Wednesday 13 March 2013

Killing me “softly”…

The title of this post reflects what an investor in “Softs” (i.e. Sugar, Coffee, Cocoa, Cotton and Orange Juice. There’s also Lumber, but it has been on a tear and is very likely close to a major top connected with the housing cycle.) might be thinking of his holdings right now…A lot of nothing/nowhere action with a slight downward bias that wears out the vast majority of market players. This might ring a bell with gold bugs as well…
Of course, we as contrarians are delighted to see this kind of action, since more often than not it accompanies major bottoms (we are obviously also humans, so we’re also bored out of our skulls and frustrated by this indecisiveness like everybody else). This is particularly true when strongly favourable fundamental conditions are present as well, as is the case with Sugar.
The objective of this post is to detail the main reasons why we think the delicious and addictive white powder (the folks at the D.E.A. need not worry…) is ripe for a major multi-year bull run that has the potential to bring it back towards its old all-time highs in the 40 to 60c$/pound region. As a general rule, we do not like to make predictions or give price targets, as we think that this is often an exercise in futility, but in this case we want to point out our strong conviction that the coming bull market in Sugar is bound to take out the interim high established in 2011 around 36c$/pound.
And now, without further ado, let’s see what’s brewing in the market…

The Fundamental Backdrop

A) Economics 101

It’s often said that “The cure for low prices is low prices” and indeed this statement is correct. The main problem lies in determining whether a certain price is sufficiently “low” to put the supply/demand adjustment process in motion. With regard to sugar the reality is that very few people involved in the global supply chain (from growers to mills in different countries) can turn a profit with a price of 18c$/pound (of course we’re not oblivious to the fact that in most countries sugar is a very heavily subsidized commodity: it’s simply not relevant to our discussion). So yes, it’s low enough: let’s then see how this impacts the market on both sides.

1. Demand

It should be obvious that a low price generally entices demand, both new and old. Current users of the product/commodity can increase their usage of the product without suffering an increase in costs, whilst users of similar products/commodities (like HFCS in the case of sugar) may find it’s economically advantageous to engage at least in partial substitution. Finally, new sources of demand that didn’t exist before may be created altogether.

2. Supply

On the other hand, producers of the commodity have no incentive to increase production and in fact may even be forced to cut it. Moreover, they’ll strive to find new, alternative uses for their products which can either provide a greater margin or at least partially absorb their surplus (this is happening with bio fuel in Brazil).
Readers interested in exploring the subject, can take a look here, here and here.

B) The Bizarre Case of Chinese Buying

This point is partially related to the one above: whenever sugar prices reach the 18c$/pound area, Chinese buyers step in and take delivery of large quantities of sugar. The reason is quite simple: producing sugar there costs about 30s$/pound and out-of-quota imports are subject to a 50% tariff, so 18c$ + a 9c$ tariff + some spare change for shipping and handling < 30c$ = a nice, risk-free profit for the importer. There are talks of restricting the ability of importers to engage in this arbitrage play, but so far nothing meaningful has been done, thus the market enjoys a strong floor at this level.
See here and here.

C) The Brazilian Milling Industry and its woes

This point really is the most important one. Brazil is both the largest producer and the largest exporter of sugar. Troubles there mean troubles for the world sugar market.
And in the Brazilian milling industry big troubles are looming on the horizon. Actually, they’re already there and getting worse by the day. Let us explain: it all started many years ago, at the beginning of the last decade, when mills embarked on ambitious expansion projects in a race to gain market share, building new facilities and upgrading existing ones. How did they finance such heavy investments? By taking on huge debts, of course: after all, those were the credit bubble years…
In 2008, problems started to surface: the financial crisis hit and numerous mills all of a sudden found out that they were struggling with debt servicing. Some of them went bust or were forced to sell their operations to more financially sound multinationals. Many just kept on going in the hope that things would somehow get better. Fast forward to today and we have low sugar prices, rising costs, rampant overcapacity and plenty of nearly-insolvent mills: instead of getting better, things actually got a whole lot worse.
The main issue is that fixed costs (like e.g. the amortization of plants and equipment) account for the vast majority of mills’ costs and, in order to reduce their unitary cost of production, mills need to operate at or close to full capacity. Unfortunately, overcapacity is so huge that even bumper crops aren’t enough to satisfy the mills’ needs. The end result is that mills are forced to compete between them for cane to process, thus further driving up their input prices. To add insult to injury, a sugar price of 18c$ basically ensures that the vast majority of mills will be selling their product at a loss, further exacerbating their already precarious situation. Of course, even the most efficient ones, capable of turning a profit at the current low prices, won’t be drinking Pétrus to celebrate: their margins are razor-thin.
To us this means only one thing: either prices will have to go up a lot on their own for some exogenous reason, thus allowing mills to regain their financial footing (prices of 20/25c$ won’t make any substantial difference), or they will go up much more as a result of a wave of bankruptcies amongst mills which will bring about a marked reduction in the available supply of sugar. This is not something that is going to happen overnight: our best guess is that it will take approximately 2 to 3 years to bring this problem to the forefront. Obviously a new financial crisis/globalized recession could accelerate the process markedly. Regardless, we have no problem waiting, particularly given that we believe the downside to be severely limited.
Here, here, here and here readers can find additional information.

D) India: a complete mess

If trouble is brewing in Brazil, then what about India, which is the second largest producer and the biggest consumer of sugar?
The situation there is messy, and this is a euphemism. Why is it so? Thanks to heavy government meddling. We won’t delve into the details: we have already bored ourselves to death with them and we do not want to inflict the same punishment on our readers. We’ll keep it short and say that in India sugar production pretty much equals consumption. There has been a surplus in the last couple of years, but our impression is that this is more the temporary result of a series of favourable phenomena than the product of careful long-term planning that is here to stay. As such, we think it’s very likely that India will at some point in the next 2 to 3 years be forced to import rather large amounts of sugar. The last time this happened prices rallied handsomely. Masochistic readers can have fun here, here, here and especially here. There are many other sources of info on the web, but the main takeaway is always that self-defeating “Fair and Remunerative Price” policies, coupled with other idiotic rules and regulations, do not allow the sugar industry to develop and thus leave it vulnerable to a few-years-long boom-bust cycle and to the occasional drought/whether catastrophe.

Technicals, Sentiment and Positioning

The technical picture looks constructive and sentiment and positioning data lend credence to its validity.

Sugar Chart of Sugar via http://stockcharts.com/.

The market continues to be stuck in a “falling wedge” consolidation pattern, which is bullish. The recent breakdown below the lower trend line (and below the important level of support around 18c$) appears to us to have been a classic “bear trap”. Price has now rallied convincingly and is back into the pattern and above the 50-day simple moving average, which has acted as strong resistance in the recent past. Further levels of resistance can be identified around 19c$ and 20c$. Both MACD and RSI show positive divergences, with the latter having broke out of a triangular consolidation and above the level of 50.
Sentiment remains subdued and below neutrality, something which has pretty much been the rule since late 2011. CoT data are very bullish, with commercials continuing to hold a small net long position (like in 2007, just before a major bull was born).



Conclusion

The sugar market continues to be very attractive. In fact, we think it currently offers one of the best risk-reward propositions available to long-term investors. We have bought it quite heavily in the recent months and we remain convinced that it has the potential to generate a very profitable multi-year bull market. Patience is of course always required, as it might continue to consolidate for a while more. What really matters is that we do not envision serious downside (i.e. we really doubt it would ever make it to 16 or even 15c$ as some analysts speculate). A powerful breakout above some key resistance levels might have us buying even more, but this time around with strict trader’s discipline (i.e. with a tight stop loss in case things do not go as planned).
A unrelated note: we’ve only made sparse updates to the blog recently and we haven’t produced any major articles (even this one is rather brief by our standards), because we’ve been quite busy following markets during the recent PMs turmoil and more importantly because we’re packing up for a very nice trip to the Seychelles, only slightly spoiled by the fact that we do not enjoy flying very much, to put it mildly. We’ll of course publish some photos of the trip, assuming we'll survive… The goal is obviously to cause some serious liver damage in over-worked readers currently stuck in their cubicles with no hope of breaking free before the summer (we are of course just joking).
As such, in the next two weeks readers can expect only occasional posts from us, which we’ll publish only in case there’s something going on in the markets which requires our attention.