Another issue that we’ve pointed to over the past few months has been the rising cost of sugar production, which presumably will make processors very keen on switching to ethanol — that is, if ethanol provides a better return on investment. One Brazilian sugar analyst says that production costs for sugar have risen to 21¢ per pound! The math is easy...at current prices processors are losing money. The analyst expects costs to ease if the cane crop is as large as expected in 2013-14, because it is idle milling capacity that increases average costs. Still, most people will be surprised to learn that the industry has been operating at a loss.
Sugar open interest has skyrocketed as trend-following funds and individual speculators continue to build a mammoth short position. Chart 2 shows that open interest is up 165,000 contracts, or 25% since this leg of the downdraft began in October. In addition, the chart also shows that speculators hold a net-short position of 73,000 contracts, the largest short position since 2006.
There is no argument with the bearish case presented by the global balance sheet. Down the road, however, it is hard to see sugar production continuing to rise in Brazil if there is a strong shift to more ethanol output. Even with current estimates for modest increases in the ethanol/sugar ratio, an abundant cane crop may not accommodate any increase in sugar production.
We were stopped out of our long-held long position at 18.50¢ per pound. We still believe that the market is oversold and that would be reinforced if the market fails to make even lower lows while not shedding a meaningful amount of open interest. As an alternative to jumping back into the market, we recommend buying call options. At present, they carry a very low implied volatility of 17%. That compares with historic volatility, which even recently has been 20% and much higher in the past. Buy July 19 calls.