Thursday, January 26, 2006

Pour Some Sugar On Me

Yes it's true, that classic 80's/drinking anthem has taken on a new dimension with the rally of sugar. How did it happen, and why did it take nearly 20 years after Def Leppard's peak? Let's explore.

First I should say that in my analysis, I rarely crunch serious numbers. Part (and maybe most) of the reason is laziness. But also, numbers can say anything you want them to. So I just look for things that I think will "probably" happen. Charlie Munger said that he never saw Warren Buffett do a Discounted Cash Flow Analysis, and I'm no Warren Buffett so who am I to argue?

Heading into 2005, sugar prices had been in the dumps for the last 25 years. This is very promising. There is a reason that commodity prices follow long term cycles, and it has to do with supply, demand, and prices. When prices are low for a long period of time, the incentive to produce drops. This is what happened with oil. Prices were in the tank since 1980 and everyone stopped exploration, building refineries, etc. Then one day, demand actually catches up with supply and the shit hits the fan. It takes a long time to ramp up supply, and in the mean time high prices persist, usually for long periods of time. So get used to high energy prices.

Back to sugar, it dropped to 5.27 cents per pound in Feb '04. To put this in perspective, sugar traded for 4 cents per pound in 1900. Nineteen freaking hundred! Same price, that is not adjusted for inflation. Given that, it's safe to say that sugar may have some upside. Also, sugar did spike over 56 cents a pound very briefly around 1974 during the last commodities bull market, so in the spirit of NBA Announcer Hubie Brown: "You know the potential is there. Sugar has some good upside."

Over the past several years, another interesting thing happened - Brazil became the lead producer of sugar in the world. Quoting data from the CRB Commodity Yearbook 2005, Brazil produced 23,810 thousands of metric tons out of the 148,874 world total for the 2003-2004 year.

Why does this matter? Instead of selling all its sugar at these bargain basement prices, Brazil started converting some of it into ethanol and running their cars off of it. And with high oil prices, it made sense that Brazil would convert more and more of their sugar into ethanol, which would put a crunch on world supplies. This is exactly what happened, as prices for sugar recently set 24 year highs over 18 cents/pound.

This is where our story begins, on 5/24/05, when I purchased 1 Oct '06 futures contract at 8.70 cents/pound. I went back to the table for seconds on 7/27/05 and purchased 1 Mar '07 contract at 9.06.

Seems silly but at the time I was a bit nervous buying sugar over 9 cents/pound since it seemed "high". Just goes to show the danger of framing prices in your mind. I felt good buying in the 8 cent range since I figured the cost of product of sugar to be around 5.5 cents/pound. How did I figure this? I read in one of the CRB Yearbooks ('04 I think) that when prices dropped this low in 2003 they were below the costs of production. This essentially provides a floor for prices, since if prices drop below this, producers will simply stop producing. This separates commodities from stocks, which can (and commonly do) go all the way to zero.

So here are the gains from the two sugar trades to date. These are still only paper gains since I have not sold yet. I am planning to sell as soon as the trend turns down, but it hasn't happened yet. After looking at the price charts of many commodities over the years, it really seems like they move up and down in consolidated trends. Buying on "drops" is probably not a good idea here.

Epilogue

I wish I could say that is the happy ending of the sugar story, but of course I'm rolling the dice on a third contract. After reading Dennis Gartman's rules of trading in John Mauldin's weekly newsletter (an outstanding free weekly investing newsletter, you can see the issue I'm referring to here: http://www.2000wave.com/article.asp?id=mwo012006), I'm going to try to keep riding the trend until it turns. In retrospect it would have worked great so far, but of course hindsight is 20/20 and sometimes even better than that.

So I do have a working limit order for 1 contract of Oct 07 sugar at 15.50. We'll see if it gets filled tomorrow. The contract closed today around 15.70, but the bid/ask was closer to 15.50 so I'll try to get this filled. I like using limit orders because sometimes they get filled at better prices than I ever see otherwise.

It is interesting to note that Mar '06 contracts closed today at 18.48 while the Oct 07 contracts closed at 15.50. So the market is anticipating a price drop in the future. I don't see any extra supply coming online myself, so I'm glad to take the discount. Again, I could be wrong, but I just don't see it.

One other intestesting thing of note - sugar can be produced two ways, by sugar cane or sugar beet. Sugar cane is grown in tropical climates, and beets in colder climates. The production of sugar has been shifted towards the tropical climates, which means sugar cane accounts for a larger amount of production than in the past. Why does this matter? It takes longer to plant and harvest new sugar cane than it does for sugar beets, so it takes longer to ramp up supply than before.

Open sugar positions (Sugar #11) as of 1/27/06:
Date........Position...Qty...Month/Yr...Entry Price...Last Price...Profit/Loss

5/24/05.....long............1.........Oct 06............8.70.................17.05............$9,352.00
7/27/05.....long............1.........Mar 07...........9.06..................16.78............$8,646.00


Working orders (not filled yet):
Oct 07 limit @ 15.50 good til cancelled

1 comment:

Peehu Sharma said...

The Nifty50 opened at 8,780 and rose to an intraday high of 8,847, thus forming a long upper shadow. It fell to an intraday low of 8,750, which
resulted in a long lower shadow.
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