October 8th 2009

NY futures turned back up this week, with December rallying 231 points to close at 63.65 cents.

Strong outside markets continued to be a supporting factor for cotton this week. The US dollar index dropped to a 14-month low, while spot gold rallied to yet another all-time high of over 1'060 dollars an ounce today. The US dollar continues to get hammered as foreigners are trying to diversify away from the greenback.

US export sales of 136'300 running bales net (92'300 RB of Upland and 44'000 RB of Pima) continued to disappoint, but it was not for a lack of mill enquiries that sales remained relatively low. Due to the lateness of the US crop and the potential quality impact from cool and wet conditions, shippers are simply not able or willing to offer some of the grades that mills require and they have to turn many of their clients away or offer them alternative growths instead.

As of last week there were only 211'781 bales of new crop classed and just 44% of these bales were of tenderable qualities. With persistent cool and wet weather preventing harvest from gaining momentum, it is likely that the US will not be able to ship some of its October and November high grade commitments on time. Since mills don't carry a lot of inventories these days, they don't have the luxury to wait and see what happens with the US crop and they have therefore no choice but to look for replacements.

With mills turning their attention towards foreign growths, the A-index and hence the AWP should remain well supported for now and that may offset any harvest pressure that typically occurs at this point in the cycle. As we have previously mentioned, the world outside the US is looking at a 17.6 million bales production gap this season, which is usually filled with US exports. However, the US surplus is not only smaller than in pervious years, but due to the inclement weather there will probably be a shortage of certain premium qualities as well.

When we look at the current composition of the A-index, which calculated 64.55 cents before today's rise, we still have Pakistan (60.50 cents) and Tanzania (62.75 cents) as the two cheapest origins, followed by India (64.50 cents) and a pack of seven other growths all bunched together between 67.50 and 68.25 cents. Without these two relatively small exporters, Pakistan and Tanzania, the A-index would calculate 245 points higher. At some point these two will disappear from the index, because Tanzania is nearly sold out, while Pakistan has a production gap of its own and cannot afford to let too many of its high grades move abroad. We therefore do not expect to see any pressure on the A-index in the foreseeable future and we may even see quotes rise, because India, Uzbekistan and the various African origins are getting a lot of demand at the moment.

If the A-index were to go up, it would force US prices higher as well, at least for the next 4 or 5 cents. Once the AWP (47.34 cents next week) rises above the loan of 52.00 cents, US cotton can be redeemed either at the loan plus carryings or at the AWP, whichever is cheaper. Therefore, if foreign prices move substantially higher, let's say five to ten cents from current levels, then the feedback loop that currently exist between foreign and US prices would stop. Once the AWP is significantly higher than the 52.00 cents loan, it is no longer relevant to US pricing, especially this early in the season when loan cotton has not yet accumulated a lot of storage and interest. This would also make it difficult for the futures market to run away to the upside, because it would no longer have to keep pace with a rising AWP, but instead it would have the 52.00 cents loan level as its reference point. Therefore, once the futures market approaches 70 cents, it offers an attractive spread for loan redemptions.

Of course the above described scenario only works if there are no more setbacks to the US crop. If West Texas gets into serious trouble all bets are off, as it would force trade shorts to scramble out of positions, which could lead to an explosive move to the upside. However, at this point it does not look like a frost is going to occur in West Texas next week, which means that the crop still has a chance to finish. We will have to keep our fingers crossed for the next three or four weeks!

So where do we go from here? Strong outside markets and the weather remain the main drivers at the moment. The weather remains a major worry as two cold fronts are dipping down towards the cotton belt, although at this point no season-ending frost is forecast. The Mid-South crop is a disaster this year, but fortunately it "only" encompasses 3.2 million bales, while the remaining 10 million bales may still produce a decent crop. However, there is no more room for error since the crops are late and time is running out. The market will therefore be on edge for the next 3 or 4 weeks and any turn for the worse could send values skyrocketing. Furthermore some powerful speculators have cotton on their radar screen and they will not hesitate to commit to long positions if the chart gives them a reason to. Depending on what indicators these chart traders are following, the trigger points are somewhere between 64.04 and 65.47 cents. The market is well supported and there is probably a better than 50/50 chance that the market will take out the triple top and rally towards 70 cents in the near future. It may therefore not be a bad idea for anybody with short futures to exchange them for some in the money puts or put spreads!