Cotton's surprising bull run to end as China imports slump

Finding a commodity still in positive territory this year is hard enough, but finding one that also appears to be defying bearish fundamentals would seem nigh impossible. Enter cotton.

More specifically, cotton futures traded on the ICE exchange in the United States. The benchmark contract is up 5.2 percent between the start of this year and Tuesday's close.

While it has tumbled in recent weeks in line with a broad commodity sell-off, Tuesday's close of 64.24 cents per pound is not far from the peak this year of 69.13 reached on June 29.

The question is why have U.S. cotton futures risen at all this year?

Top importer China has scaled back purchases dramatically so far this year, at the same time as announcing massive sales from its state stockpiles, the largest in the world.

The U.S. Department of Agriculture (USDA), probably the most-watched cotton forecaster, has raised its estimate for global cotton inventories and cut its outlook for demand in China, the world's largest consumer.

If that's not enough, competition from man-made fibres such as polyester is increasing as the price of crude oil, the raw material for many synthetic textiles, slumps and looks set to remain soft for the medium term.

China's imports of cotton dropped 26 percent to 161,775 tonnes in June from the same month a year earlier, according to customs data.

This has taken the year-to-date decline to 33 percent, with 933,779 tonnes imported in the first half of the year.

The outlook for Chinese imports in the second half of the year would appear to be similarly bearish, with international prices still too high relative to domestic supplies and most of the import quota already used.

Chinese mills are allowed to import 894,000 tonnes of cotton a year, with purchases in excess of that or brought in outside of the quota system attracting a 40 percent import duty.

A further bearish signal for Chinese imports are the government moves to encourage more consumption of domestic cotton by selling from state reserves.

Beijing plans to sell as much as 1 million tonnes from state stockpiles by end-August, aiming to gradually reduce huge reserves of about 11 million tonnes that were built up by buying up to 80 percent of the domestic crop between 2011 and 2013 to support farmers.

But all might not go according to plan, with the first week of sales attracting buyers for just 8.8 percent of the cotton on offer, with the cheapest fibre from the 2011 season the most in demand.

POOR START TO CHINA SALES

The poor outcome of the first sales in the week ended July 17 may prompt the authorities to lower prices in order to boost volumes, or it may signal that demand is so weak that even cheap cotton can't attract millers.

Either way, it's hardly a positive sign for Chinese cotton demand, which has been reflected in the main domestic futures contract on the Zhengzhou Commodity Exchange (ZCE).

The benchmark contract is down 4 percent from the start of the year to Tuesday's close of 12,580 yuan ($2,026) a tonne, which is equivalent to about 91.89 cents a lb.

While this is almost 50 percent above the equivalent ICE contract, the differential is narrowed when the import tax and transport costs are added to the U.S. price.

With Chinese prices biased lower because of the stockpile sales, it's likely that international cotton will be uncompetitive against domestic supplies in the second half of the year.

The USDA estimates that Chinese imports will drop to 5.75 million bales (1.25 million tonnes) in 2015/16, which would be the lowest since 2002/03 and down some 30 percent on 2014/15.

Given that China takes more than the next three biggest importers combined, a decline of such magnitude when global inventories remain strong must surely be negative for prices.

The likely reason ICE cotton futures have been more robust so far this year than prices elsewhere in the world is that U.S. exports to China have defied the overall weaker trend, rising by 11 percent to 436,542 tonnes in the first six months of 2015.

But if Chinese imports continue to slump in the second half of 2015, and U.S. exporters aren't spared - as they have been so far - then cotton futures on ICE should be biased weaker.