Sugar may be boring now, but not for long

Sugar prices rallied earlier this year when a Brazilian crop failure looked to tighten up world supplies, just as the global market was recovering from two consecutive Indian crop failures. Most developments over the past several months, however, have not been terribly bullish, and prices were easy prey for the broad-based commodity selloff.

Indian 2011-12 production estimates have been firming up, which means that original export targets can easily be met. The government has extended the deadline to apply for export permits by one month, to mid-February. We continue to believe that running down India’s stocks is not a good idea in the long run. Carryover stock levels are still well below the comfort level the world’s largest consumer of sugar is accustomed to, even while demand continues to grow. Nevertheless – for the short term anyway – it should help keep prices contained.

Higher-than-expected production in the EU and Pakistan has compensated for the much lower-than-expected output in Brazil. Estimates for the global 2011-12 surplus have been rising and now range between 6 million and 10 million tonnes.

That’s the bearish case. There are, however, two major issues that we believe have built a floor, not too far below current levels.

First, we’ve pointed out several times in the past that the cost of production in Brazil – still the world’s largest exporter – has been rising sharply over the past 10 years and is now not too far below current world sugar prices. Sugar statistician Czarnikow released a study this past September, which cites higher labor costs and the price of updating technology as the primary factors.

Czarnikow’s report is somewhat futuristic, with a forecast for production costs to rise to 35¢ per pound over 20 years. But costs haveactually shot up from a range of 10¢ to 13¢ per pound to a range of 19¢ to 20¢ per pound. If prices get too close to the cost of production, farmers will grow more profitable crops or divert a greater share of the cane crop to ethanol production. This brings us to the second major development, which will surely have a strong impact on the sugar, corn, and ethanol markets for years to come. Congress has ended the era of protectionism for the US ethanol market. On December 31 the 54¢- per-gallon tariff levied against Brazilian ethanol imports as well as the 46¢-per-gallon tax credit for US ethanol producers ended.

The market’s reaction to what should have been a monumental event was muted. About 40% of the US corn crop is used to produce ethanol, up from a negligible amount 10 years ago. There are several reasons why it will be some time before the effects of the rulings are felt. Brazilian sugar ethanol is more expensive than US ethanol, because it is more environmentally friendly. But aside from that, the Brazilians cannot produce enough to make any appreciable dent in the demand for corn ethanol. For that matter, Brazil is actually a net importer of ethanol from the US. From January through October, the US bought 39 million gallons of ethanol from Brazil, but Brazil bought 156.3 million gallons from the US.

What will happen eventually, though, is that US ethanol producers will be tested, because they don’t have any experience operating in a competitive environment. They have been receiving the tax credit since 1979 and did not have to worry about imports. These government programs are gone, but they did help build the ethanol industry, and to a degree, consumption is entrenched in the system because of the minimum ethanol blend mandated by Federal law. If petroleum prices remain strong, Brazilians will be motivated to increase the portion of the cane crop dedicated to ethanol production, and sugar production will slip steadily. We therefore see tight days ahead for Brazilian sugar output.

Buy May sugar.

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