Global commodity trading houses have long argued that their billion-dollar profits were rewards for taking risks, but this year's volatile cotton market has tested those arguments as farmers have defaulted, profits have shrunk or disappeared and CEOs have quit.
This turmoil has occurred amid a "perfect storm" of volatility that made losers out of some of the market's smartest traders and the damage may not be over.
In the aftermath of a roaring rally that quadrupled cotton prices in six months only to fall by more than half, farmers put merchants like Glencore International and Noble Group — the critical middlemen who buy cotton from farmers and then turn around and sell it to mills — on the hook for massive losses.
"No one got away unscathed," says Ron Lawson, a long-time trader with brokerage logicadvisors.com in Sonoma, California.
Noble reported its first quarterly loss in more than a decade on Wednesday, and analysts blamed part of a $17.5 million loss on cotton. The company also said its second CEO in two years resigned.
Others also suffered. Mark Allen, who had been hired from Noble Group as Glencore's head of cotton, departed the firm following losses, according to a source with knowledge of the situation.
U.S. agribusiness and trading giant Cargill Inc., the world's No. 2 cotton trader, posted a 66 percent drop in quarterly profit, but did not specifically blame cotton.
The focus is now on Olam International, which recently expanded its cotton business and is ranked behind the big three of Louis Dreyfus's Allenberg Cotton, Cargill and Noble. It reports earnings on Friday.
In 2008, a price spike in cotton futures in March drove two long-time cotton merchants out of business. Paul Reinhart filed for bankruptcy and the other, Weil Brothers, withdrew as it blamed volatile market conditions.
The two biggest merchants, Allenberg and privately-held Dunavant Enterprises, merged the following year in an action that traders said was a result of cotton market volatility.
DEFAULTS, CONTRACT DISPUTES HIT NOBLE, OTHERS
Even months after prices cooled, the fallout from what Glencore called an "unprecedented period of volatility" in cotton is still being felt.
Cotton prices on the ICE Futures U.S. exchange soared from U.S. 60 cents a lb in August 2010 to a record of $2.27 in March — topping the record peak in the U.S. Civil War in 1861 to 1865 — and then eventually dropped to about 96 cents by the end of October 2011.
That kind of roller coaster would be enough to roil any market, but the impact for trading houses was multiplied by the peculiar habit of U.S. cotton farmers to simply walk away from loss-making contracts. While default is a risk in any cash commodity market, it is near endemic in cotton.
The London-based International Cotton Association, which is in charge of settling cases of this nature, has been deluged by arbitration requests this year.
Trade sources said about 200 arbitration cases have been filed so far in 2011. In a normal year, the sources said the number of cases would be about 10 to 20. The amount involved in the cases this year is estimated to be about $2 billion and it could take years for the matter to be resolved.
FARMERS DON'T DELIVER
It unfolded like this.
U.S. farmers began selling forward cotton delivery contracts around September and October, as prices slowly ascended to $1 a lb, a level that looked rich given prices had only exceeded that once in the past 50 years.
But prices really shot higher after news of floods in Pakistan and poor yields in China, the world's biggest producer and consumer of cotton, set off a frenzy of panic buying that accelerated gains up to a peak in early February.
Noble and other trading houses who had bought cotton from these farmers near the $1 level awaited delivery of it.
But as cotton raced past $1 on its way to $2.27 a lb in early March, farmer defaults in the United States and other producing countries mushroomed as growers "washed out" their contracts, reselling the cotton on the spot market.
"The producers sold cotton and they didn't deliver. (Noble and other trade houses) had to buy cotton in the open market," said Sharon Johnson, senior cotton analyst at commodities brokerage Penson Futures in Atlanta, Georgia.
Glencore explained: "The period of high (cotton) prices resulted in an industry-wide environment of elevated contract performance risk and Glencore, along with many other merchants, incurred 'opportunity costs/losses' associated with various suppliers not meeting their delivery commitments."
They then got hit again by their buyers.
Textile mills in places like Bangladesh, China and Indonesia that had bought the cotton at $2 a lb or higher suddenly found that demand from their customers had withered as prices spiked, and they no longer wanted or needed costly cotton.
They refused to take delivery, leaving merchants holding millions of bales as prices crashed back to $1.
"The merchants got bit on both ends of the deal," said Lawson.
NOBLE SAID HIT IN MARKET SQUEEZE
What also hit Noble was a squeeze in the cotton market during the ICE delivery period for the May and July cotton contracts, the traders said.
Since only U.S. cotton can be delivered to the exchange and 90-95 percent of it had been sold by March, the sources said Noble found itself scrambling to secure cotton and was forced to pay up when it could not do so, they said.
Data from ICE Futures showed that of the 3,928 lots delivered against the tape of the May cotton contract, a total of 3,898 lots were stopped by Term Commodities, which traders believe was acting on behalf of Allenberg Cotton Co, the world's biggest trading merchant.
Noble was said to be on the other side of the trade.
"They passed up on an opportunity to get out and (backed) themselves into a corner," a broker familiar with the situation said.
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