Cashing In On Cotton
by Devon Brady
June 2008
Ethanol demand has been responsible for much of the record levels in the recent commodity bull run, sending grains like corn, wheat, and soybeans to record highs. If you missed out on the opportunity to profit from these moves don’t worry. There is always another train leaving the station towards making mad money. We will explore how ethanol and other factors have opened the door for cotton to drive us to new records. The complexities of ethanol production, that ethanol increases greenhouse gases instead of reducing them, are issues for another story. This article is about profiting from the dwindling supply and increasing demand for cotton.
The Ethanol Effect
The global fascination with ethanol has played a major roll in the record levels for the CRB index. Ethanol mandates from countries like the United States, Australia, Canada, and Brazil, have resulted in tight global supplies of not only corn and soy that is used to create ethanol, but for less profitable crops that farmers switch out of to produce it.
In order to satisfy ethanol demand, farmers planted the largest corn crop since 1944 last year, shifting acres that would traditionally be used for wheat and soybean into additional acres of corn. This acreage shift combined with drought conditions in Australia and other growing regions, resulted in record low supplies of wheat and soybeans sending prices to stratospheric levels.
With most of the attention on tight corn, soybean, and wheat supplies, cotton sat out much of last year’s rally. To satisfy the shrinking supplies of grains, farmers are turning their traditional cotton acreage into much more profitable soybeans, wheat, and corn. This is giving investors that sat out of last year’s grain rally an opportunity to capitalize in this year’s leader, cotton.
Shrinking U.S. Crop
While some 80 countries from around the globe produce cotton, the United States, China, and India together are responsible for over half of the world's cotton production. The United States, which typically ranks second to China in production, is the leading exporter of cotton, accounting for over one third of global trade in raw cotton.
This year, cotton acreage nationwide dropped 28 percent, hitting an 18 year low of 11.1 million acres, according to the United States Department Of Agriculture. Acreage dropped by about 22 percent in Texas, the national leader, and by nearly 20 percent in California.
Production is declining in many other countries as well, with Turkey’s production falling 9 percent and an 18 percent decline in the African Franc Zone. Global cotton production for 2008 is forecasted to increase less than 1 percent to 25.4 million tons from the previous season.
Increasing Cotton Demand
Growth of the middle class in the BRIC (Brazil, Russia, India, and China) countries is an additional factor adding to the global grain supply crunch. This composite of rapidly growing consumers is switching from a diet based on grain to one increasingly rich with meat. An increase of 18 times more soybean land is needed to feed the cattle than to feed a person if soybean was the only nutrient consumed. Cattle live on soybean.
The rapidly climbing global middle class is not only increasing demand for higher protein foods. Demand for textiles used to produce clothing, furniture, and other consumer goods are growing also. World cotton consumption is forecasted to increase 3% in 2008 to 27 million tons, resulting in a decline of global supplies by 12% to 10.9 million tons, the lowest in four seasons.
Subsiding Government Subsidies?
Brazil, supported by African countries, confronted the United States to the World Trade Organization in 2003 over farm subsidies. The WTO ruled in 2004 that the subsidies were illegal. The United States conceded to a few minor changes to the program, which Brazil and the Africans complained were largely cosmetic. The WTO agreed, but the United States has taken the issue to the slow appeals process.
The subsidies of between $2 billion to $4 billion a year provided through the Farm Bill were designed to protect small farmers from a collapsing market during the Great Depression. Today, after decades of consolidation by agriculture conglomerates like ADM (www.admworld.com), a quarter of all subsidies go to the top 1% of producers.
Recent legislation moving through Congress is threatening to take away the farm subsidy, which has provided cotton farmers with a price floor guaranteed through the U.S. federal government. Without this artificial floor, farmer’s incentives to plant cotton instead of more profitable feed grains will be erased, making it a lock that significantly more cotton acres will bear other crops like corn, that basic ingredient for ethanol production.
How to Profit From the Upcoming Move
Trading cotton futures is perhaps the most direct way of participating in this cotton bull market. Using the December futures contract you will have the leverage of 50,000 pounds of cotton per contract. A move of 1 cent would represent a gain or loss of $500. The margin required to enter into the position is $2,100 per contract.
Since recommending it just a couple weeks back the December contract has moved over 10 cents higher ($5,000 per contract). A price price close marked cotton 87.45 cents per pound. Active traders are of the opinion that cotton will eclipse $1.00 per pound in the near future. Most of the profits are still up for the taking.
The expectation is that cotton will pull back slightly and have a short consolidation period around the 82 cent level. This looks like an ideal level to enter into a position. It’s important to note that huge leverage cannot only work for you but against you. Having a stop loss order with placement just below the 76 cents support level is strongly recommended.
If you were able to enter the trade at 82 cents with a stop loss at 76, providing you don’t have much slippage, your downside risk would be around $3,000 per contract. If it does climb to over $1.00 a pound like expected, you would have a profit of $9,000 per contract.
With a risk-to-reward of about 3-to-1, and an incredible tale wind, this trade looks like a home run.
The Risk
The risk of loss in trading commodity futures contracts can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition.