The Potential for Cotton Futures

ALREADY A MONTH INTO THE NEW YEAR, traders begin trying to figure out what trades will be the big winners in the as 2008 rolls on. Now, it’s not exactly breaking news that agriculture markets have basically been on fire for the last couple of years. Corn has skyrocketed on the back of huge ethanol demand, and soybeans, for that matter, have too.

Wheat exploded this year on poor global crops and much higher demand. So is the big bull run for grains over? No, it’s actually just getting started. While I think wheat, soybeans and corn will continue to do very well, another crop may do even better in 2008 — cotton.

The longer-term effect of all the extra corn and wheat planting in the South could be a cotton shortage and much higher prices.

The general consensus is that many farmers are switching out of less profitable crops like cotton and rice and moving into the lucrative corn and wheat market, which has benefited from the ethanol boom.

According to the National Cotton Council’s early season planting intentions survey in 2007, U.S. growers intended to plant 13.2 million acres of cotton in 2007. This was a significant decrease of almost 14% from 2006, and 2008 is expected to be even more dramatic. Meanwhile, demand for cotton is showing no signs of slowing around the globe, especially in China.

China is wasting no time securing the natural resources it needs to keep its economy going — and that includes cotton. In fact, China’s so serious it’s created its own futures market. Many analysts had noted an imbalance between China’s growing economy and the relatively small size of its domestic futures markets. This imbalance was seen as a negative and something that could hinder China’s development in the long run.

Chinese merchants and manufacturers are very serious about the cotton business; all you have to do is look at cotton futures trading on the Zhengzhou Commodity Exchange.

The exchange is no joke and is the center of cotton trading in Asia. Daily volume in Zhengzhou cotton futures, which will complete their first year of trading on June 1, is now running about 50,000 contracts. Open interest at the ZCE has been running between 60,000-80,000 contracts per day since last November — that’s just an incredible number.

To put it in perspective, 70,000 contracts per day is gigantic. It’s amazing to think that the New York Cotton Exchange reached this level only after a century of trading. Literally, it took 120 years and a record U.S. cotton crop to accomplish it. The ZCE did it in less than a year. The power of China is amazing.

Even with all the global interest in cotton, the futures have sold off heavily and there is a lot of bearish sentiment — at least until now.

Oversold Territory

If the picture is so bullish for cotton, then why has it been selling off so much lately? Good question!

One big reason is demand has not been as high as expected in the first quarter, which has limited the upside trade in cotton, at least for now.

Cotton futures have had a bit of a boost in the last few months that will likely continue during 2008 because of speculative fund buying in cotton. The price for cotton is still relatively very cheap.

Analysis of the farming regions in the U.S. indicates that all areas will have some reduction of cotton. The South will be affected the most.

Another factor to keep in mind is Mother Nature. Weather is always a major factor for any agricultural commodity, and it will be pivotal in determining final crop size, no matter what.

When we apply each state’s cotton yield in 2006 to its 2007 projected harvested acres, it generates a crop size of 20.5 million bales. At first glance, that’s not all that bullish, since it’s down only 1.2 million bales from the previous year’s number. But if we examine the numbers a little closer and look at history, we see crops are often subject to yield deviations — in other words, coming in less than expected.

When we look back over the past decade, a pattern of deviations is obvious. It suggests that under ideal conditions, 22 million bales would not be out of the question, while weather problems could also push the crop to the 18 million-bale range.

While first quarter demand might not be at the anticipated levels, there’s no denying that there will always be a demand for cotton. Clothing, home furnishings, and even medical supplying are all industries that rely heavily on cotton. If the weather influences the harvest the way many are predicting, the price of cotton could be the next great bull market in commodities. Gold and oil have had their day, but now the softer side of commodities could blanket some lucky investors with big gains.

Yours for resource profits,
Kevin Kerr
January 31, 2008