The futures curve can often paint a confusing picture of market expectations and supply and demand in the spot market. For those not actively involved with the flow of information in the spot market, the picture can seem even further confusing. Take a look at the current cotton futures curve, for instance.
The first obvious point to note is that the curve is in backwardation. From our finance 101 classes, we know that there can be several possible reasons for such a term structure:
- Imbalances or disruptions in the spot market supply/demand vs future supply/demand
- Market expectations for a decline in prices in the future
- Impact from storage costs and cost of carry
We also know that for a market in backwardation, an easy arbitrage is possible if you can borrow the asset today, sell it, and buy futures in order to lock in the gain. So what does it tell us if this pattern persists? Clearly, nobody is able to borrow this asset, otherwise this pattern would reverse. What causes this situation is the notion of convenience yield. Holders of the commodity are unwilling to lend the commodity for short sellers, or unwilling to offload their own positions, in order to lock in a profit. This is because the benefits, or perceived benefits, to the inventory holders is worth more to them than the potential profit to be had. In such a situation, we can expect the futures curve to remain in backwardation until the spot market supply and demand normalizes.
As a final mention, if the market is in backwardation, we would expect for inventories to decline as those who are willing to lend or sell today do so. Indeed, on February 1st, the International Cotton Advisory Committee did confirm that cotton inventories have fallen 5% year on year.
Don’t expect any big moves until we get a clearer picture of the 2017/2018 crop estimates!