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The sugar market has caught our attention as prices have dropped substantially, yet the demand part of the equation is very positive. Brazil is producing a large crop this year and world supplies are expected to increase for the second year in a row. With prices down 48 percent from the high in 2011, the market has factored in a nearly ideal situation for production this year. With sugar demand very strong, this is an opportunity where where we see little downside risk from here and greater potential on the upside.
Demand for sugar-based ethanol should support sugar prices well into the future.
Brazil is the largest producer of sugar in the world. However, nearly half of their production is converted into sugar ethanol. This booming South American country and the U.S. produce about 90 percent of all the ethanol in the world. This fuel source is currently cheaper and much cleaner burning than U.S. corn ethanol. Imports into the U.S. have soared in the second half of 2012 and that trend is expected to continue in 2013.
The use of ethanol produced from sugarcane is mandated by the Renewable Fuels Standards (RFS). The mandate calls for the use of renewable fuels, but it has additional requirements that specify cleaner sources of advanced biofuels like sugar ethanol.
For 2012, the RFS required 15.2 billion gallons of biofuels to be used - 3 billion gallons from advanced biofuels (sugar ethanol) and 12.2 billion gallons from corn ethanol. By 2022, the RFS will require the annual use of 36 billion gallons of biofuels - 21 billion gallons from advanced biofuels and 15 billion gallons from corn ethanol. Sugar ethanol is an advanced biofuel, while corn ethanol does not qualify. You can see the large upswing in demand for sugar ethanol going forward.
Ethanol usage could be much greater than expected in 2013. Ethanol is used widely in Brazil. The government dropped their ethanol requirement in gasoline from 25 percent to 20 percent last year. Brazilian officials will raise the requirement back to 25 percent this year, which will be a sizable increase in usage.
The government of the world's fifth largest country has kept the price of gasoline artificially low, in part, to control inflation. This is costing the government billions and the policy may soon change. A Brazilian newspaper reported on January 15 that gasoline prices would be raised 7 percent. The Energy Minister, Edison Lobao, has discussed raising prices but has yet to confirm the exact details as of this writing.
The price of oil and gasoline also play a part in demand for sugar - now and into the future. As gas prices move higher, more demand will filter to ethanol. Oil prices are holding steady above $90 and this is supporting gasoline prices. OPEC is expecting oil prices to remain above $90 for 2013. This should make ethanol more competitive to gasoline and consumption should increase.
Sugar ethanol also competes with corn ethanol, which is produced in the U.S. The production of corn ethanol dropped last year, as corn prices hit record highs near $8.50. The economics don't justify high ethanol production when corn prices are near record highs. The latest USDA crop reports showed a larger drop than expected of corn supplies. Corn supplies remain critically tight and prices have moved back up to $7.50.
Overall Sugar Demand
Ethanol usage in 2013 could make the fundamentals much more favorable, but the main focus could be on China. Sugar demand in the world's second largest economy continues to grow strongly, as the country is a growing importer of sugar. The most populous country imported sugar heavily last season to make up for growing demand. While imports are expected to be down this year, we expect a strong rebound in the coming years. Chinese officials are also known to manipulate the market to receive better prices, so their estimates can be taken with a grain of salt.
Estimates from the major trade houses have China importing 4-5 million tons annually by 2020. They have a lot of mouths to feed and thus a heavy reliance on the import market. This should keep a floor under prices and leave little margin of error in world production.
The emerging economies of the world are acquiring a growing taste for sugar and that trend is hard to stop. Sugar should be one of the commodities most positively affected by the growth of the emerging economies. Demand for this commodity as a food additive and as a fuel has one of the best fundamental setups for investors in the next couple decades.
Sugar is expected to have a surplus for the 2012/13 season, but we believe this is already discounted in the market. Prices have dropped from 36 to nearly 18 cents in the last two years. Any shortfall in the large crop estimates from Brazil or China this year could send prices higher.
Much of the cane sugar around the world is grown in tropical climates. Weather issues can and do spring up at any time. A weather event could change the production scenario significantly. The strong long-term demand for sugar from China and growing ethanol demand sets up the possibility of a supply imbalance we haven't seen in years, should a major weather event develop.
We've seen a similar situation in the oil market in recent years. There are currently ample supplies of oil, but prices remain above $90. Traders know that a small uptick in demand from China, a production shortfall or an improving global economy can lead to much higher prices in a short period of time.
Summary and Strategy
We see the downside as limited in the sugar market. Sugar has become very oversold on the long-term charts and it is consolidating off a multi-year rally. Our outlook is to sell sugar puts with several months of time premium.
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