Sugar prices continue to trend lower and are now trading at a three-year low. According to the International Sugar Organization (ISO), there will be a global production/consumption surplus of 8.5 million tonnes for the 2012-13 marketing year. The ISO forecasts another surplus for the new crop year, albeit a much smaller one. The bears are firmly in control – for now.
Three issues warrant careful consideration, though, and could confuse complacent bears.
The Brazil center-south region, where 90% of the county’s sugar is grown, is set to harvest a record cane crop. Sugar output is estimated to be more than 10% higher than last year. That is a tentative estimate, though. There are ample reasons for ethanol production to surprise on the upside. First, the mandated ethanol blend was bumped up by the government on May 1, to 25% from 20%. The government has pursued a rather aggressive campaign to increase ethanol usage. It has also cut sales tax on ethanol and raised petroleum prices. The current estimate for the ethanol/sugar ratio is about 60/40. Based on the incentives the government has initiated, it’s a good bet that the ratio will increase to favor more ethanol consumption.
The next issue is cost of production. At current world prices, sugar production is not a highly profitable business. Production costs vary widely, depending on the region and the particular mill. One estimate puts Brazilian production at between 17¢ and 22¢ per pound. This could have an immediate impact on mill production and could influence future planting intentions, unless, of course sugar prices begin to rise. In the near term, producing and selling ethanol would seem to be more profitable and will help shift the ethanol/sugar production ratio even higher. Where the option exists, farmers will decide to cultivate more profitable crops.
Finally, there is India. Over 50% of sugar growing regions lack the benefit of irrigation and rely strictly on rain. Some regions in the south and the west of the country that received less than half of normal rainfall levels last year are still suffering from drought. Early estimates for the quality of the June through September monsoon were optimistic. More recent forecasts put the arrival date at June 3, still within the normal range, but possibly late by a few days.
It is far too early to consider this forecast problematic. It should be pointed out, however, that the last weak monsoon in 2009 slashed Indian output and turned the typically self-sufficient sugar producer into a net importer of sugar. Sugar prices eventually soared to above 30¢ per pound.
While the effects of low sugar prices have not yet been felt in a huge way in Brazil, the disincentive has already manifested itself in India. As of a recent estimate, plantings for the 2013-14 crop are down 10% in some areas. Should this turn out to be an indication of a more widespread downturn in acreage, it would result in a drawdown of inventories. Total production would be about 22 million tonnes, down from 24.5 million tonnes in 2012-13 and about 1 million tonnes or more below domestic consumption. Ending stocks levels would be adequate to meet the domestic shortfall, but India would certainly have to halt its exports or risk drawing inventories down to a level that the government would clearly find unacceptable.
Chart 2 shows a sharp drop in open interest during April, but over the past couple of weeks the shorts came right back. Open interest is right back up near the top of the range. There was obviously some short-covering as the May contract headed off the board, but there was no wholesale shift of sentiment among commodity funds. Commitment of Trader data indicate that the net-short speculative position is back to its highs.
We’ve steered clear of recommending a long position in respect of a classic downtrend. We do believe, however, that what appears to be an overwhelmingly burdensome supply side can spin around in an awful hurry with any crop problems in India. That’s for the near term. For the longer term, we are confident that we will see smaller output from producing nations. Buy out-of-the-money call options. And whatever you decide, do not be short this market.