Why A Depressed Price Is Just Not Fair Value

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Over the past year we have seen that demand has risen faster than expected.

With supply falling this has tightened the sugar balance sheet - contrary to the expectations of the broad market consensus. The market has rallied by more than 200pts since September as the issue of value has come into question.

  • In a balanced market environment, with supply and demand relatively aligned, the clearing price of the market should be the level that provides a normal return to producers.
  • That is not what we are seeing today with the world market’s leading sugar producers reporting losses in their financial statements and many industries around the world asking for state support to remain solvent.
  • This is a very clear indication that current prices are not covering total production costs.
  • It also highlights how the widely held belief in the market, that price can be sustained at around operating cost of production, works in the short run but fails in the medium to longer term.
  • Our view is that the market has moved beyond the short run.

“Not only is the current price of sugar discouraging re-investment but it also risks the sustainability ofsupply.”

Stephen Geldart, Senior Analyst

Financial Pressures in Brazil

  • Operating costs consider just the costs associated in producing cane and then sugar or ethanol, including factory and agricultural maintenance, but do not include costs to the business such as depreciation, interest expenses and taxes. However, once financial costs and taxes are taken into account the price needed to cover total costs increases.
  • Sugar represents less than 50% of Brazilian sector production thus total production costs need to consider ethanol as well. But operational cost of hydrous ethanol and prices are roughly aligned as the profit margin in ethanol has been degraded by inflation.
  • As a result the sector has to rely upon earnings from sugar to make the largest contribution towards fixed costs.
  • To better understand this we have modelled total costs and total earnings from sugar, ethanol and co-generation. Using the price of sugar as the main variable in this analysis we have determined that in order to achieve a return on investment the price of sugar needs to be much higher.
  • Within Brazil the risk free rate of return for capital is around 10%. To attract capital an asset needs to pay a premium to this level of return.
  • We believe that the cost of equity for most sugar producers should range from between 15-20%. Consequently, for investors to achieve this return on an investment we calculate that an established mill requires a No.11 price of around 22-23c/lb.

Global Problems

  • The financial problems faced by Brazil’s sugar sector are indicative of the difficulties that are faced in many other countries, especially by the milling sector, which has often been unable to retain the benefit of higher prices and has instead had to accommodate higher costs and a rising level of indebtedness.
  • Both India and China are also facing these challenges.

India: A Crisis in the North

  • The problems facing the Indian cane industry seem even more profound than those in Brazil. In most cane states operating costs are higher than sugar prices.
  • Sick mills now account for more than one-third of the 516 mills in the sector. 172 mills are currently closed given current poor earnings.
  • The Indian Sugar Mills Association estimates that the overall net loss for the industry as a whole this year will be more than INR30b (USD461m)
  • With no sign of this improving next season commercial lenders are withdrawing from the sector or restricting their activity to selected groups.

Rising Costs in East Asia

  • Over the past five years the cost of cane in China and Thailand has doubled.
  • Higher cane prices have been required to cover rising farm costs and the need to achieve a reasonable level of income to prevent the destruction of rural communities. Small farm sizes combined with rising labour costs have made it difficult for farmers.
  • Chinese cane prices are amongst the highest in the world but the small size of China’s cane farms makes this necessary.
  • Thailand has also experienced a similar increase in cane costs, though the Thai milling sector is in better shape as it was able to retain a large part of the additional value created during the 2010/11 season.
  • However, last season’s total cane payment of BHT 1,179/tc equates to a No.11 value of around 22-23c/lb, which is very similar to the level that the Brazilian industry needs to ensure a fair return to shareholders.

Conclusion

“Price levels are still less than what is needed to deliver a fair return in what is fast becoming a finely balanced market.”

Toby Cohen, Czarnikow Director

  • The price of sugar remains below the total cost of production for most producers who supply the world market.
  • 2013 has been a good year for consumers and the refining sector but it has been a bad year for those involved in primary production.
  • The sale of sugar below operational cost of production, rising levels of debt and insolvency all highlight the damage that low prices have done. 

 

 

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