Editor's Note: Agricultural commodities are on fire, but farmers' rush to grow more corn and wheat could create a shortage of cotton. A special report jointly developed by U.K. affiliate MoneyWeek Magazine and our experts here at Money Morning explores the cotton market and how investors can benefit. For more information on MoneyWeek, please click here.
Almost two months into a new and volatile year, investors have already been trying to figure out what will be the big winners when November and December come around.
But instead of looking ahead, in this instance, hindsight may prove more fruitful.
The agriculture markets have been on fire for the last couple of years. Corn and soybeans have skyrocketed on the back of huge ethanol demand. Wheat exploded as droughts cramped supplies and demand in emerging markets soared.
Seeing dollar signs, many farmers have decided to use their land to grow more profitible crops. For the short-term, that may pay off the mortgage but the longer-term effect could spell shortages [thus producing price increases] for those soft commodities they've stopped growing – in this case, cotton.
According to the National Cotton Council's early season planting intentions survey in 2007, U.S. growers intended to plant 13.2 million acres of cotton in 2007. This was a significant decrease of almost 14% from 2006, and the 2008 decrease is expected to be even more dramatic.
But at the same time, demand for the softest of soft commodities hasn't waned – if anything, the rapidly growing middle classes of China, India and Latin America are buying more T-shirts, jeans, hats, etc.
In fact, China is wasting no time securing the natural resources it needs to keep its economy going – and that includes cotton. China is also smartly buying now, while cotton is cheap.
The emerging powerhouse is so serious about cotton that it has created its own cotton futures market. Many analysts had noted an imbalance between China's growing economy and the relatively small size of its domestic futures markets. This imbalance was seen as a negative and something that could hinder China's development in the long run.
The 'Gigantic' Zhenghzhou Cotton Futures Market
Chinese merchants and manufacturers are very serious about the cotton business; all you have to do is look at cotton futures trading on the Zhengzhou Commodity Exchange (ZCE).
The exchange is the center of cotton trading in Asia. Daily volume in Zhengzhou cotton futures – which will complete their first year of trading on June 1 – is now running at about 50,000 contracts. Open interest at the ZCE has been running between 60,000 to 80,000 contracts per day since last November.
To put it in perspective, the New York Cotton Exchange reached the 70,000 contracts per day threshold only after a century of trading. Literally, it took 120 years and a record U.S. cotton crop to accomplish it. The ZCE did it in less than a year.
Even with all the global interest in cotton, the futures have sold off heavily and there is a lot of bearish sentiment – at least until now.
Why Cotton is Looking Oversold
If the picture is so bullish for cotton, then why has it been selling off so much lately?
One big reason is demand has not been as high as expected in the first quarter, which has limited the upside trade in cotton, at least for now.
Cotton futures have had a bit of a boost in the last few months that will likely continue during 2008 because of speculative fund buying in cotton. The price for cotton is still relatively very cheap.
Analysis of the farming regions in the U.S. indicates that all areas will have some reduction of cotton, mostly in the south.
Also, weather is always a major factor for any agricultural commodity, and it will be pivotal in determining final crop size, no matter what.
Clothing, home furnishings, and even medical supplies are all industries that rely heavily on cotton. If the weather influences the harvest the way many are predicting, the price of cotton could be the next great bull market in commodities.
Locked Out of Cotton
Unfortunately, most U.S. investors can't directly tap a cotton-specific ETF – officially calledand only traded on the London Stock Exchange.
Until something local arrives, investors will have to follow the farmers' pursuit of other hot agricultural commodities.
Deutsche Bank's Power Shares Agricultural Fund (DBA) is intended to reflect the performance of commodities in the agricultural sector – soybeans (31%), wheat (28%), corn (23%), and sugar (16%).
Van Eck's recently launched Market Vectors Agribusiness ETF (MOO) takes a different approach. This fund reflects the infrastructure of the agriculture industry, focusing on chemicals (34%), agri-product operations (33%), equipment (24%), livestock operations (6%), and ethanol/biodiesel (2%).
Those investments aren't shots in the dark, either. In fact, you might take comfort knowing that famed investment guru Jim Rogers – who predicted the global commodities boom we're experiencing more than a decade ago – has said several times recently that he is buying agricultural commodities. [To see how you can obtain a free copy of Rogers' just-released bestseller, "A Bull in China: Investing Profitably in the World's Greatest Market," please click here.]
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