Recent Turbulent Events in the Cotton Market
Beginning on February 29, 2008, events took place over a couple of days in the cotton futures markets that changed the entire landscape of cotton markets as we have known them and devastated the trading system that has worked well for 130 years.
Hedge Funds and Index Funds entered the cotton futures markets with massive amounts of contract purchases. In February, cotton had been trading in the 70 cent range based on fundamentals (estimates of cotton production, mill use, and exports) that existed at that time. The rapid run up of the futures price of cotton to near 94 cents was unanticipated by analysts and those familiar with cotton markets. This market rise caused very large margin calls for producers, merchants, end-users, and others who were hedging cotton and were short in the market.
Merchants in particular had to come up with vast amounts of cash to cover positions, so there was a large amount of physical cotton being sold to raise cash. Fearing that prices on the futures market would continue to run up, merchants only bought cotton that they needed to meet current contracts. This created a considerable divergence from futures to cash cotton, which is very unusual in a bullish futures market.
Over a period of a couple of days, a cotton futures contract became a “money” commodity rather than a cotton commodity. The industry lost the basic components of a cotton futures contract in that the opportunity for true price discovery and the means for risk management was lost.
Cotton buyers have become very reluctant to do forward-contracting because of the exposure to excessive margin calls. Options have become very expensive for the same reason. Producers have been unable to sell in an orderly manner and to manage their risks.
The Hedge and Index Funds have seen a decreasing stock market and other market declines. They saw the increases in grain futures over the past few months and the reports on decreased cotton acres for 2008. Many people felt that cotton had to follow the trend of other ag commodities. Essentially, there was an opportunity to invest in a commodity that had to go up and they did it in a big way with large, large numbers of contracts. In reality, cotton fundamentals just did not support this large run up in cotton futures prices. From a technical standpoint, the rapid run-up created frenzy.
When the futures price made a 20+ cent gain, the funds began unloading contracts almost as fast as they bought them. At the end of March, the price was back near the 70 cent range, resulting in big gains for some of these funds and a devastated cotton market.
On the surface, what was done was probably legal. There are concerns that some of the funds may not have fully met margin requirements or other trading rules. Hedge and Index Funds are not limited on the number of contracts which they can hold, as are all of the other traders who are limited to 5000 total contracts and 500 in the nearby month. Also, they do not have the same reporting requirements of contracts held as do the other players. These are the biggest problems with the system as it currently exists.
These new players in the cotton futures market are probably the same folks who brought the sub-prime market problems to us. There are people who sit at computers and just look for opportunities to make money in a big way. It is almost like a video game to them.
The Commodities Futures Trading Commission will conduct a hearing on April 22nd in Washington, DC to look at the cotton futures crisis. All segments of the cotton industry will be represented to see what reforms can be made to the system. Concerns have also been addressed to the Intercontinental Commodities Exchange (NY Board of Trade) to try to bring back a workable cotton market. Efforts are being made to revert back from electronic trading to the former floor trading. There are talks with other commodity exchanges, such as Chicago, to develop a new trading market.
What have we learned from this cotton market fiasco?
1. Cotton, not money, is the commodity being traded
2. The Cotton Industry cannot stand $1.5 billion in margin calls
3. The Cotton Industry needs a solid market for true price discovery and risk management
4. The rules need to apply fairly to all players in the market
----The above information was prepared by Randall Conner from presentations by Anthony Tancredi of Allenberg Cotton and Wally Darnielle of Plains Cotton Cooperative Association at the Plains Cotton Growers, Inc. Annual Meeting in Lubbock on April 4, 2008.
