The new crop market picture is not that clear since it is early and there are a lot of things to unfold. The major seasonal benchmarks are mostly still in front of us, e.g., USDA planting reports and the first comprehensive supply/demand estimates (in Mid-May). While there is a lot that is not clear yet, at least two things appear likely: 1) the upside potential of cotton prices will be capped somewhere in the 90-cent range for NY futures, and 2) the most important variable in shaping cotton ending stocks and prices is Chinese import demand during the August 1, 2014, through July 31, 2015, marketing year.
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Consider the Chinese cotton stockpiling policy. For three years the Chinese government has bought up cotton bales at prices ranging from $1.40 to $1.52 per pound, far above the world price. The result of this stockpiling has resulted in a net accumulation of forty- something million bales that are not available to the commercial market. Since the reserve is so large, it has created an artificial supply shortage. Now China has signaled that they are changing their policy to support some of their growers with a target price/“deficiency payment” type policy. This may result in no more accumulation of bales into the Chinese government reserve, but the presence of the existing stockpile still has major implications.
The first is that the upside potential for cotton prices is capped. The most likely source of a major cotton price rally would be from an unexpected production shortfall somewhere in the world. If that were to happen, China would likely release cotton from their reserve in order to liquidate some at a smaller market loss. The effect would be to chop the price rally off at the knees. The upside to cotton prices will, therefore, be limited, perhaps for years.
The second implication is a considerable amount of downside price risk. The Chinese reserve cotton represents a potential reduction in their need for imports. This possibility for substitution between Chinese reserve sales and imports is affected largely by the reserve sale price, the availability of duty-limited import quota, and the price of imported cotton. To whatever extent that Chinese reserve sales substitute for imports, it would have a price weakening effect in cotton exporting countries like the U.S.
Considering the possibility of downside price risk and limited upside potential, I would project a likely range of 72 cents to 82 cents per pound for Dec. ’14. Since the U.S. ending stocks will likely rise year-over-year, the historical seasonal pattern of prices suggests relatively higher prices in the spring, followed by a weakening of prices when the market gets confirmation of new crop supplies (circa August and September). From a hedging standpoint, I would be looking for opportunities to buy put options or put spreads in the upper seventies if Dec. ’14 or Mar. ’15 trades above 80 cents. The relatively low futures volatility this spring has created some good shopping opportunities for options.