4 Reasons to Be Sour on Sugar

09/26/2011 12:23 pm EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

The four primary forces that pushed sugar prices higher this summer are dampening, paving the way for a sizable correction toward a much more normal valuation that is more than 40% below recent prices.

The sugar market is one of the most volatile commodity markets. Sugar has made four moves of plus or minus 50% or more since the beginning of 2010. Sugar touched 36 cents per pound this February, which was the highest sugar futures have been since 1980, when they reached nearly 45 cents per pound.

Currently, October sugar futures are around 28 cents. I believe the fundamental supply factors in this market are set to drive sugar down to a more normal valuation around 16 cents.

Sugar prices have generally rallied this summer based on four primary factors. First of all, there have been logistical issues in Brazil’s harbors. Brazil is responsible for nearly half of the world’s sugar production. Brazil is also a major exporter of soybeans, cattle, and other agricultural goods. In fact, agriculture is responsible for 20% of their labor force compared to less than 1% in the US. Major snafus in the harbor construction projects currently underway caused delivery tightness in the March sugar contract and contributed to the market’s peak in February.

The second primary contributor to sugar’s rally has been the refining spread. This is the difference between the price at which raw sugar can be purchased and the price for which refined sugar can be sold. This spread advanced to more than $160 per ton, which attracted significant sugar purchases for delivery to refiners. This is similar to the temporary conditions we discussed in February of the crude oil crack spread that drove gas prices higher even as the price of crude oil declined.

The competition for sugar delivery also made its way into the ethanol market. The sugar-based ethanol production of Brazil and other countries is far more efficient than the corn-based ethanol industry in place in the US. However, just like in the US, food-based ethanol production pits the forces of hunger and fuel against each other. Therefore, rising crop prices coupled with rising fuel prices combine to tax individual households and define the upper boundaries consumer demand.

The final push in upward sugar prices is more persistent. The growth in the economic viability of developing third world countries has led to increased sugar consumption. Better food and a more varied diet are typically the first splurges for a rising standard of living. The growth of purchasing power overseas will continue to fuel this trend and will place a higher floor on sugar futures prices in the years to come.

World sugar production is always volatile. Over the last 20 years, the annual surplus or deficit between sugar consumption and demand has been split nearly 50/50 on an annual basis. This year, it looks like there will be a significant sugar production surplus. Reports from Thailand, India, Brazil, Europe, and Russia look very favorably towards large harvests. The shipping issues in Brazil have been figured out, and they are also reviewing the possibility of cutting back ethanol subsidies. Furthermore, the market inefficiency of the refining spread has been fully exploited and is now back to normal levels. Thus, the supply side of the sugar market looks bountiful.

Here’s a long-term chart:

chart
Click to Enlarge

And a chart since January 2010 for a closer look:

chart
Click to Enlarge

Technically, the remaining long positions appear to be held by small traders and commodity index traders (CITs), while commercial traders are actively selling their forward production at these prices. This leaves the market susceptible to a selloff as CITs and small speculators will exit their long positions as the market turns negative.

Finally, I expect the market to ultimately test lower support around 16 cents. This represents a value target in line with the global population growth and consumption patterns.

By Andy Waldock of Commodity and Derivative Advisors

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