It wasn't too many years ago that when farmers finished harvesting they began watching New York futures to determine the best time to “fix” their price either by selling cotton on the spot market or with futures in a marketing pool.
These days, growers still watch the futures market but not with the intensity that they look at another number — the marketing loan gain value or loan deficiency payment rate announced each Thursday by USDA's Farm Service Agency.
“Two questions I'm often asked are: “How can we predict the level of loan deficiency payment (LDP) rates?” and “When will the LDP rates be the highest?” says Charles Curtis, professor and Extension economist in the Department of Agricultural & Applied Economics at Clemson University.
“In other words, they want to know if they should take the LDP or producer option or POP payment now or wait until later,” he said. “Many growers remember that the LDP shrank to almost zero at harvest last year and then began to increase early in 2001.”
With New York December cotton futures trading at 36 cents a pound when he spoke at the Southern Regional Outlook Conference in Atlanta recently, Curtis said there is little doubt that farmers again will be trying to maximize their LDPs. (Since then, December has fallen to 29 cents per pound and the LDP has risen to nearly 30 cents.)
And while recent history indicates farmers should wait until the dust settles from harvest before taking an LDP, Clemson economists have developed tools that could provide guidance for making such decisions.
To help South Carolina producers address this issue, Clemson economists began keeping records of loan deficiency payment rates in 1999. Those figures are available at http://cherokee.agecon.clemson.edu/ldp_page.htm.
Using those numbers, Clemson researchers developed a table that shows the monthly average basis of USDA's adjusted world price (AWP) in relation to the nearby New York cotton futures contract. “This table allows a prediction of the AWP, which can then be compared to the CCC base loan rate of 51.92 cents per pound to calculate a predicted LDP,” Curtis notes.
Based on data from the years 1998 through 2001, the table shows a January basis relative to March 2002 futures of 16.7. With March futures at 30.57 cents per pound (on Oct. 30), the predicted AWP would be 13.87. Subtracting the predicted AWP from the 51.92-cent loan rate yields a January 2002 LDP prediction of 38.05.
(Curtis noted that research is under way to explore the relationship of the adjusted world price as the value of the dollar changes relative to other important currencies such as the Euro.)
That's about eight cents per pound higher than the Oct. 26 LDP rate of 29.87 cents per pound. (Curtis notes that the basis information in the table should be used with a degree of caution because of the relatively short period of experience with LDPs.)
What if, on the other hand, March futures do an about face and move back to the range of 40 cents per pound?
If the basis relationships of the last three years hold true, the predicted AWP would rise to around 24 cents per pound and the LDP, as a result, would fall back to 27.9 cents per pound.
“According to our long-term price charts, futures do tend to rise in winter and early spring,” says Curtis. “If that is the case, it would indicate that loan deficiency payments would be lower in the spring.”
Looking at the current market-based probabilities of prices out to next June, the prospects of prices recovering such that there is no LDP by the end of next spring “are effectively nil,” he said. “However, a price recovering to a level so that a 42-cent July 2002 call option would move in the money is near 45 percent.”
Thus, growers who are concerned that the market could follow historical trends, rebound and reduce the LDP — or who need cash to pay debts this fall — might consider taking the LDP now, selling their crop and buying a call option. The call option at 200 to 300 points is a cheaper, less risky means of speculating on future prices increases, Curtis notes.
“One strategy would be to accept the harvest market value (26.44 cents in the cash market — 28.94 December futures on Oct. 30 less the 250-point southeast basis — and the 29.87 Oct. 26 LDP rate) and reinvest 200 to 250 points into the July 02 call,” says Curtis. “With a 45 percent plus probability of gain on the option, there's a good chance of adding to the 56.31 cents that would be received for the 2001 crop.”
For now, the market is giving cotton producers little to cheer about from the futures standpoint. As the U.S. crop size has continued to climb past 20 million bales and economic conditions have continued to deteriorate, New York cotton futures have dropped to their lowest levels in more than 25 years.
When Curtis spoke in Atlanta in late September, USDA was estimating U.S. production at just under 20 million bales. The Oct. 20 crop production report raised the projection to 20.07 million bales, the largest crop in modern history. Adding the estimated carry-in of 6.03 million bales would make the 2001-02 crop supplies the largest on record.
Contributing to the market's woes is USDA's projection of 8.3 million bales of mill use in the 2001-2002 marketing year (Aug. 1-July 31).
“This is well below the average for the 1990s and is much smaller than we'd grown accustomed to in the mid-nineties,” says Curtis. “This is assumed to reflect three factors including flat product demand, a strong U.S. dollar and little incentive to buy in a falling market.”
With numerous plant closings and layoffs, the U.S. textile industry appears to be in disarray, Curtis notes. “One could expect to see the more labor-intensive activities in the textile manufacturing process to continue its move to cheaper labor markets such as Mexico. Hopefully, these overseas mills will continue to value U.S. cotton and be a source of export demand.”
Exports are projected to be substantially higher at nine million bales than what has been the average for the 1990s or about 6.8 million bales, he said. “The current forecast reflects tighter global stocks and increased consumption. Projected export market strength has been attributed to reduced price supports and a dramatic drawdown of Chinese cotton stocks and reduced southern hemisphere production.”
With the dramatic increase in production, USDA forecasts U.S. ending stocks to reach 8.7 million bales, a huge jump from the 1990s average of 3.85 million bales. The higher carryover number will send the 2001-2002 stocks-to-use ratio to 50 percent, compared to the 30 percent target in the cotton industry's farm policy objectives.
Curtis says LDPs help explain what some are calling the enigma of the cotton market; that is, why growers continue to expand cotton acres when prices have almost been in a free-fall since early this year.
“If you take the cash price of 32.50 cents (based on the 35-cent December futures price on Sept. 21) and add a 30-cent LDP to it, the grower receives 62.50 cents for his cotton in 2001,” he noted. “That's why cotton is king again in so many of our states.”
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