Understanding the Sugar Cycle!
Sugar is a cyclical and a highly regulated industry. Trade barriers, including production quotas, assured prices and import tariffs, convey a significant degree of bias to international prices. The relatively longer plantation cycle, together with restrictive trade practices, has imparted a fair degree of volatility to sugar prices.
India’s sugar industry is prone to extreme cyclical swings. In India, sugar production follows a three-five year cycle. Higher production leads to increased availability of sugar thereby declining the sugar prices. This leads to lower profitability for the companies and delayed payment to the farmers. As a result of higher sugarcane arrears, the farmers switch to other crops thereby leading to a fall in the area under cultivation for sugar. This then leads to lower production and lower sugar availability, followed by higher sugar prices, higher profitability and lower arrears and thus the cycle continues.
Part of it has to do with sugarcane itself, which, for the farmer, is practically a two-year crop. The plant-cane to be sown in Uttar Pradesh (UP) this March-May is harvest able only after 11 months in February-April. Thus, once a farmer has planted cane, his land is ‘locked’ for 20–21 months. The decision to go ahead is an investment call taken based on the cane price received from the sugar mill today. If it isn’t good, the farmer will simply not plant.
If low sugar prices lead to mills not paying, farmers would switch over to alternate crops, impacting cane availability for the next two years. By then, soaring sugar prices result in a scramble for cane. As its prices are bid up, farmers feel encouraged to plant again. They usually over plant, which is the run-up to the next crash.
Given that sugarcane is largely an irrigated crop, these fluctuations aren’t attributable to rainfall. Rather, they are more a function of cane prices prompting farmers’ planting choices.
The extensive regulatory stuff surrounding the sugar sector is precisely aimed at dealing with this problem of cyclicity. The government today fixes cane prices and assigns ‘reserved’ areas for procurement by individual factories. It also decides how much sugar each mill can sell (‘release’) every month in the open market, after surrendering a certain percentage of production as ‘levy’ for ration shops.
These controls haven’t helped smoothen the sugar cycle, though. There are moves now to dispense with monthly releases and levy obligations on mills, as part of a larger industry deregulation plan. But it again fails to address the real issue of cyclicity. This, we have seen, is primarily related to the long gestation period of sugarcane — and will remain so long as the focus is confined to what mills do with their sugar and not with their cane
Currently, mills in India crush cane only to produce sugar. Whatever alcohol or cogen power they generate is entirely from molasses and bagasse that are byproducts of sugar manufacture. Well over 85 per cent of mill revenues come from sugar: Its price decides their paying capacity and, ultimately, also the cane area planted by farmers.
Any durable solution to the sugar cycle problem, then, calls for reducing the industry’s reliance on virtually a single revenue source. That can happen only if factories have full freedom to convert the juice from crushing cane — whether for crystallizing into sugar or directly fermenting into alcohol for potable, industrial or fuel blending purposes. Flexibility to produce more or less sugar, depending on its prices relative to alcohol, would impart greater revenue stability. It makes regular cane payments to farmers possible and avoids destabilizing acreage shifts to other crops.
Mills typically crush cane with total ferment-able sugars (TFS) content averaging between 12 per cent in UP and 14 per cent in Maharashtra. Much of this TFS — sucrose plus reducing sugars (glucose and fructose) — gets crystallized into sugar.
The un-crystallized, non-recoverable part goes into what is called ‘C’ molasses. The latter, constituting around 4.5 per cent of the cane, has a TFS of 40 per cent. Every 100 kg of TFS, in turn, yields 60 liters of fuel ethanol.
Thus, from one tonne of cane, a UP mill can produce 95 kg sugar (at 9.5 per cent recovery) and 45 kg of molasses (18 kg TFS) that gives 10.8 liters of ethanol. Alternatively, if the entire 12 per cent TFS in the cane is fermented, it would result in 72 liters of ethanol and zero sugar
In Brazil (world’s biggest producer), mills are designed to facilitate segregation of the sugar and ethanol production streams at the cane juice stage itself. The juice obtained after crushing is first clarified and evaporated to either 60 per cent or 30 per cent solids content. The former goes for making sugar, and the less concentrated secondary juice for ethanol.
Due to this cyclical nature, sugar manufacturers are vulnerable to industry oscillations. However, sugar by-products like molasses (ethanol, ENA and rectified spirit) and bagasse aid the sugar producers in diversifying risks and lending stability to their revenues.
With general elections coming up in 2019, managing sugar markets and balancing the interests of sugar millers and sugarcane producers is a serious policy challenge for India’s government. Higher sugarcane production in the 2017–18 crop year has only made the problem more complex. The government has implemented a number of policy fixes to help sugar mills and cane producers. They fall into two broad categories: Increasing exports and finding alternative markets. However, both options are complex, as increasing sugar exports is not easy when world prices are sluggish. Diverting a significant portion of current sugar stocks to the production of renewable fuels, mainly ethanol, also has its own challenges, including government restrictions on food-based feed stock use on energy production.
India is the world’s second largest producer of sugar, and its domestic sugar mills face downward price pressure in both international and domestic markets. Understanding the importance of a stable sugar price for domestic sugar mills and farmers, the government has imposed reverse stock holding limits on sugar mills, restricting the amount of sugar they can stockpile.
Exporting the surplus sugar to the deficit region of the world could be an option here. In anticipation of future growth in the export market for sugar, the government took measures such as doubling customs duties on sugar imports to 100 percent, and reducing tariffs on sugar exports to zero. The government is also negotiating sugar exports to China. However, this strategy faces problems as Indian sugar producers may face tough competition from Brazil and Thailand.
Ethanol production is another viable strategy that may satisfy both producers and mill owners. Several government programs encourage sugar mills to produce ethanol. In May, the government announced payment of $0.08 per 100 kg of sugarcane crushed to certain sugar mills with ethanol production capacity. According to the Press Information Bureau, this program will cost $226 million — and presumably will help millers pay farmers. This could be a win-win situation for farmers, mill owners, and consumers, who would ultimately benefit from lower oil imports.
The government also mandates blending of ethanol with petroleum fuel, reaching 20 percent by 2020 (E20). However, as of 2016 that number was only 3.3 percent, far below the target of 10 percent at the time. Clearly, the government faces major challenges in meeting these targets. In addition, the current restriction on the direct use of sugar juice in ethanol production could make the implementation of the E20 mandate by 2020 even harder.
However, achieving the 5 percent target is feasible, as mill owners can reap the benefits of the government assistance program and pay their dues to the sugarcane farmers. In the short run, there is no need for a huge increase in sugarcane acreage, as current surplus stock can be safely depleted for use in ethanol.
Brazil has been the world’s largest sugarcane producer for many decades, and started producing cane-based ethanol as early as 1970, when a spike in world oil prices drove up its foreign debt. In order to limit that debt, the Brazilian government introduced the National Fuel Alcohol Program, known as Proálcool.
Brazil’s ethanol production system is unique. The majority of the country’s sugar mills are capable of producing both sugar and ethanol. Sugar processing facilities are considered bio-refineries and can make sugar, bio-ethanol, and electricity from bagasse. These plants are flexible, producing more sugar or more ethanol depending on the price premium of one over another. This flexibility is a key reason for the Brazilian ethanol industry’s success.
Brazil, India, EU and Thailand together account for over 50% global sugar production. India is 2nd largest sugar producer in the world and the largest sugar consumer country. Brazil is the largest sugar producer with 50–60% of sugarcane used for production of Ethanol as a substitute for the fuel.
The world sugar market could see a shortfall in 2019/20 after two years of over-supply as Brazil and the European Union cut production, but strong Indian output will still weigh on the market. The market could swing to a deficit of roughly 2 million tonnes in the 2019/2020 season, from an expected surplus of 4–5 million tonnes in the current 2018/19 season. Most notably, top grower Brazil has sharply cut its sugar output this season and it is poised to continue channeling more cane to ethanol in 2019/20. The EU, meanwhile, is poised to cut back output to roughly 17 million tonnes. The bloc’s production surged in 2017/18, after it removed output and export quotas.
Indian production is also seen falling in 2019/20 after two record seasons, but the country is likely to continue churning out more sugar than it needs. The world’s top consumer is expected to produce roughly 31 million tonnes, down from a record 35 million tonnes in 2018/19 and 32 million tonnes in 2017/18 a major recovery in prices was unlikely as the 2019/20 deficit will be offset by ample global stocks following two years of over-production, which have yielded a combined surplus of 23–24 million tonnes. While demand was historically growing at about 2 percent per year, it is now seen at about 1–1.5 percent
FY16–17 was a cycle when all the sugar stocks (specially UP based) gave multi-bagger returns. It was a sweet situation for UP sugar mills as the Maharashtra sugarcane production halved to ~4.5 mn tons, which lead to national level sugar supply shortage and increase in sugar price, and at the same time UP had bumper productions, allowing all UP based sugar mills to improve its results tremendously. Entire increase in realization trickles down to PBT, as there is no parallel increase in prices, leading to margins expanding exponentially. The same can be seen through some sugar companies’ reported financials:
Based on the sugar cycles, the market price of the sugar companies also fluctuate, and these price movements are very quick. One can both make and lose money very quickly by investing in sugar companies’ stock.
Key financials and ratios to look at
Revenue breakup: The sugar industry is closely linked to the sugar price cycle. Higher cane and sugar production results in a decline in realizations for companies. Due to this cyclical nature, sugar manufacturers are vulnerable to industry oscillations. However, sugar by-products like molasses (ethanol, ENA and rectified spirit) and bagasse aid the sugar producers in diversifying risks and lending stability to their revenues. The company that has an integrated business model stands to survive the downturn cycle. The margins of the byproducts are higher than that of the sugar segment. So companies with an integrated model are a better play.
Recovery rate: This plays an important role for a sugar company. If the recovery rate is higher than its peers, it shows the efficiency levels of the company. Higher recovery rate leads to higher volumes thereby increasing the sales.
Operating margin trend: The sort of margins that a company has vis-a-vis its peers is an important factor that needs to be looked at i.e. whether the trend is improving or is there a continuous decline. By products have higher margins than the sugar segments. Those companies that have an integrated model stand to benefit in terms of higher margins.
Cash flows: A look at the company’s cash flows and the working capital efficiencies will give an idea of the company’s bargaining power as well as its ability to utilize its resources and supply chain.
It is also important to look at the P/E (price to earnings multiple) which the company is trading at vis-a-vis its peers. Companies with an integrated model, larger capacities, better relations with farmers, contracts with power and oil companies will most likely be trading at a premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. Stocks trading at an unrealistic premium will not be a good option to invest in. After all, valuations have to justify the company’s growth prospects.
Above all this, look at the past record of the management, its vision and its integrity. The management is responsible for the survival of the company and enhancement of the shareholders’ return. If the management has a track record of being on the sly or slow to react to market conditions, then even if the company is the largest or the most efficient, it may not give you your rightful share of the company’s growth and profits.
