As cotton flirts with its next rally, traders are still coming to terms with the fallout from the last one.
Cotton prices have risen more than 50 per cent this year as global production declines and rebounding consumption breathes life into the market.
Benchmark ICE March 2010 cotton futures on Thursday rose to 74.9 cents a pound, the highest point since June 2008. Analysts say that after months of weakness the cotton market is tightening again.
In its monthly supply-and-demand outlook, the US Department of Agriculture on Thursday projected world cotton production at 102.7m bales in the year through July 2010, down 4 per cent from the previous year. Global consumption is expected to rise 3 per cent on year to 114.5m bales, drawing down global stockpiles. The International Cotton Advisory Committee says that global cotton stocks will see the largest annual decline in seven years.
To understand whether the current rally is a speculative bubble, or backed by real shortages, it is essential to try to make sense of what happened 21 months ago. A buying frenzy then pushed the price of some contracts above $1 a pound in March 2008.
The causes of this spike – the second biggest in 30 years on some measures – still divide the industry.
The Commodity Futures Trading Commission, the US watchdog, is investigating market manipulation in the run-up, including whether large bullish traders sought to inflate futures prices or pushed trading from futures into options markets to notch big gains, according to CFTC Commissioner Michael Dunn. Mr Dunn said last May that findings would be released “very shortly”, but the report has been delayed as it circulates inside the commission. A person with knowledge of an earlier draft says it identified several factors behind the surge, not one grand manipulation scheme.
People in the industry have, meanwhile, drawn their own conclusions. Joe Nicosia, chief executive of Allenberg Cotton, a unit of Paris-based trader Louis Dreyfus, says that there was an “insatiable” amount demand from bullish investors. “Prices just ran out of control in response to that.”
But Thomas Farley, president of the ICE Futures, says that rising prices led credit-constrained traditional traders to unwind positions, unleashing a burst of short-term buying into the market.
“We found there was no nefarious activity,” he says. “When large commercial players don’t have access to credit and are forced to liquidate positions, it results in very volatile pricing.”
Like other commodity markets, price moves in cotton have raised suspicions about the impact of commodity investors, who buy and hold futures as a way to diversify their portfolios and guard against inflation or dollar weakness.
CFTC officials have testified that index funds were selling cotton during the March 2008 price spike. The market is split about what role, if any, the investors are playing in the current cotton rally.
Philip Verleger, an energy economist, says that index investors have grown to more than a third of the overall number of outstanding contracts as of September. “Investor activity seems to explain the movement in cotton prices,” he wrote in a recent paper.
But others say that the rally this time is real. “The difference between now and two years ago is the fundamental story of cotton actually supports the price.” says Cliff White of Olam.
Whatever the 2008 price spike cause, the consequences have reshaped the industry. Cotton merchants, middlemen between growers and ginners on one side and importers and textile mills on the other, were especially burned.
The volatility was traumatic for many of the oldest names. “It’s had a huge impact,” says Woods Eastland, president of US cotton co-operative Staplcotn. “My guess is that since that spike, merchandising firms that would traditionally handle about 40 per cent of the US crop and a significant percentage of the international crop have gone out of business,” he adds.
The number of large cotton traders active on the main US cotton exchange, ICE Futures, has shrunk by a third since March 2008 to about 250 traders. Dunavant Enterprises, one of the largest, is to merge with rival Allenberg. Both are based in Memphis, Tennessee, the southern US city at the heart of US cotton trading for more than a century.
Other casualties of the volatility include merchants Weil Brothers, of Alabama, and the US and Australian affiliates of Paul Reinhart, a Swiss cotton trader founded in the 18th Century.
Documents filed in Paul Reinhart’s US bankruptcy proceedings provide a rare insight on how the volatility wreaked havoc.
The company typically bought cotton from farmers in North America, then exported it to customers from Guatemala to China. To hedge price risks, it would lock in sale prices on the cotton futures market.
But last year’s spike required the company, whose annual revenues totalled $580m, to scramble for $100m in fresh collateral. “The debtor suffered a severe liquidity crisis in early March 2008 as a result of the extraordinary run-up in the futures price of cotton,” a court filing says.
While old-line merchants are disappearing, the washout has created opportunities for competitors including Olam International, a Singapore trader; and Noble Group, the Hong Kong-based commodity trading company. Cargill, the agribusiness giant, also has a cotton unit in Memphis.
Mr White, who heads Olam’s US and Brazil cotton business, says that the industry is now “basically led by four multi-commodity companies,” not cotton-only companies.
The credit catastrophe for many companies also forced them to turn away from a tradition of short-term lines of credit to longer-term financing. “Cotton had a particular way of financing itself which by and large has changed since February 2008,” says Mr Farley of the ICE Futures exchange.