Sugar prices: The top 10 most important drivers

This is the start of a series of articles looking at the top 10 most important drivers behind some of the main commodity futures prices. Episode 1 looks at sugar.

1) The Brazilian Real

Brazil is the largest producer of sugarcane, producing around 740 Mt in 2013, almost 40% of global output. A decline in the value of the Brazilian currency, the real increases the incentive for Brazilian farmers to increase output for export while at the same time reducing their production costs.

Millers in Brazil can crush sugarcane to make ethanol for the domestic fuel market, priced in reals, or sugar for export, priced in dollars. A decline in the value of the real versus the dollar encourages Brazilian producers to divert more to the export market.

2) Long supply cycle

Key to understanding sugar prices is its long agricultural supply cycle. The agricultural supply cycle describes the process of activities relating to the growth and harvest of the crop. These include loosening the soil, seeding, watering and harvesting etc. The typical cycle from planting to harvest for sugar takes 12-18 months. This means that farmers price expectations (i.e. whether they expect high or low prices to continue) are vitally important in determining future supply and prices for sugar.

3) Ethanol demand

Brazilian sugar cane growers can crush the cane they harvest to produce sugar or for ethanol. As ethanol also competes with gasoline as a transport fuel, a drop in the price of gasoline (as a result of lower oil prices) will tend to lead to lower ethanol prices and hence less demand for sugar to produce ethanol. The origins of Brazil’s use of ethanol as a fuel date back to the late 1920’s but it was the first oil crisis of the 1970’s that highlighted the dangers of oil dependence.

4) Government intervention

Subsidies and import tariffs have distorted sugar markets resulting in sugar producing countries making more sugar cane than would be the case in a normal competitive market. Many of these distortions have a historical legacy. In Europe for example difficulties sourcing sugar from the colonies in the early 1800’s prompted planting of sugar beet. Today the EU is the second largest exporter of sugar in the world. In the US import tariffs designed to protect domestic farmers have raised prices for US consumers, prompting them to look for alternatives such as high-fructose corn syrup.

5) Affluence

The consumption of added sugar (sugar not contained in natural products like fruit or milk) or high-fructose corn syrup has increased dramatically over the last few decades, yet consumption varies considerably from country to country. At the top, we find the USA, Brazil, Argentina, Australia and Mexico, all at more than double the world average; ranging from 40 teaspoons for the USA to 35 for Mexico. At the other end, we find China with 7 teaspoons. Growth in demand for sugar is strongest in emerging economies, particularly South America and Asia.

6) Health concerns

Sugar is thought to be a leading cause of obesity, diabetes and tooth decay. With governments and consumers more aware of the risks of sugar over-consumption the growth in sugar demand could slow in the years ahead.

Related article: Excess sugar consumption leaves a bitter aftertaste

7) Substitutes

Sugar accounts for about 70% of world demand for sweeteners with chemical sweeteners, such as saccharin and aspartame, as well as an expanding number of synthetic chemical products accounting for the rest. High-fructose corn syrup is a more natural alternative to sugar that has been widely adopted in the United States.

8) Weather

While warm dry weather is important for the growth of sugar cane, drought in Brazil can be especially damaging for sugarcane farmers. Meanwhile, wet weather presents an obstacle to harvesting the sugarcane, delaying getting the sugar to market and risking damage to the crop. Wet weather also reduces the sugar content of the cane, especially if it occurs late in the crushing season, i.e. when mills are processing the cane.

9) Stock levels

As with all commodities, low levels of stocks indicate strong demand, weak supply or a combination of the two. In addition, low stocks provide very little in the way of a buffer in case of disruption to future harvests.

Unlike oil or copper, where the well or mine can be shut down when prices slide below production costs, sugar-cane mills can’t just leave the cane in the fields, nor do they have the capacity to store the sugar they make until prices rise. With such a long supply cycle, if problems occur on the way to or at storage (e.g. due to fire or transport delays) then this can significantly affect the price.

10) The US dollar

Like most internationally traded commodities sugar is priced in US dollar. At its most basic a decrease in the value of the US dollar relative to a commodity buyer’s currency means that the purchaser will need to spend less of their own currency to buy a given amount of the commodity. As the commodity becomes less expensive demand for the commodity rises, resulting in an increase in the price and vice versa. Unlike many other commodities sugar only has a small inverse correlation against the dollar of around -0.15 with the previous nine factors appearing to be much more important in determining sugar prices.

Related article: No sugar high in sight

The next article in the series looks at the top 10 most important drivers of livestock prices.

Natural gas prices: The top 10 most important drivers

Copper prices: The top 10 most important drivers

Livestock prices: The top 10 most important drivers

Gold prices: The top 10 most important drivers

Oil prices: The top 10 most important drivers

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“You can’t just turn cows on and off”

An article in the WSJ highlights how over optimistic expectations over Chinese demand growth helped contribute to the current lull in commodity prices we are seeing. In this article they show how strong Chinese demand growth for dairy products soared between 2008 and 2013 prompted farmers in New Zealand to ramp up production to to supply the growing demand.

“Chinese imports of whole dry milk powder soared to 619,000 metric tons in 2013 from just 46,000 in 2008, according to U.S. Department of Agriculture data. Farmers in New Zealand ramped up production to supply the growing demand, adding 450,000 metric tons of capacity during that stretch, an amount that is equal in weight to about one billion 16-ounce milk containers.”

Then when demand fell short, prices collapsed.

China’s imports of dry powder milk have since flattened. Its inventories of the product tripled between 2011 and 2014, and prices tumbled, according to the USDA.

Related article: Dairy price rebound looks unsustainable on weak Chinese interest

Since the start of 2014 whole milk powder prices have dropped from $5,000 per tonne to $2,300 per tonne (GlobalDairyTrade)

Expectations are vitally important to commodity markets. Indeed, their importance, particularly in agricultural markets has been recognised for almost 150 years.

“….A scarcity or abundance of crops affects the exchange of the world, and tends to forecast future prices, and to give some clue to future production…”

Samuel Benner, “Prophecies of Future Ups and Downs in Prices” (1876)

Cow face, Otago Peninsula, NZ

The observation was expanded on further through The Cobweb Theorem, developed in the 1930s. The theory shows how supply and demand responds in a market where the amount produced must be chosen before the price is observed. Agriculture is a great example of where the theory might apply, since there is a lag between planting and harvesting.

Suppose for example that as a result of unexpectedly bad weather, farmers go to market with an unusually small crop of wheat, resulting in higher prices. If farmers expect these high price conditions to continue, then in the following year, they will plant more wheat relative to other crops.

When they then go to market after the crop has been harvested, supply will be high, resulting in a drop in the price of wheat. And so it goes on. If they then expect low prices to continue, farmers will reduce planting of wheat for the subsequent year, resulting in a return to high wheat prices yet again.

Very short-sighted of those farmers, you might say.

Critics of the Cobweb Theory have argued that rational farmers should be able to work out what the equilibrium level of supply should be, given current information about supply and demand. The farmers, it is argued should base their price expectations on how they expect the market is likely to work, rather than just reacting blindly to price movements.

Back to those dairy farmers in New Zealand and their expectations of Chinese demand. Were they short-sighted too?

Well, may be a little.

When prices have been high and rising for some time (as it was for dairy prices as with many other commodity prices), it becomes an entrenched assumption that high prices will persist for the foreseeable future and vice versa. As much as you or I like to think of ourselves as forward-looking, the truth is that we are all backward-looking to some degree and update our perception of the world only gradually (something called adaptive expectations).

However, as with iron ore miners who reacted to strong Chinese demand growth in 2005 to bring on more iron ore supply, there is a time lag between the decision to increase supply and that supply actually materialising.

What will be interesting now is how dairy farmers in New Zealand respond. Will they now look to reduce the size of their herds, perhaps setting the stage for the next surge in dairy prices?

“You can’t just turn cows on and off”

See the FT 4th June 2015 “Dairy price plunge highlights hedging handicap”

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Have global food prices now reached a trough?

Global food prices fell to their lowest level since September 2009 in May according to the UN Food and Agriculture Organisation’s (FAO) food price index. The index fell 1.4% from April and is now down 22.4% since May 2014.

Chart: UN Food Price Index

2015-06-04_1832

Source: UN FAO

High global production, cheaper crude oil and the strong US dollar (particularly against many food producing economies, e.g. Brazil) have pressured food prices over the past year.

Related article: Why are agricultural commodity prices so weak in 2015?

Investor appetite for agricultural futures is suffering with hedge funds bearish bets hitting record highs, perhaps indicating that prices are now oversold. Could global food prices have now reached a trough?

There are tentative signs that it could.

The FAO forecasts that global cereal production will hit 2.524 billion tonnes in 2015-16, compared with its previous forecast of 2.509 billion tonnes. The higher cereal forecast is mainly due to larger than expected harvests in Africa and North America, but with 2015-16 output still expected to be 1% lower than last year’s record harvest. Cereals stocks at the end of the 2015-16 season are forecast to reach 634.3 million tonnes, compared with 646.5 million tonnes in 2014-15. Still very high by historical standards.

Societe Generale sees prices for many agricultural commodities rising above what the futures curve alone might indicate. The bank forecasts that corn will rise back above $4 per bushel early next year, up from $3.62 per bushel now. SocGen highlight the trend for years with record yields, like 2014, to be followed by poorer results while forecasting higher feed use for 2015-16 than the US Department of Agriculture has penciled in.

Crude oil prices have rebounded since the late January lows which should give some support to agricultural commodity prices. But with oil remaining vulnerable to further weakness going into the second half of 2015 its impact is likely to be muted.

The Brazilian Real since March after suffering a sharp decline against the dollar and many other currencies over the past year. This increased the incentive for Brazilian farmers to increase output for export. SocGen see sugar prices (perhaps the commodity most closely correlated to movements in the Brazilian currency) rising back to 14 cents per lb by the first quarter of 2016 with the bank seeing a continued rise in Brazilian use of ethanol shaving “some of the excess sugar off the global balance”.

The likelihood that El Nino returns may also prompt higher agricultural prices. But with grain stock levels so high the impact is likely to be limited.

Related article: Bumper harvests to curb El Niño impact on food prices

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