Response of Cotton to Oil Price Shocks

AbstractThis paper shows that the response of cotton prices in the U.S. to fluctuations in oil prices in the international market may differ greatly depending on whether the increase is driven by demand or supply shocks in the crude oil market. In the long-run, around 3% of the variability in cotton prices can be attributed to shocks to global demand for industrial commodities while none can be traced to oil supply shocks.Keywords: Cotton, oil price, demand shocks, supply shocks, VAR, SVAR(ProQuest: ... denotes formulae omitted.)IntroductionOil prices affect cotton prices in two channels. The first channel, more pronounced in recent years, is through the substitutability in consumption between oil and biofuels such as ethanol, methanol, and biodiesel. With the surge in crude oil prices to historically high levels of, initially US$60 per barrel in 2005, to $128 per barrel in 2008, the demand for ethanol has significantly strengthened. This, in turn, fueled the derived demand for cellulosic materials such as corn, among others, from which biofuels are created. In the U.S., as the ethanol industry absorbed a significant share of corn crop, corn prices have risen in recent years. Higher corn prices have provided farmers the incentive to switch acreage from competing crops to corn. One of these competing crops is cotton, the acreage for which has declined by as much as 45% from 2005-2008 (from 5.586 million hectares to 3.063 million hectares in 2008/09), the period following the passage of the Energy Policy Act of 2005 that contains a new Renewable Fuel Standard (RFS). The RFS ensures that gasoline marketed in the United States contains a specific minimum amount of renewable fuel. Between 2006 and 2012, the RFS is slated to rise from 4.0 to 7.5 billion gallons per year (Baker and Zahniser, 2006). While there is no direct linkage and evidence on the extent of cotton acreage diverted to corn, the timing of sustained acreage reductions coincided with the surge in corn demand. Through this channel, higher oil prices reduce cotton supply via acreage reductions (limited by the extent of production substitutability between cotton and corn), ceteris paribus. This, in turn, results in higher cotton prices. At the same time, higher oil prices lead to higher cost of cotton production. Most cotton growers are painfully aware that the 2008 crop was an expensive one to produce due, at least in part, to crude oil prices above $128 a barrel that sent retail gasoline and diesel prices to soar.The second channel involves the use of cotton in the textile sector and its substitutability with polyester in textile manufacturing. Higher oil prices translate to more expensive energy and electricity which raises the cost of polyester fiber production - a sector heavily dependent on chemical derivatives of crude oil for inputs. A relatively more expensive polyester fiber props up the demand for cotton. In fact, the cross-price elasticity between cotton and polyester is positive in most countries; currently, several domestic price policies account for the substitutability between cotton and polyester: Chinese internal policies and import controls have generally supported cotton prices in the range of 120% -130% of polyester prices; in India, cotton and polyester prices are roughly at the one-to-one price ratio; in Pakistan, cotton prices are around 80% - 90% of polyester prices (Laws, 2009). In the U.S., Pan, Mohanty and Fadiga (2007) found that polyester prices and cotton prices Granger-cause each other.There is no consensus in the literature on the nature of the relationship between cotton and crude oil prices. While some studies found the relationship between cotton and crude oil prices to be weak (Fadiga and Misra 2007; Plastina, 2010), others attest to the existence of a significant relationship. Baffes and Gohou (2003) examined the price linkages among polyester, cotton and crude oil based on monthly data between 1980 and 2002. …