Investing in Cotton: The New “King” of the Commodities Sector (BAL, JJS)

Gold is grabbing the headlines setting daily record highs. Silver is setting an-even-more-torrid pace. Wheat and coffee – American breakfast table staples – are surging due to bad weather around the world.But there’s another commodity that’s up big: It’s surged as much as 55% in the last 12 months to reach its highest price level in 15 years. And there’s plenty more to come: Global demand far outstrips supply, creating an imbalance that won’t be solved anytime soon.I’m talking about cotton, the “new” king of the commodities sector.”We have an extremely bullish situation,” Mississippi State University Prof. Emeritus O.A. Cleveland said during a recent Ag Market Network conference call. Cleveland, a noted agricultural market economist, said prices could climb another 30% or more due to the ongoing supply/demand imbalances in play worldwide.

One Big Breakout

With all that’s happened with gold, silver, coffee and other commodities in recent weeks, institutional investors are tossing the term “breakout” around with impunity. But here’s the reality: When you examine the facts, it’s cotton that’s poised to make one of those historic breakout moves that traders live for.”The fundamentals have gradually gotten tighter, tighter, tighter,” Gary Raines, vice president in charge of economics and analysis for Nashville-based FCStone Fibers & Textiles, told The Financial Times.When I think about cotton, four factors support my projection that prices are headed much higher:

  • Global demand easily outstrips worldwide supply.
  • Global cottons supplies are constrained by the world’s two largest exporting countries each having to deal with a weather-damaged harvest.
  • There are very long lead times on replacement crops.
  • Prices are at 15-year highs – with “blue sky” (for far higher prices) ahead.

Demand continues to grow; it’s the supply that’s in question,” says Ronald Lawson, managing director of L.O.G.I.C. Advisors, a Sonoma, Calif.-based commodities-consulting firm.It’s a “triple-whammy” of weather events that’s led to this supply crunch.

Three Strikes to Cotton Supplies

The first of the three strikes to hit global cotton supplies struck China, the largest producer and largest consumer of cotton. Bad weather there damaged the cotton crop, which prompted Beijing to ramp up imports in order to feed the country’s textile factories.”From the buying pattern we have seen out of China, it would appear that collectively, they may not have seen this rally coming,” L.O.G.I.C. Advisors’ Lawson told The FT.This extra demand prompted India, the world’s No. 2 exporter, to cap exports. India’s cotton crop was also damaged during the heavy monsoon rains. India’s leaders have stated that they will put an extremely high level of tariffs on exports above 2 million bales.Pakistan rounds out this trifecta of cotton-crop calamities. A large cotton exporter in its own right, Pakistan’s cotton crop has been badly damaged by the flooding that has seriously damaged that country’s expected harvest.Demand for cotton was already on the upswing anyway. That means that these shortages are expected to have some serious economic implications around the world. The supply shortfalls have touched off a bidding war in the commodity-trading pits, which will affect anyone who buys clothes in 2011. While farmers will attempt to plant more cotton in the New Year, that’s still a growing season away, and won’t be enough to slow the price advance in the cotton market anytime soon.Cotton has such a long “lead time” – one of the longest of any commodity, in fact – here’s the reality about prices. From the time new cotton crops are planted, to the time the mature cotton is harvested, processed and sent to a textile factory for production into a T-shirt that you can buy at your local retailer, you’re basically talking at least 18 months. For an investor, that means that there’s still plenty of time to profit from the cotton shortfall. This gives us a commodity that is in a prolonged, upward trend – and not a rocket ship whose bullish price moves are likely to end in a spectacular (and risky) blow-off. What’s more, if the 2011 crop is also not a bumper one, we can expect that prices will continue their upward move even longer. Finally, while cotton is also subject to a major new economic slow down in the economy, like 2008. Cotton has enough of a supply imbalance this year, to absorb a drop in near-term demand.The bottom line: Cotton looks to be a safer commodity investment at this time.

Cotton Prices – Where Do We Go From Here?

Historically, cotton has averaged 40 cents to 50 cents per pound. But prices have been climbing for a year, now. It has recently traded in excess of $1.00 a pound, and some other experts have publicly forecast prices of $1.25 a pound or more.If that happens – and I certainly believe it’s possible – you can expect the cost of a T-shirt to increase by 20% or more from what you’re paying today.The United States, which exports 80% of its cotton crop, is expected to increase total acres planted in cotton next year, to try and capture some of this move. However, that is still a growing season away.As I stated above, cotton is poised to make one of those historic breakouts that traders live for. Cotton has the fundamentals in alignment for a continued bullish run. Let’s look for a near-term price pullback to use as an entry point.When that happens, let’s capitalize by using some of the investments that I detail in the “Actions to Take” section that follows.

Action To Take: Cotton is currently king in the commodities market. It is trading near a 15-year high in price, with growing demand and a lack of near-term supply. While cotton prices have already advanced – a lot – I believe there is still significant upside potential in the next three months to nine months. There are a couple of ways to play cotton from here. The first – and most obvious – way for retail investors to join in is to gain exposure to the crop via one of the exchange-traded notes (ETNs) that focus on commodities. Here are two of the best options:

  • The iPath Dow Jones-AIG Softs Total Return Sub-Index ETN (NYSE:JJS) is based on the soft commodity sub-index. It allocates nearly a third of its assets under management (AUM) to cotton, and also invests in sugar and coffee. This ETN has traded as low as $41.22 to a high of $59.82, and closed yesterday (Thursday) at $58.35. Like most of these commodity ETFs or ETNs, the total assets haven’t yet reached a substantial size, meaning liquidity risks exist.
  • The iPath Dow Jones-AIG Cotton Total Return Sub-Index ETN (NYSE:BAL) is based on the total return sub-index for cotton. It is based on the return of a single futures contract in cotton. The ETN is extremely small, but gives investors direct exposure to the expected changes in price. At yesterday’s closing price of $47.70, this ETN is trading near the top of its 52-week range of $31.50 to $50.49.

If you are an investor with access to the futures market, you do get a more-direct exposure to cotton, albeit with greater risk. If you are interested in reviewing cotton futures contracts or their charts, check out FutureSource. If I was buying futures contracts, I would be looking at the May 2011 contracts and, once the market becomes more liquid, at the May 2012 contracts.

[Editor’s Note: If there’s one thing top global investors understand, it’s that you have to “follow the money” to reap the benefits of the best profit opportunities that are available at any one time. Money flows point out the next profit opportunities. Sometimes that means “following the money” from one sector to the next. Other times that means moving from one geographic market to another. To make those moves successfully, investors need a compass or, better yet, a guide. And successful investors will tell you, one of the best guides out there is The Money Map Report. This monthly advisory service – an affiliate of Money Morning – employs many of the same experts whose columns you read here each day. The difference is that The Money Map Report is straight investment analysis. Our writers use proprietary money-flow indicators to identify and isolate the most timely profit opportunities you’ll find anywhere. For more information about The Money Map Report, please click here.] 

Written by Jack Barnes From Money Morning

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