When it comes to cotton, China holds all the cards
One could argue that no U.S. agricultural product, and the fortunes of its producers, is more dependent on the whims of a foreign government than cotton. And Joe Nicosia, who heads the world’s largest cotton trading organization, gave U.S. producers a lot to lose sleep over this week in his keynote presentation at the 2013 Beltwide Cotton Conferences.
The root of the problem is China’s "market distorting policy," says Nicosia, who works for Louis Dreyfus Commodities. The Chinese government buys millions more bales of cotton than it needs every year, stores them in a reserve, and occasionally sells them back to Chinese textile mills at about $1.25 a pound, 50¢ above current market prices.
Why would it do this?
"Years ago," Nicosia told a rapt audience in San Antonio, "China decided it needed more food for its people and didn’t want to increase acreage for cotton." Keeping cotton prices artificially high encourages the production of polyester to supply the country’s hungry textile mills. China has gone from 1.1 million tons of polyester staple fiber capacity in 1995 to 14 million tons this year, the equivalent of 60 million bales of cotton a year.
Whose to say whether China's policy couldn't change overnight? Here are five "scary thoughts" Nicosia presented, nearly all of which have the potential to undermine the U.S. cotton market.
1. China has accounted for all of the worldwide increase in cotton consumption within the last decade.
From 2000 to 2010, world consumption of cotton grew by 28 million bales. But during that time frame, Chinese consumption increased by 29 million bales. That means that purchases made by the rest of the world contracted by 1 million bales. Last year, the U.S. exported 11.7 million bales of cotton and 6.4 million went to China.
"They are your largest customer and you are completely dependent upon them. If we can’t increase that consumption inside China, and get away from them becoming self-sufficient in cotton, you have no place to market your crop," Nicosia said.
"The entire world’s increase in consumption can be explained by what happens inside of China," he added, noting that world cotton consumption topped out 123 million bales a couple years ago. "Today we’re at 106 million. That’s 17 million bales of consumption that’s no longer taking place, and the reduction is all within China."
The industry's biggest challenge over the next 10 years is to grow foreign demand for its product, especially within China, the trader said, adding that lower prices would help in that regard.
2. China has enough cotton in its reserve that it doesn’t have to buy any more to supply domestic use for 10 years.
"They have a 10-year supply just sitting in reserve. If they didn’t want to, they wouldn’t have to import a bale for 10 years," Nicosia said. "Imagine what would happen in the world cotton market if that took place? It’s not going to, because they are going to want to hold their reserve. But that’s kind of a scary thought."
China’s practice of stockpiling reserves means that world-ending stocks have gone from 48.9 million bales in 2010/2011 to 79.6 million in 2012/2013. World-ending stocks are "about to go into the 80s," said Nicosia, who found the number hard to believe. "Eighty million bales of cotton, almost twice of what we had just three years ago."
The Chinese government bought 14.7 million bales of their domestic crop last year, at a price of $1.20 and put it in reserves. "That’s more than we are probably going grow this year as an entire nation," Nicosia said, adding that this year the government is expected to buy another 27.1 million bales at around $1.25 per pound.
3. China is getting dangerously close—within 4 to 5 million bales—of producing all the cotton that it needs.
"The scariest thing to you is that deficit today is only 4 million bales," Nicosia said. "But look what they imported last year, 24.5 million bales. They only needed 5 million."
4. Chinese cotton purchases keep prices artificially high. What if they stopped buying?
Given total world cotton supplies, including back stocks, cotton prices should be in the mid-50s to 60s, Nicosia said. Instead, they are in the mid-70s. "If we dip down below 70, China steps in to buy it. If we move up toward 80, China doesn’t buy anything, the world slows down, producers get discouraged, and prices go back down," he explained.
The Chinese reserve situation creates a valuation problem. Looking at total supply, Nicosia said, cotton prices should be in the mid-50s to 60s. But when reserve bales are pulled out of the equation, prices should be closer to 95¢. "So, how do your prices adjust? The marketplace struggles with this every day," Nicosia said.
The bottom line is that as long as China buys cotton at such high prices, the world will be prone to the over-production, Nicosia said. "We need lower prices," he said, to encourage China’s mills to use cotton again instead of polyester. It would also get the market’s demand/supply equation back in equilibrium and "encourage demand down the line."
5. China recently announced that it would start selling from its reserve.
Cotton prices have dropped since China last Friday announced that it would begin selling cotton from its reserves. Nicosia said the move was expected. He estimates that the government will sell 8.3 million bales this crop year, and that’s on top of importing 11.5 million bales.
"They own so many bales within their country that they have actually starved their textile mills and their total supply, so they have to start to sell," he said. "They will probably start that next week or very shortly."
Unless they start sales, the Chinese government is on a pace to own 45.9 million bales by March. If they had to mark that product to market, they would record a loss of more than $10 billion.
"The longer China keeps buying and holding cotton, the more dire the future becomes," said Nicosia in conclusion.
"We have a major challenge in front of us. We have to revive cotton consumption. It used to 124, 125 million bales. Today it’s 106....We have to regain that cotton blend. We have to provide those textile mills with competitively priced cotton so they’ll move that blend back from polyester into cotton. Once that happens, consumption will start to grow again and we’ll be able to match that growth with increasing production."
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