Sugaronline Friday Editorial - To Hedge, or Not to Hedge by Meghan Sapp
Published: 12/09/2011, 5:48:00 PM
With Rabobank guessing sugar prices will fall 12% next year, would you see that as risk or opportunity?
Commodity markets have a long and glorious history all over the world for being the key risk management tool for users and producers alike. Users want to get the lowest price possible to secure the best margin possible, while producers want to secure the highest price possible to secure the best margin possible.
There’s a simple beauty in understanding that when it comes down to it, the whole world is only interested in getting the best margin possible—be it economic, social, emotional, what have you—while little else matters.
The biggest question is, how safe do you play it? Do you hedge just enough to make sure your basic operating costs are covered? Or do you hedge more, to be sure that your minimum acceptable margin is covered? Or do you let it all ride, and leave hedging for the weak? As with life and love, it all comes down to risk aversion and the varying degree of comfort levels.
So when someone fairly knowledgeable, trusted even, tells you that the price you’re going to get for your production next year is going to be 12% less than what you got for it this year, you tend to believe him. And you hedge accordingly. In an uncertain global economy, you might even boost the percentage of your production that you hedge traditionally, to secure the price paid today and hope that you can cover your liabilities in the future.
Now say that your biggest competitor, who has the exact same information as you do from that same trusted resource, decides to suddenly lower his traditional hedging level. Then what do you do? And what does it mean?
Perhaps he has more information than you, and is confident that prices will be higher next year instead of lower. Perhaps he’s betting on everyone hedging more, giving him more flexibility to take advantage of spot price peaks while you’re hogtied into whatever price you secured in your attempt to be covered.
So on one hand, you’ve got Rabobank. They figure sugar production will rise 5% for 2011/12, meaning a total of 174.5 million metric tonnes of sugar. In simple numbers, they figure that equates to 6 million tonnes of surplus. The not-so-simple numbers are that markets from China to the US are playing catch up on their stocks-to-use ratio and will be importing or hoarding much more than they’ve been able to for the past few years but no one really knows how much.
Rabobank acknowledges, of course, that this early in the season it’s difficult to forecast what weather ‘events’ may occur and what their effects will be on sugar production. The same can be said for the Euro or the state of banking bailouts. It’s fairly certain that Brazil is going to have another bummer of a crop, but with sugar production up in India and Russia among other countries, the surplus should shake down to the markets it needs to fill. It should shake down so much, in fact, that it figures average prices in 2012 will fall 12% to 22.6 cents. The ICE March 2012 contract settled Thursday at 24.13 cents with March 2013 at 23.79.
For Rabobank to be so sure in its numbers isn’t unsurprising, as that’s its job. What is surprising is that Cosan, Brazil’s giant sugar producer and new JV partner with Shell, disagrees so entirely Rabobank’s analysis that in the same week, it announced that it was dropping its hedge to just 25% of its crop.
For the past several years, Cosan has hedged 30% of its crop in order to be sure that its house was in order. As the country’s largest producer, in a country that supplies half of the world’s free sugar trade, leaving 70% of a crop up to the market’s whim is pretty gutsy. But with the kind of bargaining power that must be available at those volumes is its own certain kind of hedging mechanism.
But here we are, looking down the barrel of the first real surplus in three years at prices that five years ago would have still been considered a miracle, and Cosan sees an opportunity to cash in even more rather than a reason to play it safe.
Being such a dominant player, the company probably more than anyone else knows the state of the country’s crop and more importantly, the state of the country’s infrastructure. If they say there’s going to be difficulty in getting sugar out of Brazil, then that’s probably a good indication that they’re right. It means that when supply availability for sugar starts looking like supply availability for ethanol—that is to say, little or none—then Cosan will offer the additional five percent of its crop that it didn’t hedge and offer it to the spot market for what it hopes is enough of a margin to offset the risk.
For them, they may not even see it as a risk. For others who are smaller with less of a handle on infrastructure, transport and financing, they’re the ones at risk of not being able to take advantage of the opportunity surges in the spot price could offer.
The key here, perhaps, is that access to financing. The global economic situation isn’t getting better very quickly, and with that banks are still hesitant to lend into risky markets. Trade financing is still one of those lucrative, but very risky, markets that banks are not always comfortable to get involved with. Even those experienced with sugar trade may look at company x or y and decide to deny them the Letter of Credit needed to get that sugar from the mill to the destination port.
Cosan doesn’t have that problem. They’ve got the cash to finance their trade, Shell to back them up if they need it, and they will charge the premium deserving of such an opportunity to access sugar when it seems there’s none around.
Or maybe not. They could just be trying to mess with the collective mind of the global market.