contracts.
Bob Goodman, an agricultural economist at Auburn University in Auburn, Ala., explains it this way. “Certificated cotton stocks are bales of cotton that are certificated for delivery on a futures contract, and in 99.9 percent of futures contracts, no one wants to take delivery of actual product.
“You've got people who are either speculating or hedging and who have bought cotton on the futures market at a given price. Then, you've got these people with the certificated stocks that are saying they are going to deliver this cotton to the owners of the futures contracts. But, the speculators and hedgers don't want the cotton; so instead they want to rid themselves of their position in the market,” he says.
“Basically, the hedgers and speculators are afraid if the price of cotton goes up, somebody is going to show up with actual certificated cotton to fulfill the futures contract. They don't want to physically own the futures market cotton. Even if the futures contract holders are cotton farmers, they usually want to buy and sell the actual cotton on the cash market.”
How and why, then, do certificated stocks affect the cotton market?
“There may be a nugget of truth to the idea that certificated stocks are pressuring cotton prices,” Kent says. “But the number of bales of certificated cotton stocks outstanding really has a small effect on futures prices. If you look at the A Index relevant to New York, they have both taken a downward plunge. To say that certificated cotton stocks have had a 10-cent impact on prices, I think is far overstating the case. In the big scheme of things it's really a small component.
“I'm sure it may have somewhat of an impact on the market, but it is not the reason for the low prices we're currently seeing. The fundamentals in the cotton market are why the cotton market is so low. It's simply a case of supply and demand.”
If current certificated cotton stocks are not delivered against contracts on the New York Board of Trade, they will either continue to hang over the market, or be decertified.
This could happen, Lanclos says, if the owners of the cotton stocks no longer believe futures cotton prices will move as they previously suspected they would
“In the futures market essentially everything is a gamble,” he says.
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