DONKEYS, COWS, AND SOULS
Whenever you want to know why this sugar market in NY suddenly goes up and then plummets into a void, just take a look at the position of the funds. Well, look at this, based on the COT report released this Friday by the CFTC, the non-index funds (those that hold a more speculative bias) increased their long positions by more than 25,000 lots over the week that runs from Tuesday to Tuesday. And you thought it was El Niño, Thailand, India or whatever that pushed the market up, huh? Well, dear readers, it was the funds.
Despite this effort to increase the market without the acquiescence of the fundamentals, the funds (at least for now) have fallen flat. In Portuguese we would say “they had their donkey fall face down into the water”, an expression coined in the XVIII century when muleteers would ride on donkeys to cross wetlands and the poor animals would drown. Well, with no donkey or muleteer deaths being reported, the fact is that NY closed out the week 111 points down (more than 24 dollars per ton) for October/2023 and 98 points down for March/2024 (almost 22 dollars per ton). For the following trading months, which make up the 2024/2025 crop of the Center-South, the average fluctuation was 54 points down (about 12 dollars per ton) and for the 2025/2026 crop, there was only a 12-point downturn (less than three dollars per ton).
Those who have been following the market can tell that the fluctuations are not for the weak-hearted – sharp fluctuations within short intervals that challenge the logic and make the insertion of a minimally coherent narrative difficult. We saw that coming. Vacation months in the northern hemisphere result in smaller volume and greater fluctuation. The daily average of the traded volume at the NY exchange in July has been 91,000 contracts, 58% below the businesses registered in June.
Since volatility is calculated on the fluctuation of the daily closings over a certain period of time, a market that shows a greater daily fluctuation, but always closes out near a limited interval of price won’t necessarily show greater volatility. For example, suppose a market fluctuates 100 points between the minimum and maximum of the day, but closes out pretty close to the previous day’s closing, for the volatility calculation (based on the Black & Scholes model) the fluctuation from one closing to the other is what counts.
The ethanol price is what concerns the mills the most now. Although the profitability of the sugar has been huge for those who fixed their exports when the market was bullish, ethanol seems to pulverize this profit with the gloomy perspective of prices getting worse and worse. The biggest challenge is how to hedge ethanol.
Sadly, in Brazil we don’t have a commodities exchange that engages in fostering the risk management of the agribusiness. Not just in ethanol, but in every commodity that Brazil produces and that could have a safe harbor for trading and efficient management at B3 (the Brazilian Exchange). There is no political will and this discussion has been going on for decades. Besides, a commodities futures contract that doesn’t allow for the physical delivery of the product and is settled by means of a price indicator inhibits the use of this mechanism. The local exchange doesn’t want to run any risks that a physical delivery might cause, though having agricultural contracts in its portfolio is a convenient flag for the public view. The volume traded at B3 yearly is laughable. If we had physical delivery of the product, the situation would be a whole lot different.
But getting back to the business at hand (in Portuguese we would say “picking up the cold cow”, an expression that goes back to when the Portuguese would serve a dish made out of cold beef before the hot meal, but which means stop stalling and go straight to the point), what the mills want today is a hedge for ethanol. The obstacle for this undertaking is the market liquidity; B3 is out of the picture. What could we do then? Buy a Brent oil put, which serves as reference for Petrobras and so, if the oil price drops on the foreign market – assuming that Petrobras keeps the parity internally – the gain gotten out of the operation could make up for the ethanol price drop on the domestic market.
We have two problems here. First, the liquidity in oil options is exiguous. Second, when we make a cross-hedging, that is, using an asset (oil) to hedge another one (ethanol), we run a basis risk because the assets might not be necessarily interdependent.
So, what is left? Though it might be frowned upon, the most plausible alternative would be buying a sugar put to protect the ethanol. Assuming that the spread between the two of them stays on, if the sugar market drops, the gain out of the option of a long put should make up for the ethanol price drop. But again, there is the basis risk and the loss of correlation.
As we can see, it’s not an easy problem to be solved because there is some huge difficulty finding an adequate tool with enough market liquidity to drain the risk of the mill.
We understand that ethanol is worthless or as we would say in Portuguese “in the basin of the souls” (an expression going back to when graves were moved from one place to another within the cemetery and those mortal remains that couldn’t be identified were put into a basin, which means something that is worthless). This time around, hedging now can be the worst moment. What’s the rationale behind this claim?
Examining the sugar price in NY over the last twenty years, converting it into real per ton and adjusting it by the inflation rate, we would assume that considering the narrow supply and demand that is said to be coming next year, even if we don’t have any deficit, but the uncertainty coming from restrictive policies in India and elsewhere, the market should not trade below the 3rd quartile. I will explain. The 3rd quartile is the one that delimits the 25% highest values. Therefore, we assume that we are thinking about the line of the third quartile as the supporting one for a market.
Today this line represents about R$2,350 per FOB ton, that is, in our view this would be the great support of the sugar market. Taking into account the dollar curve that closed out the week at a R$4.7299 low with a 1% appreciation over the week, we are saying that NY should hold at about 21 cents per pound (for October/2023 and March/2024). If we take this ex-mill sugar and convert it into ethanol discounting 650 points (the hydrous has a discount of 350-400 points on average) we will come to an ethanol of 2.300 for now and 2.400 for December at B3. That is, ethanol is already too discounted. Hedging now would be foolhardy.
It’s worth remembering that this week 4,000 puts at the strike price of 21 cents per pound for January/2024 were traded in NY. There are lots of people protecting themselves from the drop that should be coming along.
We are totally screwed – an expression I’d rather not explain.
Do you want to learn everything about ethanol from independent people? Archer Education is sponsoring on September 20 (Wednesday) and September 21 (Thursday), 2023 in Ribeirão Preto, the course Ethanol Marketing Intelligence on the Fuel Market, given by Tarcilo Rodrigues. This is the third edition of a course that has already become a benchmark in the sector due to the strategic view of all the ethanol marketing chain, from supply to service stations, detailing the major points of pricing, stocks and demand all through the supply chain. Contact priscilla@archereducationçcom.br for further information.
You all have a great weekend.
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