I think it was the investor Warren Buffet who talked about the difference between price and value some time ago. To him, price is what is paid for an asset or service, whereas value is what is taken. The two of them are not always at the same level. Sometimes a lot is comparatively paid for the value of that asset; other times little is paid for the value of that asset. For the stock market investor, buying a share whose price is below the company’s value and, by the same token, selling a share whose price traded by the market is above the company’s value, is good business.
The futures sugar market in NY closed Friday extremely undervalued with October/2018 traded at 10.96 cents per pound, a 55-point drop in the week, equivalent to 12 dollars per ton –the lowest price since April.
I wonder if the current sugar price is below its value. If Warren Buffet were to invest in sugar, what side would the mega-investor be on? He is known for his long-term approach and, evidently, for this fiction exercise I am proposing here, the commodities market has pretty different traits from the stock market that hinders long-term positioning. But let’s see.
At the end of 2016, when sugar in NY was trading pretty close to 24 cents per pound, it was clear to us that the traded price was above the asset value. Commodities that trade, as was the case of sugar in that period, extraordinarily above the production cost without any supply and demand rupture of the product, stimulate production up to the point where prices come into balance with the product value. In the last quarter of 2016, looking at the prices the futures market pointed to for 2018/2019 (all of them above 16.50 cents per pound), was to sell as much as possible, because at that point in time the price was above that of the product value. But that is history.
Today what we see on the sugar market is a situation out of step with the future which is coming up on us. The sugar price on the futures market in NY reflects a momentary situation (I will explain) that devalues the product way below its value. It is not common for the foreign market to trade so below the production cost of the most competitive producer because its effect is the opposite of that mentioned in the previous paragraph – production slowdown, lack of cultural care, investment downsizing, expansion delay and so forth. But, even so, why does this occur?
We won’t even mention the world surplus because this has been factored in the prices for a long time. The cost of sugar production in the Center-South is within an interval ranging from 42 to 49 real per bag, ex-mill, with no financial cost or depreciation, that is, basically the cash-flow cost. Taking the average dollar over the last thirty days as base, the production cost in the Center-South is between 11.30 and 13.00 cents per FOB Santos pound, that is, the most efficient mill in the country isn’t able to sell sugar with profit margin at the current price level of the NY closing.
Just as the stock market stresses out under situations of political and/or economic panic, the commodities market mainly stresses out under supply and demand ruptures. In our opinion, the delay in pricing by the mills has been particularly decisive for sugar price downfall. Up until May, only 60.6% of the sales for the 2018/2019 harvest had been fixed. Two harvests ago this percentage was 85%. This weakness has strengthened the price drop because the mills were forced to fix their contracts whose sugar was already ready to be shipped. There was blatant selling pressure and there are still remainders of this process.
It turns out that this pressure will be soon deactivated by the combination of three factors which are maturing: the first (short-term) is the reduction of crushing for this harvest; even the most efficient mills show a 2-3% drop in the previously estimated volume, the least efficient ones show a drop of up to 10%. If this has not been reflected on prices yet is because dryer sugarcane (isoporization) will be crushed as of July and August and will come up in UNICA numbers by the first fortnight of September.
The second factor (mid-term) is that lots of trading companies are paying or have paid sugar to the mills in advance based on July (which has already expired) or October, whose counterpart is load it in their warehouses for free until the trading companies decide to make it available. The October/March spread has even traded with an embedded carry of almost 25% per year. That is, there is a potential downsizing of the product for the last quarter of the year.
The third factor (long-term) is that the way things are going, next year sugarcane availability in the Center-South should be even smaller than this year (540 million tons of sugarcane) and Brazil will have to solve an equation that has the decrease in sugar supply on one side and the increase in fuel consumption (Otto cycle) on the other and the increase in the fleet of light vehicles (and more than 2.5 million units in two years discounting scrapping). The equation does not add up.
The three mentioned points can be optimized if the oil price on the foreign market continues its high pace, if the production mix in the Center-South shows the percentage destined for sugar below 39% and if the funds decide to shift their current position from short to long.
The recovery of the sugar value will be compromised if Petrobras pricing policy is dropped or if a foolish populist as Ciro Gomes is elected, for example.
In short, there are so many uncertainties that it is understandable that the market has moved by fear. At this point, it is up to the disciplined trader to define if the sugar price today has a fair value or if it is too undervalued.
To the readers: there won’t be a comment next week. I plan to take five days off to recharge the batteries which were very much affected by the excess of neuron burning.
It is almost time – the 30th Intensive Course on Futures, Options and Derivatives – Agricultural Commodities will be held on August 7, 8 and 9 in São Paulo-SP at the Hotel Wall Street on Rua Itapeva. The next one will be only in 2019.
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Have a nice weekend.
Arnaldo Luiz Corrêa
