Author: John Robinson

The picture painted by the U.S. Department of Agriculture (USDA) of U.S. cotton production has been reframed several times this year already.  In August, USDA cut a historically large three million bales off of their previous month’s forecast.  The direction of that adjustment was not a surprise to anybody, but the size of it surely was.  Then, in September, USDA’s National Agricultural Statistics Service (NASS) reversed themselves and added a million and a quarter bales back to their estimate of U.S. cotton production^[1], now at 13.83 million bales of all cotton (i.e., upland and pima combined).   

Hopefully, and happily, we can expect the forecast to get more accurate going forward.  The reason for this is rooted in three sources of future information.  First, as we saw in USDA’s September forecasts, available USDA Farm Service Agency (FSA) certified acreage data were used to revise forecasted planted acreage.  This was the main reason for the September upward revision to U.S. cotton production this year.  New data on certified acres from FSA sometimes arises later in the fall or winter, so this remains a possible source of refinement.

Second, NASS surveyed more than 7,000 U.S. producers, including major cotton producing states.  This survey process includes what they call “objective yield surveys” for major crops.  For cotton, this means boll counts from randomly selected field samples in September, October, November, and December.  So again, this data flow suggests a more accurate forecast of U.S. cotton production over time.

Third, NASS also reports monthly on cumulative bales ginned, which is another independent (albeit lagged) measure of U.S. cotton production.  Altogether, we can expect fewer surprises and an increasingly clearer production picture.  This expectation is supported by historical data in Figure 1.   Figure 1 shows the percent deviations of USDA’s U.S. cotton production forecasts in August, September, November, and December, relative to the final production estimate at the end of the marketing year (i.e., the following July).  As expected, the spread of the percent deviations shrink across the fall season, presumably informed by the previously described data flow.  It is also apparent from Figure 1 that USDA tends to overestimate the crop size, at least in the September through December time period.

The marketing implication of this refinement is a fading production risk premium in U.S. cotton prices, all other things being equal. 

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^[1] https://downloads.usda.library.cornell.edu/usda-esmis/files/tm70mv177/qr46s7546/kd17f282m/crop0922.pdf

Robinson, John. “Refinement of U.S. Cotton Production Forecasts“. Southern Ag Today 2(41.1). October 3, 2022. Permalink

Since mid-May, ICE cotton futures have witnessed an historic short-term collapse (see this article https://southernagtoday.org/2022/07/what-is-behind-the-recent-cotton-futures-market-plunge/ ).  In the two-month period between May 16 and July 14, the December ’22 contract fell over 49 cents.  In the last 40 years, there have only been six December cotton contracts with more than that total level of change, measuring from the contract high to the contract low.  The reason for the price decline has been attributed in the farm press and industry newsletters as “demand destruction” which is probably intended to mean both 1) a lower quantity demanded at the formerly high prices, and 2) an inward shift in demand in response to recessionary expectations.

Besides the major downward trend of this price movement, it is also associated with high volatility.  By volatility, I mean that prices are gyrating more variably and more quickly.  Historical volatility is a measure of the spread or risk of price movements over a defined period.  Figure 1 shows historical volatility in ICE December cotton futures during the period March through Mid-May.  The underlying measure of dispersion used in Figure 1 is the standard deviation of December futures settlements.

Contributing to the high volatility of the December ’22 contract were the strong price moves higher and lower, including many limit up and limit down moves.  Figure 1 indicates that the volatility of the December ’22 prices is approaching that of the notable price rally of 2010-11, which then reverted to more normal prices, a pattern that economists call “mean reversion”.  Like 2010-11, the current price movements will likely become smoother and less volatile, but perhaps not until the post-harvest season.  (Note: the 2010-11 price spike was triggered by a global supply shortage that was several years in the making.  In contrast, the 2021-22 price spike appears more demand driven.) 

The plunge in cotton futures represents a lost opportunity for growers with unsold or unhedged production this year.  The contribution of high volatility also increases the costs of marketing since more variable price moves increase the costs of hedging for growers or merchants.  The experience of high volatility in 2022 should serve as a reminder to growers about the riskiness of cotton price movements.  

Robinson, John. “More Volatile Cotton Prices“. Southern Ag Today 2(32.1). August 1, 2022. Permalink

This article highlights some differences between U.S. cotton and other ag commodity markets. The subject really involves the nexus of politics and economics.  There is a long history of government regulation of commodity markets. A textbook example is the Onion Futures Act of 1958 which banned trading of onion futures (and which was the basis for subsequent studies of efficient markets by Working^[i] and Gray^[ii]).  

Our cotton example begins in 1929 when the U.S. Congress singled out cotton in a notable policy restriction.  It seems that two years earlier, one of USDA’s routine monthly forecasts had projected lower cotton prices.  When this forecast proved accurate, some in the cotton industry assumed that the forecast caused the price decline. This led to a political reaction where the USDA was banned from forecasting (only) cotton prices, a policy that remained in place until the 2008 Farm Bill.  

Cotton was unique in dropping out of Title 1 commodity programs in the 2014 Farm Bill, only to come back in 2018 with “seed cotton” as a new, covered commodity in the Bipartisan Budget Act of 2018.  Space does not allow an adequate discussion of the underlying events of that story.

A unique reporting requirement of U.S. cotton since the 1950s is the CFTC Cotton On-Call report (https://www.cftc.gov/MarketReports/CottonOnCall/index.htm ).  This is a weekly report of merchant on-call (i.e., basis contract) transactions reflecting purchases from farmers and sales to textile mills that are unfixed with ICE futures, presented by delivery month.  These data are potentially informative in identifying large, hedged positions in ICE cotton futures (see the peaks of the red line in Figure 1).  This market transparency could benefit suppliers and smaller merchandisers and market analysts, but in some cases it could lead to speculative trading on anticipated short covering prior to futures contract expiration (https://southernagtoday.org/2021/12/current-squeeze-dynamics-in-ice-cotton-futures/ ).  

Why have these different policies existed for cotton? One reason is the historical dominance of southern politicians during the 20^th century.  Thus, if the cotton grower segment was angry at USDA, even mistakenly, they had the political power to have something done about it for a southern crop like cotton.  The global aspect of cotton is another feature that brought about the trade talk attention, the Doha Round, and the WTO case, which precipitated cotton leaving and returning to federal farm programs. Finally, some cotton-specific regulations may have to do with the concentration of the cotton merchandising sector, relative to grains.  Compared to grains, the U.S. cotton market is dominated by a handful of global merchandising firms.  The cotton on-call reporting requirement originated as a way for the cotton merchant sector to report their futures transactions as legitimate hedges, which they are. Curiously, it is the cotton merchant sector that now opposes the collection and publication of the cotton on-call data, which they consider proprietary (https://acsa-cotton.org/wp-content/uploads/2020/05/ACSA-Position-Limits-Comment-Letter.pdf).  The merchant sector also has had an ongoing concern since 2008 with excess speculation in ICE cotton futures.  This may explain their opposition to publication of cotton on-call data.  

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^[i] Working, Holbrook (1960-02). “Price Effects of Futures Trading.” Reprinted from Food Research Institute Studies, Vol. 1, No. 1, February 1960, in Selected Writings of Holbrook Working, Anne E. Peck, ed., Chicago Board of Trade, 1977. pp. 45–71.

^[ii] Gray, Roger.  1963. “Onion Revisited.” Journal of Farm Economics,. Vol. 45, No. 2, May 1963.

Robinson, John. “Some Quirky Aspects of Cotton Marketing“. Southern Ag Today 2(27.1). June 27, 2022. Permalink

A producer’s marketing plan is a contingency plan to sell a commodity in the context of price risk. Cotton prices have been in a long term up-trend, with considerable volatility in recent weeks (see the blue line in Figure 1). A typical marketing goal would be to sell commodities at relatively higher prices, or (conversely) protect un-sold commodities from down-side price risk.  

One way to reduce the risk of lower prices is to forward cash contract portions of expected production.  However, drought-elevated production risk in 2022, coupled with uncertain plantings, uncertain yield impacts from reduced fertilizer usage due to higher fertilizer prices, inverted futures markets, likely price volatility, and higher costs of financing have all likely led cotton merchants to limit their forward cash contract offerings.

Futures hedging by selling ICE cotton futures contracts is another approach to set a price floor, subject to basis risk. However, the possibility of higher trending futures has raised the actual and potential margin risk of futures hedging.  In addition, futures hedging sacrifices any benefit of potentially selling at higher cash prices if the market continues to rise.

Put options are one way to lock-in high price levels without margin calls or sacrificing upside flexibility. A put option gives the buyer the right, but not the obligation, to sell cotton futures at a certain price. In Figure 1 below, Dec’22 cotton futures (the blue line) have trended higher since 2021. As of May 3, the Dec’22 futures settled at 126.18 cents per pound. While this has happened, the premium for put options on Dec’22, like the $1.20 put option graphed in red, have gotten cheaper over the long term. The $1.20 put option means that the buyer of this put option has the right to sell Dec’22 cotton futures at $1.20 per pound.  Note that hedgers have flexibility in the price coverage level by being free to choose from different strike prices.

Put options at a given strike price cost less in a rising market because the put option gives the right to have sold Dec’22 futures at $1.20, which has intrinsic value only when the underlying futures price is below $1.20.  Therefore, put option premiums move opposite to the direction of the underlying futures price.  This is important because an increasing put option premium can act as an insurance payment against falling futures and falling cash prices (assuming a stable cash basis).  The insurance analogy is important since nobody knows the direction of futures prices for certain.  And unlike other forms of insurance, put options can be offset when they are no longer needed, e.g., when the crop is sold in the cash market, giving hedgers a chance to recover  some of their initial expense in option premiums.

At 9.71 cents per pound (as of May 3), buying a $1.20 put option on Dec’22 ICE futures is essentially buying the right to a 110.29 cent short futures ($1.20-$0.0971) position, without the margin call exposure and without removing upside potential if markets continue to strengthen.   Waiting to implement this strategy could be beneficial, i.e., more affordable, if ICE cotton futures continue to rise, which they might.  So hedging portions of expected production with put options over the next several months might be a good way to dollar-cost-average decent hedged prices.

Figure 1. Dec’22 ICE Cotton Futures Settlement Price (in Blue) vs. Associated 120 cent Put Option Premium (in Red).

Daily

July 28, 2021 – May 3, 2022

Robinson, John. “Forward Pricing with Options on ICE Cotton Futures“. Southern Ag Today 2(22.1). May 23, 2022. Permalink

It is generally the case that the U.S. cotton market is influenced by aggregate production uncertainty.  One reason for this is that a majority of the U.S. acreage is planted in Texas (Figure 1), with much of that under dryland conditions contributing to historical abandonment rates between 4% and 62% statewide.  In drought years like the current one, this production risk is only heightened.  The management of this risk is potentially helped by publicly available market information data.

The first upcoming major information source is the May 12^th USDA “World Agricultural Supply and Demand Estimates” (WASDE) report published by the USDA’s World Agricultural Outlook Board (https://www.usda.gov/oce/commodity/wasde ).  The May report is notable for publishing USDA’s first official, comprehensive projections of U.S. and world crop supply and demand variables.  Historically, the May WASDE report tends to be closely watched and is frequently associated with cotton market volatility.

Like other crops, U.S. cotton is monitored by weekly crop condition reports and crop progress reports (on Mondays) from USDA’s National Agricultural Statistics Service (NASS, https://www.nass.usda.gov/).  Because cotton is a perennial bush in its native habitat, its growth and response to stress are different from annual grain crops.  Hence there is less correlation between weekly crop conditions and progress for cotton yield outcomes compared to grains.  Nevertheless, the news media and some market analysts pay attention to these weekly observations between the major report milestones.

June 30^th “Planted Acreage” is another closely watched major report that is conducted by USDA/NASS.  This report is sometimes associated with market volatility when it contradicts expectations based on the March 31^st “Prospective Plantings report from USDA.  USDA’s Farm Services Agency (FSA) provides supplemental acreage information with periodic certified acres data through the summer (https://www.fsa.usda.gov/news-room/efoia/electronic-reading-room/frequently-requested-information/crop-acreage-data/index ). 

For U.S. cotton, the September WASDE report represents the first extensive proven yield sampling for areas outside of South Texas, in addition to grower interviews.  This sample-based production estimate is refined in subsequent WASDE reports through December, as well as with data on cotton ginnings.  The uncertainty about cotton yield may be further exacerbated in 2022 from restricted input applications.  For example, anecdotal evidence of reduced quantities of nitrogen fertilizer applications (due to the higher cost) could contribute to lower-than-average yields.   The resulting yield effect from fewer inputs might not be realized until the ginnings data in November.  Hence, this season could involve extended price volatility beyond the normal resolution of weather market uncertainty.

Robinson, John. “Milestone Indicators of U.S. Cotton Supply and Demand“. Southern Ag Today 2(20.1). May 9, 2022. Permalink