SUGAR

I believe that sugar is going to have a big bull market in the next two years. Of course two years is a long time in the commodities business. But that's part of what this blog is all about: finding ways (usually through equities) to participate in long run commodity fundamentals. We want these trades to be no-carry or positive carry. That's the idea here.

According to the analyses I have seen, sugar to energy has the most favorable economics of all biofuels. It may be the only biofuel that can be planted for fuel without government support. (There are a lot of crops that will work with a biofuel byproduct.) Sugar to ethanol has worked in Brazil since at least the '70s, when I used to go there to buy cocoa. Its technology is well known, stable and easy to implement. Its costs are predictable.

Sugar is a staple crop around the world. It has various levels of production cost and government support. The cheapest sugar in the world comes from Brazil. Most industry people I have spoken to say the cost of new production there is about 15 cents a pound. The current cost of existing production is of course much lower. Brazil has plenty of area for increased production. It also has a plenty of ways to switch sugar cane between sugar and ethanol depending on economics. So Brazilian sugar output can actually fall with no acreage or yield reductions. Other countries can also increase production, but the costs are higher.

Sugar ran up in late '04 and '05, partly because of supply/demand, but mostly on the back of the oil price and biofuel value. This was followed by the inevitable disappointment. New ethanol facilities (and facilities for ethanol consumption) take a long time to develop. The US, to protect its own ethanol industry, has a tax on Brazilian imports. Supply reacted to the higher prices the way it always does, and we now have a four or five million tonne surplus.

If you look at the history of sugar cycles, it seems to take two to three years to work off a surplus caused by production increases. My guess is that this one will take less. The Brazilians are already diverting cane to ethanol. The EC is sharply reducing the subsidies that drove farmers to produce for world export. (Exporting at French costs to 3rd world markets. That's gotta be the worst ag distortion of all time.) More important, the ethanol story makes sense. This will provide a rising floor under demand that will cause continued periods of tightness. I'll bet that sugar prices will overreact on the upside once again.

OK, how to play this? The classic commodity trade is to follow the fundamentals, watch the charts, and buy major breakouts. There will be some false ones, so you have to use stops, and you have to keep trying. This should work, but given the time frames involved, you may lose interest and/or hope. Another way would be to buy out of the money '08 calls. I don't generally like to buy options. I'm a good enough trader that I can control my risk more cheaply with careful timing (in effect doing my own delta hedging). Additionally, the sugar chart still looks bad and counts to under nine cents. Nonetheless, if a bull market does come, options volatilities could expand a lot. So this might be a successful strategy.

But I think even better is to buy shares of sugar companies. Many of these companies have facilities that has long been depreciated. They can and do make good money at current sugar prices. They have no plans for expansion, so they tend to pay good dividends. There's a real positive carry here. Of course if sugar prices don't go up, there will be no growth. But that's the bet.

As far as I can see there are no US companies with significant exposure to world (#11) sugar. The biggest name is an Australian company CSR (Yahoo symbol CSR.AX). CSR is about half sugar, but it is also a major force in aluminum and building products. Readers of this blog know that I like aluminum companies. Building products are a little more problematical. CSR sell in the US, and has had some liability issues. Nonetheless it's a good conservative issue with a P/E of 14 and a 4% dividend. I like it.

This was added on April 26 --- Here are two small caps with high exposure to world sugar. Illovo Sugar is a S. African company with sugar interests there and in other African nations. It's selling for about 3.2 times book. It is majority owned by British Foods. That would be a red flag, but S. Africa has western-level accounting and corporate governance standards. So you may be all right.

Another is Maryborough Sugar (AUS), a Queensland refiner. This is quite a small cap, but pays a good (10%) dividend! Remember though, that Queensland is low on rainfall, so there may be production problems.