The NY futures market closed out Friday’s session with the expiration of the March contract and the delivery of almost 900,000 tons to exactly who the market expected already – Wilmar. It was weird that AKS (Al Khleej Sugar), a refinery from Dubai, was among the deliverers, but experienced market traders believe that it is just a swap operation starting with the ultimate recipient, but you know what the market is like…
Over the week, sugar dropped 44 points compared to last week. May/2021, which is the first trading month as of now, closed out at 16.45 cents per pound. The question everyone is asking is if there is room for it to go up any further or if we have already seen the market high.
I understand that the market went overboard on the high and the reasons are based on the shrinking of the global economy, the steady decrease in consumption which had been growing by 2.2% for 20 years and before the pandemic was showing 0.46%, the balance of supply and demand that today shows a surplus of at least 3 million tons of sugar depending on the source used and the fact that Brazil has exported an additional 12 million tons over the last twelve months. I will elaborate on that next.
Based on the model we created more than a decade ago, 80% of Brazilian sugar exports for the 2021/2022 crop, which hasn’t even started being produced, are already fixed. This is a historical record.
There are four basic alternatives for the mills to hedge their export sugar: a) those that hedge at the NY exchange in their own futures account they have with a broker; b) those that hedge using credit lines with the banks they have business relation with; c) those that hedge in the futures accounts of the trading companies as long as there is a commercial contract to back that up; d) those who use suppliers of over-the-counter operations, bound to a preset credit limit.
The alternatives used by the mills aren’t excluding, that is, there are companies that use the four alternatives. Those having a solid financial situation and an adequate risk management concentrate especially on alternatives a) and b) and transfer the futures contracts sold to buyers (the trading companies) to fix the physical price of the commercial contract among them as far as the agreed-upon term allows. For example, the trading companies accept to receive from the mills the lots hedged in advance on the futures market which can range from a fortnight to two years prior to the shipment period, depending on the financial health of the mill.
Many mills, be it for practicality or submission to the restricted cash flow, prefer using alternatives b), c) and d) together. The functionality is the same with the added benefit that they get rid of possible margin calls which can affect the cash flow. Using the trading company’s account on markets with great variation can bring an advantage of 10-20 points per year for the mill if we take into account the financial cost over the daily adjustment and brokerage expenses. This calculation was made using the Monte Carlo simulation.
To have an idea of the stress a margin call can cause, considering the abovementioned percentage of fixation (80%) covering an average period of 6 months (let’s say that the company will ship 25% of the export volume on each contract) and with a 30% volatility, it would be recommended that the company have a mattress and/or credit limit with banks and financial institutions of US$120 per ton in order to withstand a possible market stress- that’s a lot of money.
In addition to the four alternatives pointed out above, there is also a myriad of operations and structures that can be executed depending on the appetite for risk of each company. The fence, which consists of buying a put and selling a call both out-of-the-money where a company protects a minimum value of profitability (if the market falls) in exchange for a maximum value (if the market goes up), is the simplest one.
Going back to the starting point which is my concern – the fixed sugars for the 2021/2022 crop are priced at 13.13 cents per pound on average while the average closing in the week, using the abovementioned criterion, is 15.92 cents per pound. Therefore, this huge volume of sugar not even produced yet and, of course, not even shipped is causing an overall margin call estimated at US$1.2 billion.
A margin call is not a loss, but it sucks up the cash flow of the company and hinders the normal business flow forcing a reduction in volume. In thesis, the profit of a trading company that doesn’t have a directional stance will depend on the difference between the basis bought and the basis sold, to make understanding easier. However, where markets fluctuate a lot, the trading company which only mediates, is subject to the fact that the seller might not deliver the product when the market is way above the price he fixed or the buyer doesn’t want to receive the product when the market is way below the price he fixed. And then, we have a risk of credit and performance.
We are going through this soybean situation today where some producers who fixed soybean at R$70 per bag won’t deliver with the market at R$140. We have no sign that this might occur with sugar. We are just discussing the risk concept.
If there is a rupture on the market because of any fortuitous event, the hedgers (mills, trading companies, banks among other participants) can be forced to get out of the position or use strategies (buying calls to diminish the delta of the position) which end up re-feeding the market high. Tail events (of little probability) occur and we need to watch out for them.
In short, I understand that the market has room for accommodation (low) due to the fundamentals, but we cannot rule out the impact that the volume of transferred money for the daily adjustments might cause if someone starts bleeding.
Have a great weekend everybody.
Arnaldo Luiz Corrêa
