🧵 Your Guide To Investing In Cotton. From Textiles, To Soaps, To Bank Notes, Cotton Is More Versatile Than You Think

Brief Background

Cotton, as we all know, is widely used in the textiles industry to create all sorts of clothing & household items. However, it’s not just the cotton fibre itself that gets used. After you take out the fibres, you’re left with cottonseeds, which also has a variety of uses that go beyond textiles & clothes. Fun fact: cotton & crude oil price movements are related. We’ll explain why shortly, but first…

What Can It Do For You

🧺 Portfolio Diversification. As always, adding commodities to your portfolio can help diversify and lower risk. Adding cotton to your portfolio means owning an asset that tends to act differently to other asset classes, and even to other commodities. Furthermore, cotton can act as a hedge against inflation & a weak US dollar. This is because although we can grow more cotton, there will always be a finite supply of cotton in the market at any given point, which makes it more likely to retain its value during times of inflation.

💰 Profit. From the price chart below, cotton prices can certainly undergo periods of volatility and has a somewhat cyclical pattern to them. Because of this, there are opportunities for speculation & profit. Furthermore, there is a link between cotton and crude oil prices. A lot of machinery is used in the cotton production process, and cotton’s substitute competitor, polyester, is made from crude oil. Under normal market conditions, crude oil prices could act as a guide as it can have an affect on cotton production & therefore its price. So, rising crude oil prices could indicate a rise in cotton prices.

Price chart for the cotton futures contract over the years
Price chart of crude oil (orange) & cotton (blue) futures contracts over the years. Notice how price movements are similar.

What Affects Cotton Prices

There are several key factors that are involved in moving the price of cotton:

  • 🇮🇳🇨🇳(🇺🇸🇧🇷) India, China & US/Brazil Production. India & Chian accounts for a whopping ~50% of the world’s supply. Add the US & Brazil to the list and they produce a combined ~75%. Any major events that can affect production in these countries will certainly affect prices.
  • 🌍 Global Demand. Cotton is used to make products we don’t necessarily need. When the global economy is strong, consumers have more purchasing power to then spend on goods, which could drive up cotton demand. On the other hand, when the global economy is weak, consumers may have less purchasing power, which could dent demand.
  • 🏛️Government Policy. Similar to other agricultural commodities, cotton subsidies have been introduced to incentivise farmers to produce more cotton. However, this basically creates artificially high levels of supply, which keeps prices low. Any changes is US subsidies could have an impact on cotton prices.
  • 📈 (Chinese) Stock Levels. As with a lot of other commodities, inventory levels can be indicative of supply & demand levels. What’s unusual about cotton is that between 2011 & 2013, China implemented a cotton stockpiling program to make sure they have enough cotton & to support local farmers by artificially increasing its price, and essentially imported a lot of cotton. A lot. At its peak, China held about ~60% of the world’s cotton stockpiles. The stockpiling demand became one of the factors that led to the 2010/2011 price spike. However, any attempts at selling the cotton stockpile could certainly push down prices as more supply enter the market.
  • ☀️ Weather. Like all the other agricultural commodities, ideal weather conditions are needed for cotton crops to grow. Poor weather conditions in India &/or China could lead to decreased production & therefore supply constraints, resulting in increased prices.
  • 🔄 Substitution. Substitution also affects cotton. Synthetic fibres like polyester & alternative natural fibres like wool can certainly impact demand. China is a big producer of a crude oil-based PTA, or purified terephthalic acid, the raw material for polyester. The price of PTA (along with other alternatives) can certainly impact cotton prices as textile manufacturers choose between them.
  • 🛢️ Oil Prices. You’d be surprised to know that there’s a link between cotton & crude oil prices. Cotton is actually pretty expensive to produce because of all the machinery & vehicles needed to harvest the crop. Yes, machinery & vehicles are also used for other agricultural commodities too, but cotton has the highest energy costs compared to all the others. This means that crude oil prices can certainly affect production & supply. In addition, PTA (as mentioned above) is made from oil, so cotton’s competitor is also affected by crude oil prices.
  • 💵 US Dollar Strength. Like a lot other commodities, the benchmark for the pricing of cotton is in US dollars. A weak dollar compared to other currencies (i.e. need more USD to buy other currencies) may incentivise foreign buyers to buy (since their currencies are worth more in dollars & so can buy more cotton) & drive up demand, increasing prices, and vice versa.

🚀 What Happened During That 2010/2011 Price Spike?

Basically, it’s a mix of different factors that happened at the right time, which triggered the domino effect of panic buying that led to the massive price spike as shown in the price chart above. Flooding & bad weather from major cotton producing countries at the time, in Australia, Pakistan & China, basically hurt & caused delays to supply in the market, which caused a lot of uncertainty. Roughly around the same time, China implemented their cotton stockpiling program to support local farmers by artificially increasing its price by paying premium prices for local cotton as well as importing a lot of cotton. A lot. Then, there was a lot of panic buying by speculators, textile mills & cotton consumers which really drove it up. The result: prices going up almost 200% in a matter of months.

Chinese cotton imports in 2011/2012 rose dramatically as they implemented their cotton stockpiling program. This perceived soaring demand contributed to the panic buying that led to the price spike.
Chinese cotton stock levels grew dramatically over the years. At its peak in 2013/14, holding 62,707,000 bales of cotton, accounting for about ~60% of global cotton stockpiles.

What Is It Used For?

Cotton is actually a pretty versatile commodity. Did you know that cotton is both a fibre AND a food crop? Here are the products & byproducts of the cotton plant, and their use cases:

  • 👕 Cotton Fibre. This is the white fibre you think of when you imagine cotton. It’s used mainly in the textiles industry, but can also be used in a number of other products too, like coffee filters, fishnets, book bindings & papers.
  • 💵 Cotton Linters. Once most of the cotton fibre is removed, linters are the residual fibres left on the seed. Yup, cotton has seeds, just like any other plant. They’re used in products like stamps, bank notes, and also in the pharmaceutical & chemical industry.
  • 🐄 Cottonseed Hulls. The outer layer of the cottonseed, or the cottonseed hull, is removed and is pretty much used to feed livestock.
  • 🧼 Cottonseed OIl. Once the hull is removed, the oil can be extracted from the seed kernel. Like a lot of plant-based oils, cottonseed oil can be used as a cooking oil. It’s also found in a number of other products, like soap, margarine, cosmetics, and even in pharmaceuticals, rubber & plastics.

The Case Against Cotton

There are a number of risks involved when trading or investing in cotton. As previous mentioned, China has a massive stockpile of cotton due to their earlier stockpiling program aimed at supporting local cotton farmers. Though they’ve ended that program & switched to providing subsidies, they still hold more than a third of the world’s cotton reserves, according to the most recent report by the USDA. If they were to start selling this stockpile, it could lead to oversupply in the market, putting downward pressure on prices. In addition, falling prices or increased production in cotton’s substitute competitors like wool or polyester could certainly take away cotton’s market share. This is worth monitoring as China is building new chemical manufacturing facilities used to make polyester, increasing supply in the market & potentially making it cheaper, which could be further incentive for mills to switch away from cotton. Furthermore, increased subsidies in many countries could distort the market with artificially high supply in the market, which could push down prices.

The Case For Cotton

Cotton is still a commodity and can help diversify one’s portfolio & as protection against inflation. Although China still has quite a large stockpile, it is slowly going down. As China’s economy recovers and grows, consumer demand for cotton clothing & products could certainly pick up & increase as well. China isn’t producing enough cotton to meet its own domestic demand. Eventually, this stockpile will diminish to a point where the government will have to consider policies that will replenish cotton reserves, possibly through the continuation of the stockpiling program. Alternatively, they could increase subsidies for cotton, but that would take away from other crops that could have been planted instead, an especially important point as there will be increasing demand for food crops as the population increases. Furthermore, as previously mentioned, cotton is linked to crude oil prices. Higher energy demands from an increasing population could lead to higher oil prices. Cotton could benefit should oil prices rise.

Popular Ways To Invest In Cotton — Pros/Cons of Each

Like some of the other agricultural commodities, you can’t really invest in physical cotton. Here are some of the more popular ways instead. If you’re still confused about how any of these work, refer back to our basics newsletter for a refresher.

  • Cotton ETNs. You’re pretty limited here, but there is an ETN that invests in continuously rolling cotton futures contracts. Because of this, on occasion, there may be times when the actual price of cotton & the price of the ETN may differ since they invest in futures contracts, a derivative investment. Regardless, they’re traded on stock exchanges, so they’re pretty easy to buy and sell. Depending on which broker you go with, you may be charged with trading commissions. ETNs also charge an expense ratio, or management fee that gets taken out of their total holdings and is then reflected on your account. Just be aware that since it’s an ETN, you are essentially buying a bond, an IOU, a debt note, and not in actual, physical cotton. Be sure to read the fine print & understand the risks and costs involved.
  • Cotton Stocks. Similar to a number of other agricultural commodities, unfortunately, there are no public companies that solely focus on producing cotton, but there are large public companies that provide general agricultural products to cotton farmers & producers, including the seeds. Because of this, you aren’t directly following cotton prices since there are other factors at play. As always, you may want to consider looking at the company’s annual reports (especially operational costs), portfolio of what products & assets they have, what research & development they’re currently conducting, and potential product-line expansion plans.
  • Cotton Futures Contracts. A binding agreement traded on futures exchanges between two parties where they agree to buy/sell cotton at a specified time in the future with an agreed-upon price. A standard contract deals with 50,000 pounds of cotton! These futures contracts are settled physical delivery after the contracts have expired. Because you are using a significant amount of borrowed money, even small price changes in cotton can either lead to massive profit, or massive losses beyond what you paid for, potentially leaving you in massive debt. They are certainly high-risk and not recommended for beginners. Further, fees associated with futures trading include broker commissions, and exchange/clearing fees.

TL;DR — Is It The Right Investment For You?

As always, it depends on what your aims are. As an agricultural commodity with a variety of use cases, cotton can be used as a hedge against inflation & for portfolio diversification. In terms of the long-term outlook, China’s stockpile is the elephant in the room, so to speak. It’s unlikely that they would dump it on the market as they’re currently consuming more than they produce, & it could act as a buffer against higher cotton prices, supply local mills with the stockpiled cotton. However, increasing subsidies to cotton farmers & production of chemical compounds used to make polyester can certainly have an impact in the future, which could lead to an oversupply of cotton & polyester in the market. That being said, there are other factors that need to be taken into account, including crude oil prices & China’s stance towards environmental standards. In 2018, China has shut down roughly 40% of its manufacturing sector, including polyester plants, that haven’t abided by regulations set by a pollution reduction program, which lead to disruption in polyester production. If they were to take a more aggressive stance in raising environmental standards, the government may favour cotton over polyester.

🧺 If you are considering adding cotton to your existing portfolio or bundling it with a number of others, you may want to consider doing dollar-cost averaging (regular investments over time) to build your cotton position so you can take advantage of any volatility in the market.

💰 If you are considering adding cotton for speculation and profit, you may want to monitor the factors that affect cotton prices mentioned above. You may also want to keep track of monthly reports of world production, consumption & stock levels released by the USDA, so you can keep track of supply & demand. In addition to monitoring the factors mentioned above, you may also want to consider performing some technical analysis on cotton’s price chart to help consolidate trends and patterns to help with your decision. That being said, its prices can also swing unexpectedly, so be prepared and have an exit plan in place.

As always, if you are unsure, check in with a professional financial advisor before making any moves.

Thank you for reading! Let us know if you found this helpful. You can connect with us @VNewsletters, or check out our website for more information @ vaultcomms.com.

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