Back to surplus, and a return to normality?

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The expiry of the May’12 futures contract appears to have finally convinced the market that the sugar balance is now through the deficit period.

The expiry of the May’12 futures contract appears to have finally convinced the market that the sugar balance is now through the deficit period and returning to a period of normality. Hedge funds are reducing their positions as the return to normality limits potential returns, while the market more generally moves into a contango structure.

Improvement in agricultural production prospects is not unique to sugar: corn and wheat production has also been helped by better weather and increased acreage. Overall, this has made food more affordable, indicating that 2012 is shaping up to be a better year for consumers: however, the ‘new normal’ may challenge producers’ ability to contain costs following three years of good prices.

The Long-Awaited Surplus Arrives

  • Rising demand, a lack of investment in production, and increased weather risk have been the key drivers behind higher prices during the past three years.
  • The 2011/2012 season marks the first clear return to surplus since 2007/08, following improved weather conditions and higher plantings.
  • The May’12 is the first raw sugar futures contract since 2010 to trade at a discount ahead of its expiry, while the market is moving from backwardation to a contango structure.
  • Overall, greater availability will enable stocks to rebuild and make sugar less volatile and more affordable, to the benefit of consumers.
  • For producers, the reversion of prices towards marginal cost levels is likely to discourage a continuation of growth.

The ‘New Normal’

  • Despite a return to surplus, the path taken has been surprising, with Brazil faltering and production elsewhere bridging the gap.
  • This causes uncertainty for refiners, many of whom have rarely operated with sugar from sources outside of Brazil.
  • Production growth around the world has been enabled by increased milling capacity. Thailand, for instance, managed to accommodate a 40% increase in cane throughput availability, whilst China and India's industries have come close to historic highs.
  • In the EU and the CIS, beet industries have also shown their industrial base can accommodate improved agricultural output.
  • Compare that with Brazil, where costs have risen as productivity falls, despite higher sugar prices globally. This situation is exacerbated by the falling return from ethanol in real terms as a result of energy prices being capped by the Brazilian government. These factors have held back growth in Brazil's cane acreage, and coupled with falling cane yields, means that some of the country's expanded industrial capacity is sitting idle.

Risks from the 'New Normal'

  • This duality in sugar industry prospects (Brazil vs. rest of world) points to substantial risks going forward.
  • Stability is dependent on a shift away from Brazil and an increase in Thai exports, with India potentially emerging as a stable exporter.
  • In the short term, the market will remain focused on Brazil, and the extent to which its industry succeeds in terms of cane throughput and sugar production.
  • Cash-flow considerations and stock funding requirements look set to increase within the Brazilian industry. In the physical market, there is no doubt there will be an increase in willing sellers this season, the very opposite of the situation seen over the last three years.

Toby Cohen, Czarnikow director, said: “We are seeing a ‘new normal’ emerge, with Brazil’s sugar role seemingly in decline, and other exporters rising in importance. We continue to believe that 2012 will be a better year for consumers but are not sure that the return to a normal carry-structure means that we are going to see reduced volatility.”

Peter de Klerk, Czarnikow analyst, said: “Lower sugar prices and more availability means producers are going to have to work harder to control their costs after three years of good prices.”

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