Cotton: It's back in the news again, though probably not the way the government would like. You see, the U.S. just got its hand slapped by the World Trade Organization over cotton subsidies. This is happening at an interesting time in the agriculture sector: Wheat and cotton are in the middle of a turf war. It may not be as flashy as Jets vs. Sharks, but it’s much more important.

Just like other crops, cotton competes for acreage. With wheat prices at all-time highs (see chart below) due to a tight global supply, and farmers making planting decisions, expectations are that farmers are going to follow the money and plant more wheat.

Don’t be fooled; nobody plays the market like farmers, and betting on softs against the guy out in the cold fall wind with his finger in the air is a tricky business. We saw a similar pattern with corn last year: Farmers rushed to cash in on record corn prices by planting huge fields of golden maize. And though you might be tempted to say soybeans were the biggest loser in acreage (dropping 15% from 75.5 million acres to 64 million acres), it turns out cotton lost almost 30% of its acreage (dropping from around 15 million acres to around 11 million acres). In other words, on a total-market basis (not just acreage), the impact on cotton was bigger than the impact on soybeans.

So … what’s happened with cotton? Well, cotton prices have risen, but nowhere near like wheat. Wheat’s been in the center of a perfect storm of factors: reduced acreage, massive drops, plagues of locusts, etc.

As farmers look to cash in on this by planting more wheat, we might expect prices to drop if the harvest comes in well. That's always a big if: We could see the same replay of biblical plagues destroy the harvest anew.

Still, one thing we can be sure of is this: If wheat is in the field, cotton isn’t, creating a perfect setup for cotton prices to rise … possibly through the 80-cents-a-pound level as some expect. That is a price that has only rarely and briefly been breached in the last 10 years.

Current Update

Right now is cotton harvesting season, and it’s looking good if Mother Nature cooperates. The USDA estimates that farmers are pulling in an average of 826 pounds per harvested acre, which is 12 pounds above 2006, and the third-highest yield on record. The world is ready for it. The U.S. is one of the largest exporters of cotton, thanks in part to our massive subsidy system, which encourages farmers to grow cotton even when it’s uneconomical (68% of U.S. cotton exported in 2006 was sold below true production cost). Meanwhile, foreign cotton consumption continues to grow and even outpace production: The USDA estimates there is still a 23-million-bale gap between supply and demand.

So let’s refresh:

• We have a global market that has consumption outpacing supply
• We have farmers turning cotton acreage into wheat
• We have the have the WTO's ruling that the U.S.'s subsidy program goes too far, and a new left-right coalition emerging (as detailed in The Wall Street Journal's editorial, The Cotton Club) outlining some of the reasons the WTO and others are up in arms about those subsidies, and how they affect the global market.

Follow the dominoes as they fall. If the U.S. subsidies are cut, many U.S. farmers will find that cotton is suddenly less profitable than it used to be, so we may see U.S. production drop as farmers turn to other crops. This is exacerbated by current high prices for wheat and other crops. Whammo presto: higher prices.

Of course, there’s a flipside to that cycle: As prices rise, cotton will become more profitable to plant. Supplies will come up. And eventually the market does what markets do best and everything settles into place. But the ride to get there could be wild if the subsidies are cut. So … watch that space.

Wheat and cotton in commodities turf war FT.com October 11, 2007
The Cotton Club October 15, 2007
National Cotton Council's response to "The Cotton Club" WSJ editorial National Cotton Council of America October 16, 2007
WTO
WTO rules against US cotton supports, US bristles Reuters October 16, 2007
Cotton and Wool Outlook 10/15/07 USDA
Facts and Figures: The Cotton Trade NOW on pbs.com March 9, 2007
Tight Cotton? HAI August 9, 2007

Cotton prices Monthly CBOT

Wheat Prices, Monthly CBOT