Demand Fundamentals

1
Demand Fundamentals

• The Demand picture used to be a lot more stable
  with a mainly domestic market
• Now the vast majority of U.S. cotton is exported,
  implying a lot more uncertainty
• Foreign supplies?
• Transportation issues and costs
• Exchange rates (weaker dollar stimulates
  exports)
• Trade agreements, treaties, internatl
  relations, etc.
• Demand forces tend to weigh more heavily on the
  old crop (storage month) futures contracts (e.g.,
  March, May, and July). See 2007/08 example in
  the following slides.

2
The Supply Question is usually a settled matter
after the New Year. In the case of 2007/08,
there is a very healthy supply of cotton to
digest.
3
Main driver of old crop values (e.g., Mar08
through July08 futures) is expectations about
whether well reach USDAs forecast of 15.7
million bales of U.S. exports. We are currently
not on pace to reach that target.
4
U.S. Exports of All Cotton
Average needed rest of year
Average needed all year
We currently need to be exporting an average of
335,000 bales per week (the green line). Actual
weekly exports (red line) are sub-par.
5
March 08 Futures Price Chart
6
2007/08 Outlook Summary

• Longer term, supply/demand rationale for Mar08
  futures to be in mid 60s
• 66 to 67 cent level on Mar08 may be supported by
  Far East mill demand
• Mar08 may see resistance above in 70 to 72 cent
  range as growers, co-ops, and merchants hedge
  their inventory
• Higher futures prices and stagnant demand may
  stimulate futures deliveries (weaken prices
  next slide)

7
Side Note on Certificated Stock

• Certificated stocks refer to the total amount of
  bales (of old crop inventory already in merchant
  hands) that merchants officially certify as
  eligible for delivery against futures contracts
• Certificated stocks must be in warehouses at
  delivery points
• When futures prices are high and export demand is
  lagging, sophisticated merchants with short
  futures positions can make more money by
  delivering this cotton against those short
  futures contracts
• This has occurred repeatedly in recent years with
  certificated stocks building to levels exceeding
  500,000 bales, which we just reached this week.
• The potential for large deliveries acts as a
  bearish force since it implies a lack of
  (off-setting) futures purchases
• It also may scare away potential long specs

8
Supply Fundamentals

• Typically affects the harvest time futures
  contracts more (e.g., October and December)
• Planted acres depend on economics of cotton v.
  competing crops (influenced by farm programs)
• Yield, Harvested Acres, and Production depend on
  weather and technology
• There are a LOT of variables involved

9
U.S. Cotton Acreage Map
10
U.S. Upland Cotton Planted Acreage by Region,
1984 - 2007
11
U.S. Upland Cotton Plantings by Region, 1984 -
2007

• Upland cotton planted area in the United States
  has been on a slowly rising trend since the late
  1960s.
• Prior to 1996, planted acreage was strongly
  influenced by farm programs
• There has been lots of regional fluctuation
• Through the mid-1970s, cotton moved westward as
  Delta/Southeast production costs rose
  significantly from pest management problems.
• By the 1990s, though, water concerns in the West
  and the successful boll weevil eradication
  program in the Southeast saw cotton returning
  eastward.
• Now with widespread BWE and new varieties, cotton
  productivity is higher than ever. Recent years
  have seen large shifts to grains/oilseeds,
  especially in the Delta and Southeast, due to
  market forces. California and Arizona acreage is
  declining due to urbanization and alternative
  crops (orchards).

12
U.S. Upland Cotton Plantings by Region, 1984 -
2007

• Over the past several years, upland cotton area
  has been about equally divided between the
  eastern half (Southeast and Delta regions) and
  the western half (Southwest and West regions) of
  the Belt.
• Planting flexibility under the 1996 and 2002 Farm
  Acts has facilitated some fluctuation in upland
  cotton area as producers respond to market
  signals and expected net returns.
• During the years covered by those acts
  (1996-current), upland cotton area has ranged
  between 13.1 and 15.5 million acres, with the
  last 3 years.
• This year may see more planted acres in Texas
  relative to other states.

13
Texas Cotton Acreage Map, 2006
Upland Cotton Acres Planted - 2006
1 dot 1,000 acres Dots
indicate acreage without respect to geographic
location within the county.
Note 2007 plantings were 23 less!
14
U.S. Upland Cotton Production by Region, 1984 -
2007
15
U.S. Upland Cotton Production by Region, 1984 -
2007

• Production has stronger upward trend. Upland
  cotton production, like planted acres, has seen
  an upward movement over the past 20 years, but
  the production trend has been more pronounced.
• U.S. production gains during the previous two
  decades have paralleled advances in technology
  (seed varieties, fertilizers, pesticides, and
  machinery) and in production practices (reduced
  tillage, irrigation, crop rotations, and pest
  management systems).
• Three out of the last five years have seen record
  yields.

16
Average All U.S. Cotton Planted, Harvested
Acreage, Yield Per Acre and Production
Wasde 1/11/08
17
Supply/Demand of Competing Crops

• Corn competes directly with cotton on lighter
  soils in the Deep South
• Soybeans are also a ready substitute, and require
  little fertilizer
• Soybeans and wheat are common on heavier soils

18
Farmers Planting Incentives based on USDA
Cost/Return Projections
Cotton price increases have not kept pace with
soy/corn/wheat. Rising operating costs have also
impacted relative cotton profitability.
19
2008 Acreage Question

• Economics strongly favor corn, sorghum, soybeans,
  and wheat vs. cotton in many regions
• Individual farms may differ, e.g., those with
  large fixed assets or integration, e.g.,
  harvesters, gins, warehouses, oil mills, etc.
• Other constraints on southern grain production
  include availability of seed, storage, local
  markets, and grower familiarity

20
Background Reduced U.S. Cotton Plantings in
2007 Economic Response to High Grain Prices
Southeast 2.255 million -32.75 Mid-South
2.750 million -35.06 Southwest 5.122
million -25.06 Texas 4.900
million -23.44 West 0.411 million -21.71 All
U.S. Cotton 10.830 million -29.10
21
2008 Considerations
22
2008 Considerations

• Economics favor wheat, soybeans and feed grains
  over cotton in many regions of the U.S. and the
  world in 2008. This includes a lot of
  sorghum/corn in South Texas Gulf Coast, and
  wheat/sorghum in Rolling Plains.

23
Continued Dryness
24
Lower 2008 Ending Stocks
Planted Acreage Texas will probably be same or
higher. But expect another major cut in the
Delta. Southeast and Far West will probably also
be a little lower.
25
Lower 2008 Ending Stocks
26
Lower 2008 Ending Stocks
Oct08 and Dec08 futures prices will be largely
shaped by supply-focused things like acres,
weather, and yield. Major benchmarks
are February 22 first USDA guesstimate Mar.
31 June 30 USDA acreage reports Mid-August
1st USDA monthly supply report
27
Lower 2008 Ending Stocks
Ending stocks this low will support cotton
futures in the 70 to low 80 cent range.
28
Dec. 2008 Futures vs. Average Dec. Futures for
Smaller Carryover Years
Envision volatile prices during the planting and
growing season, with a possible spike up into the
mid-80s. Then a likely leveling off of the
trend, in keeping with the seasonal pattern (blue
line below)
Dec08 Futures
Average Prices for Smaller Carryover Years (89,
90, 93, 94, 02, 03)
29
Growing U.S. Cotton Stocks/Use Usually Implies
U.S. Lower Prices
U.S. Stocks-to-Use Percentage (Purple Bars) and
Nearby Futures (Blue Line)
38 stks/use level
January 11, 2008 WASDE report
30
Same Relationship between U.S. Cotton Stocks/Use
Ratio W. TX Price
W. Texas Price, (cents per lb.)
Stocks/Use ()
1980/81 2007/08
31
So Will Dec08 Follow The Seasonal Pattern?
Dec08 Futures
Average Prices for Smaller Carryover Years (89,
90, 93, 94, 02, 03)
32
2008 and 2009

• We expect lower ending stocks in 2008/09
• Ordinarily, the resulting high prices lead to
  more acres, more production, and then several
  years of lower prices
• What may prevent that this time around is
  continuing high grain and oilseed prices What
  is going to give acres back to cotton in 2009?
• This is leading to forecasts of continued high
  prices for 2009 futures (0.90)
• Caution while this is a reasonable expectation,
  supplies and prices of all these crops will
  eventually adjust (i.e., higher supplies and
  lower prices)

33
World Cotton Fundamentals

• Most of the supply and demand factors that we
  have considered for the U.S. have their
  international counterpart
• Important to understand the Foreign and World
  picture in order to predict U.S. exports (and
  hence, U.S. price outlook)
• Also important to know outlook for world cotton
  prices to predict loan deficiency payments

34
World Patterns in Cotton Production/Use

• For hundreds of years, importing countries have
  accounted for much of the world's cotton spinning
  (e.g., England). As late as 1979, the imported
  share of the world's cotton spinning reached 46
  percent.
• Later, spinning shifted to countries that grow
  rather than import cotton, and only 28 percent of
  global cotton spinning used imported cotton in
  1998.
• More recently, major cotton growers, like China,
  have also become significant importers, raising
  the imported share of consumption once again.

35
World Patterns in Cotton Production/Use

• While many factors play a role in determining
  the location of cotton production, cotton's long
  growing season and need for adequate water and
  sunshine limit the ability of many countries to
  produce.
• Therefore, although the world's four largest
  consuming countriesChina, India, Pakistan, and
  the United Statesare also the largest producing
  countries
• Many important cotton consumers, such as
  Indonesia, Mexico, and Thailand, produce almost
  no cotton at all. As a result, a much larger
  share of the world's cotton is traded between
  countries than is the case for grain.

36
World Cotton Production 2007/08
Estimated Production 118.25 million bales
37
Cotton Production for Major Foreign Producers,
2007/08
38
Cotton Yield for Major Foreign Producers, 2007/08
39
Cotton Harvested Acres for Major Foreign
Producers, 2007/08
40
Cotton Production, Yield Harvested Acres for
Major Cotton Producers, 2007/08
41
Chinese Cotton Belt
42
West African Cotton Belt
43
Indian Subcontinent
44
Trends in World Cotton Production
Irrigated production expanded in China,
Australia, Turkey, and to a lesser extent Syria
expanded irrigated acreage for cotton during the
1990s. Turkey's expansion was part of an ongoing
expansion likely to continue, while a slowdown in
the other countries may reflect economic or
natural constraints on expansion. Central Asia's
irrigated cotton area contracted significantly,
and is unlikely to rebound. Dryland cotton
area has expanded in India, West Africa's Franc
Zone, Eastern China, and Brazil. For China and
Brazil, this represented a rebound in area back
to levels of the mid-1990s however, new
technology has meant substantially higher yields
and production. India's yields have grown less,
and West Africa's average yields actually
declined. In 2004/05, Eastern China's planted
area was significantly below previous highs,
while West Africa and Brazil have prospects for
adding new area in the future. The adoption of
insect-resistant cotton varieties containing
Bacillus thuringiensis (Bt) has begun in India
and may have been an important factor in recent
improvements in that country's traditionally
lagging yields. Brazil's yields are currently
extremely high and future trends there will
depend on developments in insecticide resistance
in Brazil's new tropical production zone.
45
Another Point Prices have to Drop lt50 Cents to
Affect Foreign Acreage
Harvested Acres
A Index
46
Trends in World Cotton Demand
Incomes, household preferences, and policy
drive cotton consumption. Economic growth
primarily determines demand for cotton products
(more people with more income equals more
clothes). After stagnating in the early 1990s,
world demand for cotton resumed its long-run
growth in recent years. Since 1995, total world
demand for cotton has grown 2.1 per year. World
cotton use is expected to grow about 1.5
annually as economic growth in Asia slows,
converging on the global average. Since 2000,
developing Asian countries have replaced North
America as the main source of global consumption
gains in cotton products, and the trend is likely
to hold through 2014.
47
Cotton World Production and Consumption, August
1986 January 2008
Consumption
Production
48
Trends in World Cotton Trade
World trade will expand a little more slowly
than the 1.5 growth in world demand, but trade
will still be sufficiently strong to sustain U.S.
exports and the U.S. share of global trade.
However, the United States is likely to face
continued competition from Brazil, Australia and
West Africa in the coming years. Australia's
2001-03 drought highlighted the dependence of
cotton producers on weather. Australia's ability
to produce even irrigated cotton will continue to
depend on El Nino oscillations, and West Africa's
output will depend on the longer cycles that have
included sustained precipitation since the
beginning of the 1990s. Central Asia is unlikely
to return to its former status as the leading
U.S. competitor in cotton trade due to reduced
irrigation capacity that limits production and
increased domestic production of textiles that
keeps more cotton in the region.
49
Trends in World Cotton Trade
China and India are expected to continue
importing rather than exporting. The impact of
Bt cotton on India's output is a significant
uncertainty over the next decade, and some
industry analysts even suggest that India could
return to a net export position. China's
cotton area in the past has been substantially
higher than foreseen in the baseline, which
highlights the significance of uncertainty about
the outlook for China's cotton area. With the
adoption of Bt cotton, China may not need to
import cotton if area returned to its previous
highs.
50
Emerging Issue Potential for Increased Foreign
Productivity Cotton Yields
China
U.S.
World
Brazil
1970/71 2007/08
51
EXAMPLE
The current world forecast
gives a bottom line
picture
of weak to level prices
52
Cotton A Index and World Stocks/Use, August
1999 January 2008
A Index
Stks/Use
A weak to level price forecast from a very high
level suggests only small chance of trading below
the mid-60 cent range in the A-Index.
53
This Suggests Negligible to Zero LDP
A Index of World Prices (as of 1/25/08)
74.74 Adjustment to US location and grade
-16.52 Adjusted World Price (AWP)
58.22 Loan Deficiency Payment
(Loan-AWP) 0.00
54
Cotton A Index vs. China Ending Stocks-to-Use
Other Foreign (sans China) Ending Stocks-to-Use
A Index
China Stks/Use
All Other Foreign Stks/Use
55
World Price Outlook

• No broad fundamental reason for a substantial
  increase in A-Index before 2006/07
• Big caveat is how much more China might need to
  import (somewhere between 17 and 20 million
  bales)
• Implies world supply is a function of (very
  uncertain) yields in India/Pakistan, China, and
  other exporting countries

56
Again Why Do We Have To Focus on All This
Foreign World Outlook?

• U.S. cotton prices reflect U.S. supply/demand,
  but EXPORTS is a big variable there.
• Foreign trade is a lot more important in cotton
  than other crops.
• Knowing world price outlook is important because
  U.S. cotton program payments (the LDP) is
  determined based on world prices.

57
Speculative Forces

• Index Funds buy/hold cotton futures as an
  undervalued commodity in overheated world economy
• Hedge Funds follow trends up or down using
  charts, technicals, etc.
• When both Index and Hedge funds are buying, it
  can raise cotton futures five cents, regardless
  of near-term supply and demand outlook

58
Why Have Funds Gotten Into Commodities?
59
(No Transcript)
60
Attractive Positive Returns
61
Example of One Index Funds Holdings

• PIMCO
• Over 12 billion in assets in 2006
• Tracks Dow Jones AIG Commodity Total Return Index
• Unequal commodity weights
• Ag, metal, and energy commodities
• PIMCO investments implied by DJ-AIG index weights
  ( million)
• live cattle 754
• lean hogs 539
• corn 727
• soybeans 962
• soybean oil 343
• cotton 391

62
Fund Influences Besides Volatility

• Another way that the Funds influence the futures
  market is near contract expiration
• These funds typically roll their positions
  forward from the expiring contract to the next
  contract
• The size of these rolls creates an entirely new
  price dynamic (focused on the spread, not the
  contract price itself)
• This is currently happening now (rolling massive
  long positions from March to May)

63
Influence of Speculative Traders on Short-Run
Price Trends
Weekly Average Nearby Futures Price, March 26,
2004 January 18, 2008
These levels reflect 6 million bales worth of
cotton futures contracts held by just the Hedge
Funds!!!
64
Marketing Plan Thoughts

• Nobody ultimately knows whether prices will trend
  up or down
• Marketing plan a contingency plan to take actions
  as things develop
• Options strategies allow for the most flexibility
  with an ultimately uncertain future

65
Underlying Premise of Hedging

• While we can apply the most current information
  and analysis, we can ultimately never be certain
  of the outcome.
• A marketing plan should therefore protect from
  bad (downside) price risk while allowing for
  possibility of good (upside) risk.
• Example 1 buy a put option at planting
• Example 2 fix cash price and buy a call option
• Either way, you set a floor while allowing for
  upward potential
• What are different ways to fix cash price in
  Example 2?

66
Different Ways to Fix Your Cash Price

• Forward Contract (advantages v.
  disadvantages)
• Marketing Pool (advantages
  v. disadvantages)
• Post-Harvest Contract (advantages v.
  disadvantages)
• The CCC Loan (advantages
  v. disadvantages)

67
Cheapening Up Basic Strategies

• Your basic flexible strategy will have a core
  option position a LONG option position
• Example 1 buy a put option at planting
• Example 2 fix cash price and buy a call option
• In some years (e.g., 2005 2006) the market is
  trading lower such that youd have to buy an
  expensive in-the-money put to get a relevant
  floor price
• In other years (like NOW), time value or
  volatility will make your core options very
  expensive
• You can cheapen up your basic core positions by
  SELLING out of the money options
• Sell an out-of-the-money call (fence) against
  your core position
• Sell an out-of-the-money put (?) against your
  core position
• Do both a) and b) against your core position
  (three way)

68
Cheapening Up Basic Strategies

• For example, if you think the market risk is to
  the upside
• Fix your cash position
• Buy a call option (as of Monday, a Dec08 80 cent
  Call was 4.41 cents)
• Assuming Dec08 wont trade below 0.67, sell a 66
  Put for 1.87 cents. This money is received into
  your brokerage account. It effectively reduced
  your core position to 2.54 (4.41-1.87).
  However, this requires an initial margin of
  roughly 2,000. Further, your brokerage account
  will rack up additional losses (requiring more
  margin) if futures fall (and the cost of buying
  back that put rises and rises). Eventually, if
  futures expire above 66 cents and the put isnt
  exercised, the money is yours.
• Alternatively (or in addition) if you thought
  Dec08 wouldnt go above 1.00, you could sell a
  100 Call for 0.89 cents. Same margin and risks
  apply. This could cheapen up your core position
  or further cheapen your fence strategy in 3)
  above. Doing both 3) and 4) would be a bullish
  three way spread in trader lingo.
• There are obviously risks to taking marginable
  positions.

69
Putting It All Together

• Write down an outline of a contingency plan for
  2008.
• What production cost/lb do you need to cover?
• What are your information resources?
• What pricing strategies?
• At what time of the year?
• In response to what target prices, market
  conditions, or other indicators?
• What net price floors are you penciling out?

70
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