Not even Aristotle will help
The sugar futures market in NY closed out Friday with October/2021 at 19.49 cents per pound, a 61-point drop against the previous week. The October/March spread closed out traded at 66 points, showing a discount of 8.9% per year between the two months. Putting it simply, nobody wants sugar for physical delivery in October and those who have a long position rush to liquidate it or roll it to next expiration hoping for better days.
How can a market that advertises a reduced sugarcane crop and the danger that there might be a shortage of sugar explain such a weak spread? Markets with critical availability problems tend to invert. In our case, the pieces don’t fit together, and yet we watch everything without understanding anything.
Experienced traders point out that the issue is a little more complex than simply looking at the cold numbers of the spread. They say that the high international freight fees distort the basis (the sugar value on the physical market minus its price on the futures market) and reduce (when they don’t wipe it out) the profit margin of the trading companies, which try to put off sugar which would be delivered now by the mills until 3-4 months ahead, even paying premium (we heard 45-50 points on the market) in order to do that.
The fact that margin calls that hit the trading companies because of the sudden increase in quotations left them with a pretty low cash flow might also affect their decision making. Based on our numbers, adding up the fixations of the two crops, 2021/2022 and 2022/2023, though there are also fixations in 2023/2024, the total margin calls for the trading companies, banks, OTC providers and the mills themselves is around US$2.7 billion.
But why does sugar price go up so much on the futures market after all? Well, the funds have increased the long position even further and according to the number released on Friday by the CFTC, based on last Tuesday against the previous one, they have added on 7.600 lots, increasing the total position to 256,600 long (equivalent to more than 13 million tons of sugar).
It’s interesting to note that in the month-to-date of August, sugar contrasts to the other commodities: it went up 9% while the energy ones went through a substantial fall: WTI oil dropped 16%, gas dropped 14%, Brent dropped 13% and corn ethanol in Chicago dropped 10%.
The global market is running away from the risk: China shows a slowdown (a growth of 8.5% against 8.7% a month ago), the concern over Covid-19 Delta variant is increasing in several countries (hospitalization in Israel has increased to the level seen in March), the appetite of the Central Banks to inject more money into the economies has waned. Sugar in NY is still on an upward trend, though. Go figure.
In Brazil, inflation is creeping up on 9%, unemployment is at 14.6%, the economy isn’t moving and should have a small growth next year. Besides the pandemic, we are in the midst of a fiscal and institutional crisis that should drag on for a long time bringing further political instability and distrust on the part of the local and foreign investors. The dollar closed out the week at 5.3780 and teamsters have threatened to go on strike, closing roads on September 7, led by country music singers (imagine that) who think they represent the agribusiness sector. It’s a true and ridiculous Banana Republic, which would make the eyes of director Sacha Baron Cohen shine.
There’s little doubt that we are headed for strong turbulences next year and their impact on the exchange rate will be strongly felt in sugar quotations, which would devalue in order to adjust to a weaker real. This is a point that deserves attention on the part of risk managers. I will explain.
What is most heard on the market is a superficial analysis about those who fixed prices in real per ton and now see current prices at much higher levels. “Ethanol is paying more”, some say. “Ah, if only I had waited longer to fix”, others complain. The fact is that prices are where they are for a simple reason: everybody fixed and the funds are alone putting the market wherever they want to. If there wasn’t as much fixation, prices wouldn’t be strong enough to increase in the vacuum as they do now.
Have NY prices gone up because the volume of fixation was high [back then] or is the volume of fixation high because prices went up [back then]? Here’s a corollary to the Aristotelian principle of contradiction. To be studied by market philosophers.
I myself would rather follow the old and well-worn philosophy that nobody breaks with profit in the pocket. Many mills, despite the high prices in real per ton, combination of higher interest rates perspective in Brazil and a weak real on the spot market, feel insecure to increase their fixations for the 2022/2023 and 2023/2024 crops.
At Friday’s closing, the arithmetic average of prices in NY for the 2022/2023 crop, adjusted to the current value, showed R$2,232 per ton. Since the start of 2000, adjusting the converted values in US$ by the inflation, only in 10% of the events has the adjusted price been higher than this value. Do you want a conservative suggestion? Fix prices in real per ton and buy 10% in at-the-money calls.
You all enjoy your weekend!
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Mr. Arnaldo Luiz Correa is the Director at Archer Consulting. He is a Risk Manager with an experience of almost 30 years in the agriculture commodities market.
To get in touch with Mr. Arnaldo, write on firstname.lastname@example.org