High Volatility in Cotton: Should You Buy or Sell?

The cotton market has been experiencing unprecedented volatility. About two months ago, the U.S., the world's largest exporter, was under a serious drought threat, and stockpiles were expected to reach a two-decade low.

But fortunately, good rain levels in Texas -- the top growing region in the country -- encouraged vast planting action, and now the government expects inventories to reach a six-year high before the 2015 harvest. In fact, according to a report by Plexus Cotton, U.S. output might rise 32%, with the crop exceeding 17 million bales.

Is it a good time to invest in cotton-related assets?
Whenever there's volatility, it's a good time to step back and look at the big picture. Oftentimes the market overreacts, and that's exactly where opportunities arrive.

If you take a look at iPath Pure Beta Cotton (NYSEMKT: CTNN  ) , its price rose steadily from November until the beginning of May, when it began a steep downward slide that continues today:

CTNN Chart

CTNN data by YCharts.

The reduction in U.S. supply estimates pushed prices up until new data confirmed that supply would increase, pushing prices down. As you can see, prices in this ETN move fast. This fund is directly linked to the Barclays Capital Cotton Pure Beta TR index, which reflects the returns that are potentially available through an unleveraged investment in the futures contracts in the cotton markets.

According to a Bloomberg survey of seven analysts, futures may drop 6.1% by year-end to their the lowest level since June 2012. So be careful, as such a drop would be directly reflected in the ETN's price.

The same goes for iPath DJ-UBS Cotton TR Sub-Idx (NYSEMKT: BAL  ) , which provides exposure to the Dow Jones-UBS Cotton Subindex but essentially tracks cotton futures contracts as well. The correlation is extremely high.

An investable opportunity?
A drop in cotton prices is not bad news for everybody. Considering that it reduces a primary cost for fabric, companies like Culp (NYSE: CFI  ) could see their margins go up. Culp uses cotton fibers for the fabrics it manufactures for the upholstery and bedding industries.

Culp is among the largest producers of mattress fabrics and one of the largest marketers of upholstery fabrics for furniture in North America, measured by total sales -- so we're talking about a lot of fabric production. But don't get too excited. Despite the fact that Culp purchases yarn and unfinished fabrics that contain cotton from outside suppliers, the movements in cotton prices do not affect the company's business significantly.

Culp's material costs are much more sensitive to changes in prices for petrochemicals and the underlying price of oil. Most of the company's products hold a high percentage of synthetic fibers, which correlate to movements in prices for oil and petrochemical products. Due to the price stability in the oil markets during the past year, Culp's costs have not suffered major distortions.

And since demand responded quite well, this past fiscal year the company showed a 6.8% net sales growth to $287.2 million, making this the fifth consecutive year of overall annual sales growth. Its mattress fabrics segment sales grew 4.3%, showing a record figure of $160.7 million. This segment accounts 57.3% of total net sales, with upholstery comprising the rest. This past year Culp introduced Culp-Lava, a line of mattress covers that aims at the premium segments, which are showing the greater growth. This new venture relies on new production lines in a new dedicated manufacturing plant.

Final foolish takeaway
For now, everything indicates that supply will increase and cotton prices will continue to drop. As a result, we'll probably see a continuation of the correction in these two ETNs. But there is one unpredictable factor that could change this analysis: potential weather damage during the months from planting to harvest, affecting futures again.

On the demand side, a recent report from the Cotton Advisory Committee forecasts weak cotton consumption for this year. The report expects world production to exceed consumption in 2014 and 2015, projecting enough cotton inventory to cover consumption for nearly 11 months -- all the more reason to expect a continued slump in cotton prices.

The case for Culp is not highly related to cotton price variations and depends more on the oil markets and how well the company anticipates fashion trends. The company has been successful, and its sales continue to grow, which makes it an interesting diversification asset in case these ETNs do not behave as planned.

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