Extreme volatility in cotton prices in 2008 not only hurt producer confidence in the futures market, but eventually led to a loss of 30 percent of U.S. merchandizing capacity, according to Gary Taylor, president and CEO of Cargill Cotton Co., in Cordova, Tenn., speaking at the 2009 Beltwide Cotton Conferences in San Antonio.
The volatility led to cotton merchants Paul Reinhart, Inc., filing for Chapter 11 bankruptcy and caused Weil Brothers to cease operations after 130 years in business.
Taylor said cotton merchants consider a price move of 20 cents to 25 cents during the season as an average move. When cotton prices swung nearly 70 cents from March to November, it was “highly disruptive” for cotton merchants and led to a confidence crisis in the futures market.
Most disturbing for cotton producers said Taylor was that they were not able to take advantage of March futures prices hovering close to a dollar a pound, “because merchants were unwilling or unable to help you price your cotton.”
Taylor said several factors are responsible for the market disruptions including the advent of electronic trading – which has cost the market some stability – and increased activity from large market participants such as hedge funds and passive index funds.
“A futures market must not allow a large trader to control it,” Taylor said of huge fund positions in early 2008. “And it must not become a cash market for any participants to dump cotton on the market. Delivery points are best located in neither producing nor consuming areas.”
Taylor said that in mid-July, funds including Goldman Sachs and AIG had roughly $200 billion invested in the commodity markets. Today those positions have dropped to about $60 billion. “Some of that money was lost, but the majority was scared out of the markets.”
Meanwhile open interest in cotton dropped from over 300,000 contracts in March 2008 to around 120,000 contracts today, “driven either by losses or lack of confidence.”
Taylor said several factors need to be addressed to improve the cotton futures market.
Transparency – All participants must report positions on an aggregated basis (total cash, futures and over-the-counter transactions). “At the present, hedge funds are not required to report.”
Speculative limits – “We need to support the Commodity Futures Trading Commission to withdraw the requests for increased position limits for speculators.”
Daily trading limits – “We need to support current daily trading limits and ensure these limits are the basis for daily fluctuation margin calls.”
Taylor says that one factor less likely to affect the cotton market as it has the wheat market and others is the lack of convergence of futures prices and cash prices. “What makes commodity markets work is that relationship between cash prices and futures prices,” Taylor said. “The cotton market does have adequate, well-located delivery capacity to allow convergence.”
The futures market has unique objectives for each of four categories of market participants, noted Taylor:
Producers – To seek protection against falling prices which can threaten profit margins.
Commercial trade such as processors, merchants, refiners, etc. – To seek protection against rising prices which can threaten profit margins.
Speculators such as local traders and hedge funds – To seek price risk exposure to generate trading profits and deliver returns to investors.
Passive index funds, which refer to relatively new participants such as pension funds, endowments, mutual funds and retail investors – Their goal is to seek protection against rising prices (inflation) and diversify portfolios into assets that historically tend to perform well when other assets do not.
Three things attracted the passive investor in 2008, according to Taylor. Investors seeking protection as expected inflation rates spiked; real commodity demand from China and India that increased global prices; and domestic monetary policy which caused weakness in the U.S. dollar.