This is this year’s first weekly comment since the recess started last December 19. Wow, what a substantial change in scenario we have witnessed in a little over six weeks. The positive picture being painted in late 2015, with perspectives of better sugar prices (in US cents per pound) vanished in early 2016 due mainly to two fundamental factors which had an impact on sugar pricing in NY: the dramatic price fall in oil and the sharp devaluation of the real against the dollar. The icing on the cake lies with the macro scenario which has worsened a lot for the commodities.
The fall in oil barrel price has changed the opinion on the part of the participants of the sugar market that the Center-South harvest for 2016/2017 would be more ethanol-oriented. In theory, the decrease in ethanol profitability because of the fall in import price of gas makes the mills favor sugar production. The forecast numbers for the Center-South harvest state that. Sugar production estimates up to 36 million tons have been shamelessly published. The sharp devaluation of the real against the American currency sped up the volume of price fixation of sugar for exporting. Archer Consulting model, for instance, estimates that by late January about 17 million tons of sugar from the 2016/2017 harvest had already been fixed at an average price of 13.75 cents a pound equivalent to R$1,213 a ton. I will have more to say about this model further on.
Since mid-December, March/2016 has fallen nearly 200 points. May, July and October 2016 have plummeted 150 points, 120 points and 100 points, respectively. The pressure on months with shorter maturities usually reflects the lack of demand on the physical – which has melted from 51 points (in the case of March/May spread) to zero point. We have gone from a market whose price curve was inverted to a practically flat market in the three first maturities – that’s a sign of weakness on the physical.
Does this mean the picture is that negative for the prices and this increase we saw in the last quarter of 2015 was just a fake recovery? Well, that depends. The sugar market in NY hasn’t had the directional performance that the heavily long funds expected. And the funds get tired of holding a position that doesn’t live up to their expectations. You see, the sugar fundamentals are still strong, but oil and real devaluation is what is hugely tipping the scales.
Paradoxically, ethanol has broken the consumption record despite the unfavorable parity. The explanation given by a businessman linked to the distribution sector is that the consumer doesn’t do the math. If ethanol is R$1 a liter cheaper than gas, the consumer chooses ethanol even if it is economically unfavorable. Parity is damaged from R$3.33 against R$2.33; however, according to the same source, gas at R$3.79 a liter and ethanol at R$2.79 a liter, still makes the consumer prefer ethanol because he thinks a R$1.00 difference is a good deal in spite of a parity close to 74%. Go figure!
The dilemma for the mills with a tight cash flow at the start of the harvest is to decide between producing sugar or ethanol. An executive from the sector argues that the expected sugar turnaround in the 2016/2017 harvest can turn out to be a fallacy. When the mill exports sugar, it takes it at least another 39 days to get the money. Ethanol is sold at the spot. Take an abusive tax rate charged to the less capitalized mills (2.8% a month, conservatively) and decide what is better for them: a 39-day sugar forward sale or a ethanol spot sale? On current levels of negotiation for May/2016 and taking into account the discounts sugar negotiates on the physical at the start of the Center-South harvest and the financial cost, even if ethanol trades at about R$ 1,700 a cubic meter ex-mill, it will more advantageous to produce ethanol than sugar, strictly from the point of view of those who have a tight cash flow. This reasoning makes sense.
2016 should be marked by heavy sugar volatility. After four years of global production surplus, it was expected that in this first year of deficit (whose predictions range from 3.7 to 8.0 million tons of sugar) we would have the futures market showing a trajectory of rising prices. The macro scenario doesn’t help. The commodities show a disappointing performance in the yearly accumulated values: oil – 28%, gas -25%, sugar – 14%, cocoa – 13%, coffee – 10% and cotton – 8%. No agricultural commodity came out positive.
Better fundamentals have been eclipsed by the high stocks in China and India and – risking to sound like a broken record – the devalued real and the plummeting oil. The sector’s debt is frightening – R$94 billion. On the other hand, Brazil has the lowest production cost on the planet. Were it not for the subsidy, a lot of the competitors would have disappeared. This harvest, we will have fewer mills crushing (the same number of plants as in 2007). The sugarcane production in the Center-South has been stagnant for a decade. The production peak assuming 252 days and the industrial exploitation of 89% (the highest I have seen in the sector) is 635 million tons. Without new investments and with a high-potential demand in the next 4-5 years, we will need to produce more sugarcane. The logistics can be strangulated given the difficulty of some operators. If you had to take a bet on the price of sugar (18 months), where would you place your bet?
Despite the bad macro picture, any change in the course of supply or in the perception of the participants of the market about the harvest size, or in the Brazilian political picture, or any spark can ignite this market upwards.
I repeat what we said in the last comment last year, for I think it’s relevant and current, “…the fixation of sugar for May/2017 settles at R$1,530 a ton, a very appealing price…if the dollar goes up to R$5.0000 on the maturity, sugar will need to be at least at 13.34 cents a pound so we can reach the same R$1,530. If…the American currency…is worth R$4.0000 the balance point goes up to 16.67 cents a pound…If, on the other hand, the political crisis gets worked out and the country regains its credibility and the dollar goes back to 3.5000, the balance point in NY changes to 19 cents a pound. It looks like the risk for this operation is limited; in addition, if the company doesn’t feel comfortable, it can buy calls at the next exercise price on balance levels, participating in an eventual rally which can happen at the price in dollars”. On Friday, May/2017 closed at 13.66 cents a pound and considering NDF the fixation is R$ 1.400 per ton.
We have gotten a lot of comments about the fixation volume of the mills in NY found by the model developed by Archer Consulting – everyone finding the volume too high. Mathematical models fail since they are a simplified representation of the reality. They try to provide a view or scenario based on a fragment of the whole. We have been using the same model for five or six years and for the first time it has been strongly questioned. The thing is today, unlike what happened years before, more and more mills are fixing their export volumes for the next harvest year too and not only for the current harvest year. I believe, without being able to state categorically, that this behavior on the part of the mills (which aims at capturing the advantage of the devalued real on a rising curve) has added an extra volume of fixation for 2017/2018 which cannot be isolated from the model. In other words, it is as though the model estimated that 17 million tons have already been fixed for 2016/2017 and the next harvests. However, given the impossibility of separating the fixations per harvest, we will continue to inform the total volume of fixations despite the distortions the model seems to present.
Dilma virus continues to be bent on taking the country to the depths of Hades.
Registrations for the XXV Intensive Course on Futures, Options and Derivatives in Agricultural Commodities are open. The course will take place on March 29, 30 and 31 from 9:00 am to 5:00 pm in Sao Paulo. Send in a message to priscilla@archerconsulting.com.br for further information.
Have a great weekend everybody.
Arnaldo Luiz Corrêa
