Are ICE and ZCE Cotton Futures Poised to Strengthen Further in Second Half of 2009/10?

for more analysis like this, please click here.

After the unprecedented spike in global cotton prices witnessed in 2008 and the resultant shockwaves felt thereafter across the global cotton market, prices in 2009 returned to levels more in line with traditional influences. These drivers include factors internal and external to the cotton market, and show strong correlations to futures prices. Looking ahead to 2010, these signals suggest cotton prices are likely to remain firm, above their long-term average level, as the global economy re-accelerates from a tumultuous 2008, driving renewed growth aggregate demand for cotton textiles and apparel.

Perhaps one of the most influential drivers on global and U.S. cotton prices is fundamental analysis. The study of the ebb, flow and interaction of supply and demand yields insight into current price levels and can hint at the future direction of price. A measure of this interaction, the stocks-to-use ratio, is often strongly correlated with price. More specifically, the tighter or looser the ratio between anticipated ending stocks and expected demand changes, the higher or lower we can expect price to trend. This relationship is evident in the graph below, showing that in recent months, the forecasted stocks-to-use ratio for the U.S. cotton market has fallen, or tightened. As this has occurred, the monthly average futures price has risen in tandem, breaching 70 cents per pound over the first few days in December.

Analysis of the stocks-to-use ratio can yield important clues to the future direction of price. For example, the USDA’s November forecasted stocks-to-use ratio for the 2009/10 marketing year is 35.2%, the smallest ratio in fourteen months. Not coincidentally, November’s average prices for nearby cotton on ICE Futures U.S. were 68.73 cents per pound, the highest in fifteen months. Reports of likely changes in supply and demand can cause this anticipated ratio to rise or fall, in turn driving price lower or higher in tandem.

Looking ahead to 2010, we expect the U.S. stocks-to-use ratio to tighten further in coming months, suggesting price could strengthen even further. We base our forecast on prospects that the U.S. harvest size may be smaller than currently projected, and on the belief that U.S. exports may outpace the current target in the remaining months of this marketing year. Certainly, this bullish outlook is tempered by the notion that prices already outpace the level suggested by this historic relationship. This implies that any continued appreciation in futures prices may not be commensurate with continued declines in the stocks-to-use ratio. Regardless, we look for the market to remain firm well through winter, perhaps until attention turns to the outlook for higher cotton plantings again in the spring.

Looking more broadly across the U.S. economy, factors external to the cotton market are also having a strong influence over cotton prices. First, the weaker U.S. dollar is boosting the outlook for a host of exportable commodities, including cotton. Both the dollar and cotton prices moved in lock-step over the last two years and presently stand near levels not seen in sixteen months. The outlook for the dollar in 2010 is dependent upon myriad factors both in the U.S. and abroad, including the outlook for interest rates, capital markets, inflation, government policies, and other economic indicators. While it remains impossible to accurately forecast the value of the dollar, we, along with many other market observers, remain pessimistic on the prospects for the greenback, helping support the outlook for a range of commodity prices, including cotton.


Second, speaking of capital markets, cotton prices have had an uncanny correlation with equity prices in the U.S. recently. As darkening clouds over the U.S. economy grew more ominous in the final months of 2007, stock markets in the U.S. began a hasty retreat as investors moved money to safer investments. After peaking in October 2007, the Dow Jones Industrial Average lost more than half its value over the next year and a half, falling to its lowest level in a dozen years. Since then, the Dow has posted one of its biggest rebounds in history, soaring roughly 50% from its March 2009 low. The Dow now sits near its highest level in fourteen months. Similarly, after spiking to the highest level in years in early 2008, cotton futures prices plunged more than 60% over the next eight months to 39.14 cents per pound, the lowest level in more than six years. Since then, nearby cotton prices have steadily climbed, surpassing 70 cents for the first time in sixteen months. Similar to gauging the value of the dollar, forecasting stock prices naturally is next to impossible. But many analysts agree that the impressive jump in the Dow in 2009 is unlikely to be duplicated in 2010, suggesting that any continued re-strengthening in cotton prices is likely to come at a slower rate than witnessed this year.
Aside from fluctuations in cotton supply and demand and factors external to the cotton market, the sales of merchants and positions of large traders and funds in the market continue to be strongly correlated to cotton prices. Week-to-week on-call sales across all contract months continue their co-movement with nearby cotton futures over the last two years. In fact, less than two months ago unfixed call sales reached 54,135 contracts—their highest level in fourteen months—at the same time that weekly nearby prices surpassed 68 cents, the highest level in sixteen months. In the weeks since, a gap opened between the two measures. But we look for this divergence to narrow in coming months, whether in the form of lower cotton prices or higher unfixed call sales. Given the bullish other factors noted earlier, we are more confident that unfixed call sales will slowly expand to fill that gap.


The role of hedge and index funds is likely to remain integral to commodity prices—including cotton—well into 2010. The increasing prevalence of long-only commodity indexes and the increasing acceptance of commodities as an asset class are helping drive interest—and therefore volume—in this area, boosting prices. Likewise, the prominence of agricultural commodities in these indexes has substantially increased in recent years. The cotton market has enjoyed a relatively consistent share of the surge of index and hedge fund monies into the market over the last two years, supporting price. In fact, for well over two years, the ebb and flow of index funds’ net positions have mirrored the rise and fall of cotton prices. Just as the net position of index funds is hovering near a fourteen-month high, so too are cotton prices. Looking ahead, aside from political wrangling over new bills governing increased transparency for some larger market participants, we see little reason to expect the inflow of hedge and index funds to ease in 2010, supporting an outlook for robust price in the months ahead.

Lastly, we turn away from the U.S. futures market to the impressive performance of cotton on the Zhengzhou Commodity Exchange. Since commencing trading on the ZCE over five years ago, cotton futures prices have trended in step with their American counterparts, reflecting efficient market-clearing and price-discovery mechanisms in place in both markets. Clearly, the issues that impact price in one market are felt half a world away, driving price in the other market.

This relationship has been particularly evident over the last year, when prices on both the ICE Futures U.S. and the ZCE exchanges reached near-term lows on virtually the same day. Since then, nearby prices on both exchanges have risen in step with one another to the highest levels in roughly fourteen months. It is only over the last month that ZCE cotton prices continued to climb, far outpacing gains on the ICE and peaking recently at record levels just as market volume also soared to more than 500,000 contracts, also a record. This surge in price easily outpaces gains in downstream intermediate yarns and fabrics and appears inherently inflationary—and therefore unsustainable. While we are optimistic on the prospects for continued strength in global cotton prices into 2010, we are not as confident ZCE prices will be able to maintain such a premium. We expect that any continued gains in ICE futures prices are unlikely to be met with commensurate increases in ZCE prices. And should this sudden spike in ZCE volume and open interest suddenly plunge, we would expect Nearby prices in China to retreat closer in line with U.S. futures prices in coming months.