With energy markets in a sustained uptrend and few analysts expecting prices to recede any time soon, many investors are looking for energy plays without having to buy crude oil at such lofty levels. To accomplish this, one school of thought is to look for alternative fuel investments in companies that produce products such wind, solar, hydroelectric power and other new forms of energy. While these may very well turn into good investments, alternative fuels are long term plays that could take years to realize gains, if they gain at all.
Traders looking for immediate ways to cash in on high energy prices might consider a commodity product that is already actively substituting for gasoline, causing demand to make quantum leaps within the last two years. The product is ethanol and one way to invest in ethanol is by investing in its chief component in many parts of the world, sugar. About 60% of the world’s ethanol production comes from sugar.
Granted, the sugar/ethanol play is not a new story to most investors. But while crude oil prices topped $76 a barrel this week, sugar prices have dropped substantially since early 2006, making the alternative fuel source look like a bargain.
Sugar prices experienced a heady ascent in late 2005 and early 2006 when investors and commodity funds poured into the market, as demand for sugar outpaced available supplies. The 2005/06 crop year was the third consecutive year that sugar experienced a world supply deficit. The world produced a record 149.7 million tonnes of sugar in 2005/06, yet consumption still outpaced it at 149.9 million tones.
In the pre-ethanol era, substantial price increases in sugar were due primarily to supply related issues, as demand remained stable from year to year. The latest rally is due in no small part to a growing world economy hungry for energy. Thus, as crude oil prices soared, ethanol finally became an economically viable alternative. Demand for the new product and its key ingredient, sugar, has soared. This leaves confectioners, the traditional buyers of sugar, to bid against energy companies for raw product. At the same time, demand for sugar as a food has increased because of emerging economies in China and India. Sugar has now become a demand led market.
Another factor contributing to the shortfall in sugar is that the world’s top producer and exporter of sugar, Brazil, producing roughly 20% of the world’s sugar, just happens to be the world’s leader in flex-fuel automobile production. Flex-fuel vehicles can run on 100% ethanol.
Flex-fuel car sales in Brazil reached 62% of all new car sales in 2005. With this new market in domestic demand, Brazil has shifted a considerable portion of its exportable sugar supply into domestic ethanol production. This takes supply off of the world market and thus increases price. With ethanol prices running about 30% less than gasoline prices in Brazil, the country plans to continue its switch over to the flex-fuel vehicle. It is estimated that by 2011, 100% of new car sales in Brazil will be of the flex-fuel variety.
But much of this is old news. Why buy sugar now?
It is our opinion that many sugar traders and analyst are not accustomed to trading a demand led market and continue to favor the production side of the equation when making price estimates. Ethanol production, at least to its present day extent, is a brand new demand component to sugar and forecasting its usage is an inexact science at best. The old formulas for projecting demand are not as useful as in yesteryear. Demand for ethanol is subject to far more variables than was projecting how much chocolate the world would consume in the coming years. Sugar prices are now at least partially subject to the same variables as the energy markets.
Yet the sugar market has lost its luster in recent months as traders focus on larger supplies expected from Brazil and India. What these traders are ignoring is the fact that 06/07 ending stocks (total amount of sugar left over at the end of the crop year) are forecast at 30.9 million tons, down 58,000 tons from 05/06. This would make it the fourth consecutive year that ending stocks have declined and shows that despite increased world production, overall supply is still eroding.
In addition, it is our opinion that 06/07 demand is being underestimated. With crude prices most likely remaining above $70 for the foreseeable future, a number of possible events that could occur could drive values substantially higher, meaning an increase in demand for alternative fuels. And with traditional demand rising, confectioners will have to wrestle supply away from ethanol producers. The only way to do this is to drive prices to a level where it becomes economically impractical for ethanol producers to purchase sugar.
In the meantime, sugar prices have fallen to what we feel are below value levels because of speculators attempting to price in “higher production.” As we mentioned above, however, most traders are not accustomed to trading demand led markets in sugar and we believe they will be caught flat footed by year’s end.
In comparing a crude oil chart to a sugar chart, the better value becomes obvious if one is considering an energy play. In addition to being a less volatile market, sugar has corrected substantially from its highs in January while crude oil has continued to hover near its highs.
For investors considering taking a position, we recommend the strategy of selling puts because one does not have to pick the absolute direction of the market to profit. By selling puts, sugar prices do not necessarily have to increase for the seller to profit. They can remain steady. They can even move moderately lower. As long as prices are anywhere above the put option’s strike price at expiration, the put expires worthless and the seller keeps all premium collected as profit. Therefore, as a put seller, you are not betting that prices will go up, per say. You are only betting that prices will not decline substantially before option expiration. While prices are bound to rise and fall on a daily basis, we find it difficult to envision sugar prices falling substantially lower given the current demand environment.
If you would like more information about selling options in the sugar market or building a portfolio based on the option selling approach, please feel free to call or visit us on the web.
To watch CNBC’s August 3 interview with Liberty Trading’s James Cordier on the sugar market, visit our website or click on the link below. http://www.libertytradinggroup.com/graphics/Liberty_Trading080306.wmv
James Cordier
Michael Gross
Liberty Trading Group
(800) 346-1949
www.optionsellers.com
Office@libertytradinggroup.com
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. James’ market comments are published by several international financial publications and worldwide news services. Michael Gross is an analyst with Liberty Trading Group. Cordier and Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
