Sterling Terrell

smart ideas from books (mostly)

The Problem with Asking: “Do You Think Prices are Going Up or Down?”

The Problem with Asking: “Do You Think Prices are Going Up or Down?”
I began in the world of commodities selling physical cotton.This soon led to hedging with futures and options and then into the occasional trading of physical cotton.

Now I trade futures contracts for profit.

The most common question I have gotten in the commodity business is the obvious:  “What do you think prices are going to do.”

I understand the sentiment behind the question from producers, consumers, and even from traders looking to make a profit.

However, when someone with a financial interest in the answer asks what prices will do, they are actually asking three separate questions – the answers to each of which may, or may not, be helpful.

These questions are:

#1. Will prices go up or down?
#2. By how much will prices go up or down?

#3. When will prices go up or down?

#1.  Will prices go up or down?

This is how most questions start.  And, unfortunately, also where they end.  “I think, based on supply this and demand that, quality, weather, something – that prices are either headed up or down.”

End of discussion.  Cotton producer nods their head and walks away.

However, the answer to this question from most people’s point of view does not really help them.

Say you have 1,000 bales of cotton to sell. You ask me: “Will prices go up or down?”  I predict up.  And then slowly over the next six months, prices rise half of a penny per pound.  I was correct in my prediction, but did that help you out?

Of course not.

#2.  By how much will prices go up or down?

Simply knowing that prices are going to increase or decrease is not enough.  In addition to the direction of prices, one also is interested in the magnitude of a coming price increase or decrease.

Right?

For a cotton producer holding cotton and asking, “What do you think prices are going to do?” the price of cotton needs to increase by about half a penny per pound each month for them to break even on storage and interest on their operating line.

So I predict higher prices to you, and higher prices come.  Not only are prices higher but prices increase to a level that would be extremely profitable for you.

However, what if the price increase comes two weeks after your farm loan is due.  That does not help either, does it?

#3.  When will prices go up or down?

The timing of a move in prices matters too, doesn’t it?  A large price increase for a producer that takes place after their crop is sold is not much help.

I knew prices were going up, and I knew they were going up by a large magnitude – but it happened too late to do you any good (at least for this year).

The same is true for an options trader.  Does a profitable price increase or decrease help if the put or call option has already expired.

It turns out, learning how to predict oil prices is not difficult.

In fact learning how to predict the price of cotton (and all other prices) is about the same.

But now you can join me.

When someone asks:  “Do you think prices are going up or down?”

You can smile and think:  “I get the idea.”

10 Reasons Why Cotton Producers Don’t Sell to Textile Mills

10 Reasons Why Cotton Producers Don’t Sell to Textile Mills

An old colleague of mine called me the other day, and we hashed out the same discussion we have had many times before. It starts with harvest time nearing, a 1,000-point fall in cotton prices over the last month and a hot cup of coffee on an early morning as the DTN screen blinks in the background.

Suddenly a grower says, “Why can’t we just sell straight to the cotton mills and cut everyone else out?”

Usually, when that question starts, all you have to do is stand back and watch, because ten minutes later, you’ll have nearly a dozen riled up cotton farmers fuming in the gin, or insurance, office.

So what is the answer to this sometimes toxic question? Why don’t cotton producers just sell straight to the cotton mills and cut everyone else out?

It’s just not that simple. Here are ten reasons why:

1.  Weather. So you want to supply cotton mills with cotton?  First, mills will need a certain amount of supply on hand to keep their mill running. They will probably even want a contract guaranteeing that timely supply. And, depending on what part of the country you are in and how much it has rained (or not rained) or hailed (or not hailed), your supply can vary greatly. I would hate to have contracted and promised to deliver bales that I, or my new grower-run marketing group, simply don’t have.

2.  Quality. Say you do have the bales, so quantity is not a problem. Well, what about quality? What if you contracted to deliver bales to a mill that produces primarily fine linens? The mill needs 31-3-36 cotton with no remarks or better, and this year was too hot, or too wet, or you harvested too soon, or too late and all you have is bark-filled cotton with a loan value topping out at 51 cents. Or, maybe the opposite happens – you have perfect cotton, and the mill only wants lower grades.

3.  Timing. Mills do not purchase all of their bales to be consumed for the coming year in a one-shot spree during harvest. They may need, for example, something like 5,000 bales per month all year, every year – not 60,000 bales delivered on January 1. And what if their cotton demand changes? The mill that you were delivering 5,000 bales per month to now only wants 3,000 bales per month in their new contract. How quickly can you find another mill with similar quantity/quality specifications that will absorb your new cotton surplus? Conversely, maybe the mill wants 1,000 more bales per month. How quickly can you increase your output by 20 percent, or will you have to go elsewhere to purchase the bales that you must deliver per your contract?

4.  Storage. Because of the timing issue, do you have an adequate place to store your cotton while your bales wait to be delivered to the mill? Have you factored in what that storage will cost? Or, do you use a warehouse owned by someone else? If you produce more cotton than the mill needs, are you prepared to store the surplus bales for an indeterminate amount of time, or will you sell the surplus in the open market?

5.  Transportation. A great deal of the time, textile mills are not located relatively close to where cotton is produced. Do you know how to get bales to a rail station? Maybe so. But what about the paperwork requirements to get cotton, by rail, to the west coast?  Finally, are you capable of following the customs laws and requirements required to ship cotton to China or Turkey or Pakistan?

6.  Risk. Clearly, being a cotton supplier to mills involves a lot of risk. What if I don’t have enough of the right quality of cotton, and I have to go to the market to make up the difference? I sure hope I didn’t contract to supply all of my bales for 75 cents while the market has risen to 90 cents. If I do decide to hedge my price risk, do I use options or futures? Do I have the expertise to manage price risk, quantity risk, timing risk, credit risk, and – if delivering internationally – political risk and possibly exchange rate risk?

7.  Capital/Financial Know How. If cotton suppliers hedge with futures contracts, they obviously go short the market to cover their natural long position. Because of this short futures position, there is a risk of margin calls if prices move higher. What if the market locks limit up multiple days in a row and you are unable to get out of your short position? A cotton buyer once told me that when his company hedges this risk, they keep a cushion of capital sitting in the bank of sometimes nearly 50 cents per pound. If you hedge with option spreads and ladder down as prices fall, can you financially absorb only a 75 percent hedge? Do you have the financial know-how and capital to look at a base price for cotton and correctly subtract your costs for storage, transportation, quality, and an appropriate risk discount to sell your bales at a profit 7,000 miles away?

8.  Productivity. At the heart of economics and an increasing standard of living is increasing productivity. Textbooks talk about comparative advantage. But it all really boils down to the fact that when people specialize in what they are best at, wealth is created. Simply put, in the world of business and profit, being incredibly good at one thing is better than being average at many things. Multiple companies competing over the profit to be had in cotton trading and delivery is simply more efficient than other alternatives. And chances are you will not be more efficient than companies that specialize in this business.

9.  Expertise. This ability to be more productive boils down to expertise. When companies compete over the profit potential in an industry, they gain an expertise in their business. And, this expertise allows them to be more productive in their business than others are. Just like many cotton buyers know very little about agronomy, soil science, and plant biology, few cotton producers likely have the expertise to discount, buy, transport, and deliver cotton to mills in a profitable way.

10.  Headache. Cotton producers don’t sell to textile mills because who wants the headache? You already farm. You work hard every day. You love your wife and worry about your kids. You also worry about cotton prices, fuel prices, seed prices, fertilizer prices, land payments, equipment payments, the weather, water, property taxes, the school board, your church’s finances and everything else under the sun. Why would you want to get waist-deep into another business that you have never been part of?

I recently spoke with an executive of a large multinational textile company about this topic. I gave him a short outline of the ten points listed here, then posed the question, “Why don’t cotton growers by-in-large sell directly to textile companies like yours?”

He said, “As far as problems, you listed almost everything I was going to say. We have done this before. As a test of sorts, we have bought cotton on a small scale directly from growers close to one of our plants. We may continue this experiment in the future, but I would probably summarize the entire process as ‘high maintenance work for too little volume.’ We just get such great service from the merchants and the coops.”

So, my advice is to forget about discounting, transportation, contract negotiation, price risk, exchange rate risk, quality and quantity risk and international terms of trade. Let the companies that specialize in cotton trade and delivery battle it out over the existing profit in that business.

In other words, let the market do its job. You’ll be astounded how good it can be.

First published by Cotton Grower.

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