Cotton Price Forecast: After Our 123% Gain, Here's Our Next Call

Back in late September, in an essay to Money Morning readers, I crowned cotton as the "new king" of the global commodities sector.

At the time, cotton was trading at roughly a dollar a pound - after having traded in a range of 40 cents to 50 cents per pound for decades. I told readers that cotton prices could hit $1.25 a pound anytime within the subsequent six months.

As it turns out, I was correct in being bullish -I just wasn't bullish enough. Just one year ago, cotton was trading at 70 cents a pound. Today it's trading at roughly $2 a pound.

Readers who acted on this call have more than doubled their money. In fact, the exchange-traded note that we recommended in that report has soared more than 120% since I recommended it and is already up 46% year-to-date.

The real question, of course, is: What happens next?

Here's my cotton price forecast. And here's how to play it.

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The Case for Cotton

Let's cut to the chase - after which I'll fully articulate my case.

Cotton remains a long-term "Buy." But there is a near-term shakeout due (something that at this point is pretty much true of everything in this crazy commodity bull move). After that, however, there are four very good reasons to expect a long-lasting upward trend in cotton prices.

In making my cotton price forecast to readers, I have to say that the long-term outlook for cotton is bullish because:

  • Cotton has the longest commodity lead time - from the time that crops are planted to the time that the harvested-and-processed cotton is ready for use.
  • We're seeing a 30%-plus "cost-push" inflation in basic cotton products.
  • China is the world's largest grower of cotton, meaning it can "set" global prices.
  • And China has announced that it will drastically increase the price of cotton products.

Let's look at this in deeper detail.

The very nature of cotton as a crop makes it an extremely long-lead-time commodity. In fact, it is said that cotton has the longest cost - in total time - of all commodities. From the time that a farmer plants the seeds, until that cotton grows into a plant that's harvested, cleaned and prepped for actual usage is 18 months to 21 months.

In China - the world's biggest cotton consumer - demand for the fiber is soaring.

China imported 390,720 metric tons of cotton in January, the country's customs agency reported late last month. That's 31% more than a year earlier. And it follows an 86% increase for all of 2010, which saw China import 2.84 million tons, the customs agency said.

Global investors are worried that worldwide cotton supplies are not keeping pace with China's growing - and seemingly insatiable - appetite for the fiber.

Indeed, China's National Bureau of Statistics reported early this week that cotton output declined 6.3% to 5.97 million tons last year.

"China wants to import a whole lot of cotton," Louis Barbera, a broker at VIP Commodities in New York, told Bloomberg News this week. "The lack of cotton that we see will not change for the next few months."

This - and several other factors, including damage wrought by storms and flooding in Australia - has fueled the huge run-up that we've seen in cotton. In fact, the 34% rally in cotton prices so far this year is the biggest of the 19 commodities tracked by the Thomson Reuters/ Jefferies CRB Index.

After hitting a record of $2.0893 on Feb. 18, cotton prices have declined about 6%. Most of that loss came last week, when prices for the fiber dropped 5.5% - the biggest decline since November and the first weekly loss in seven weeks.

Cotton was trading at $1.9621 during trading yesterday (Thursday).

Investors don't expect this retrenchment to continue. In fact, as Toshimitsu Kawanabe, an analyst at commodity broker Central Shoji Co. told Bloomberg: "After last week's drop, funds are returning to the market where supplies are very tight."

A Pullback ... Followed By Another Breakout

If you missed the last move in cotton, but are intrigued by this long-term outlook, I would suggest being patient. You see, I'd be remiss in not pointing out that cotton has experienced a "blue-sky breakout" - meaning there should be a high probability of a real (but near-term) correction as profit-takers provide liquidity to the market.

But don't interpret my advice to "be patient" to mean "ignore cotton." At this point, I am still very bullish on the prospects for longer-term cotton prices.

The bull market in cotton kicked off when China - desperate to keep its factories humming along - had to turn to the United States and buy up its supply. Global weather patterns have damaged Australia's crop.

In China, the weather patterns for this spring have not changed much from what they were last fall. If this continues, you will see a continuing boom in the price of physical cotton.

This trade has gone remarkably in only one direction; I would expect some choppiness before the next major up leg breaks out. We need to see the volatility get squeezed out of the options on the futures before it's truly safe to enter again.

With any investment prediction or "call," there's always a qualifier - an "if." And my near-term prediction for a market pullback is no exception. I see a pullback unless China shows up in the pits and starts buying in size again. If that happens, cotton could hit $3 a pound before it sees $1 a pound again.

It really comes down to how China spends its Ben Bernankes (née Ben Franklins).

Action to Take: If you followed our advice and invested in cotton after our Sept. 24 market call ... well, congratulations on a great run - you're sitting on a gain of 120% or more.

Given that it has been such a great run, it's probably time to take some risk off the table. My suggestion is that you consider selling half of your position, and holding the rest. This locks in a solid 100% gain on your risk capital.

If you weren't a participant as cotton prices doubled in the last six months (resulting in one of the ETNs we recommended turning in gains of more than 120% since our market call - or nearly 50% year to date), there is currently no fundamental reason to believe that cotton will pull back to the "breakout" price. You could use the current weakness to establish a position that's half the size of the total investment that you'd like to have in cotton.

To do this, buy the iPath Dow Jones-AIG Cotton Total Return Sub-Index ETN (NYSE: BAL).

This ETN is based on the total-return sub-index for cotton - 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 Wednesday's closing price of $106.29, the ENT was up 123% from its closing price of $47.70 on Sept. 23 (the price we used when we made our call). It's trading right at the top of its 52-week trading range - which means it is well above its 52-week low of $35.64.

The ETN is already up 46% year-to-date. And it will most likely be higher by the end of the year. In fact, the odds of it being even higher at the end of 2011 dwarfs the odds that it will be back at its nadir, for there's very little chance that cotton will drop back to its breakout price.

Inflation is real. And as long as the U.S. Federal Reserve is going to export inflation, you can expect the price of such commodities as cotton to head in only one direction - up.

[Editor's Note: Columnist Jack Barnes - who also writes Money Morning's popular "Buy, Sell or Hold" column - started his career at Franklin Templeton in 1997. He started out in the company's fund-information department - just as the Asian contagion infected the Asian tiger countries. Barnes launched his own shop, RIA, in 2003, just as the second Gulf War was breaking out. In early 2006, after logging a one-year return of nearly 83%, Forbes named Barnes the top stock picker in its "Armchair Investors Who Beat the Pros" competition. His two audited hedge funds generated double-digit returns in 2008. Barnes - the author of the popular blog, "Confessions of a Macro Contrarian" - retired to the beach in the summer of 2009, and continues to write from there now. His "Buy, Sell or Hold" column appears in Money Morning on Monday.]

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