Tags: Agriculture, Brazil, China, Commodities, Cotton, India, Weak Dollar

Two Ways to Profit From Wall Street's "Soft Commodity" - Cotton

By , Contributing Writer, Money Morning •

Some of the best investment opportunities can happen simply by ignoring the Wall Street herd and venturing onto the road less traveled.

Take such traditional "breakfast club" commodities as sugar, cocoa, coffee and orange juice. They all enjoyed a great year, despite bearish forecasts of doom and gloom. Sugar and cocoa even traded at multi-decade highs.

Similarly, cotton got a bad rap going into 2009, though it motored into the end of the year with a tidy profit, rising on the standard laws of supply and demand.

That supply comes from subtropical regions around the world, with China ranking first in cotton production - though it also imports the most - followed by India and the United States.

Meanwhile, the United States exports the largest amount, followed by India and Brazil.

The "soft commodity" serves as a necessary ingredient in such traditional wardrobe materials as denim, corduroy and terrycloth, but also for coffee filters, tents, fishnets and gunpowder.

With that said, cotton prices still largely rely on clothing and textile production levels. So the recent uptick in global economic activity naturally sparked a cotton craze that should last at least this year, especially with the weaker U.S. dollar making it relatively cheaper.

But the most compelling reason that prices will rise this year is a very simple one: It's all about supply.

Supply-Side Story

The low price for cotton we've seen for the past several years has made it a very unprofitable crop for farmers everywhere to grow, leading them to focus on other crops and only devoting small amounts of acreage to this all-important textile base.

That shows, too, since global-production levels haven't been this low since 1986. And in the United States, it's even worse: American farmers haven't planted less than this since 1983.

If all that weren't enough, we find that rain played havoc with cotton in 2009, affecting U.S. yields so much that U.S. shipments could drop by as much as 21%. China suffered, too.

After factoring in all these developments, the U.S. Department of Agriculture (USDA) projected that global production would fall 4% to 102.7 million bales in the 2009 - 2010 growing season.

Yet the USDA also expects demand to rise 3% to 114.5 million bales because of an increased call for cotton from China.

There's clearly a significant supply/demand imbalance. And all else being equal, basic economic theory tells us that when demand outstrips supply, market prices will increase.

And demand does outstrip supply here. In fact, that shortfall of 12 million bales is the biggest we've seen for cotton worldwide in seven years. Analysts expect the 2009 world cotton inventory-to-use ratio to fall below 50% for the first time in five years. Finally, a return of global growth and a rise in clothing exports from China will likely shrink inventories even further.

Cashing in on Cotton

Traditional investors don't have to worry about trading futures in order to gain exposure to cotton - not with two exchange-traded notes (ETNs) on the market. Investors can take a look at:

  • The iPath Dow Jones-UBS Cotton Subindex Total Return ETN (NYSE: BAL): This ETN advanced 29% in 2009, but has trended back about 2% so far in 2010. It links to an index that focuses on single futures cotton contracts.
  • And the iPath Dow Jones-UBS Softs Subindex Total Return ETN (NYSE: JJS): This ETN rose 30% in 2009 and is already up 1% this year; it devotes 27% of its portfolio to cotton, 29% to coffee and 44% to sugar.

Until farmers start planting more or people stop needing less, smart investors should pick cotton - the potential profits could easily pay for a whole new wardrobe.

[Editor's Note : Article author Tony Daltorio is a staff researcher and writer for Investment U. For more information about Investment U, please click here.]

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