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Cyclical Investing

Sectoral Analysis

We have learned about cyclical investing so far. Now, let us make a case study on the sugar industry, which is categorized under the cyclical sector. 

 

Let us discuss the nitty-gritty of the sugar sector in this module:

India is the world's second-largest producer & the largest consumer of Sugar. It is the second largest agro-based industry in India, second only to cotton with annual revenues exceeding 1 lakh crore in SS 2018-19. Around 81% of this revenue was from sugar while by-products contributed 19%. Around 3.5% of the country's population is dependent on it both directly and indirectly for livelihood. The sugar sector in India is highly regulated by the Government. It is a hot topic of discussion in the political landscape of Uttar Pradesh & Maharashtra. 

 

 

There are two sources of sugar demand in India with direct households contributing 35% to the revenue pie while bulk buyers constitute the other 65%.

 

Why the buzz around sugarcane?

Sturdy crop - Sugarcane thrives in tropical & subtropical areas with temperatures ranging between 21-27 degrees. Extremely high temperatures are harmful to its growth while low temperature slows its growth. Heavy rainfall results in poor crop i.e. low sugar content (recovery rate)

  • Better remuneration - A study by CACP shows that the average yield per hectare of sugarcane is around ₹60,000, over 10 times that of cotton & gram put together.  No wonder farmers have not shunned despite years of protests against cane arrears.
  • Assured buyer- Each farmer has a tie-up with a sugar mill. The mill cannot shut until every sugarcane in the area is crushed. There is an assured buyer regardless of the output.
  • Assured price - The farmer gets a fixed price assured by the central or state government, even if late which is not the case with other crops
  • No middlemen- There is no third-party intermediary or ' dalal' involved in the purchase & sale of sugarcane. All payments are made directly to the farmers. 

 Sugar Production process:

 

 

Sugar is extracted from sugarcane. The Sugar extraction process yields various by-products which also can be sold/processed for an additional source of revenue. Baggage which is the crushed residue of sugarcane is used either for paper production or power generation.  The total installed cogeneration capacity in all sugar mills is about 4200 MW, of which about 3200 MW is being exported to the grid.

 

Molasses is another key by-product that is used in the production of Chemical Alcohol or Portable Alcohol (liquor). It is also used in making Ethanol for fuel blending purposes.

 

1 tonne of sugarcane gives about 110 kg of sugar (at 11% recovery rate), 45 kg molasses (18kg TFS), and 10.8 liters of ethanol. 

 

Global Sugar Industry:

Top 10 sugar-producing countries in 2019-20 (in million metric tons) :


 

Global 2020/21 Sugar Production is estimated higher USA, India and Brazil up 10 to 40 %

 

 

The top 5 countries account for 57% of the total sugar production globally.

 

The global sugar industry is staring at a supply deficit in 2020-21. According to estimates by The International Sugar Organization (ISO), Global sugar consumption is expected to be around 175mn tonnes against an output of 171mn tonnes. 

 

International sugar prices are still recovering from a 10-year low of 9.19 cents per pound during the 2020 market crash and are currently hovering around 15 cents a pound at the onset of 2021.

 

Brazil- contributing around roughly 20% of the world's sugar output might see a dip in production in 2020-21 due to drier weather conditions & firm crude oil prices. Indian production is expected to rebound given high yields & increased sowing area. Thailand at 9% of the total output is also facing dry weather & may plant less this year. The EU is set to record a fall in production for the third consecutive year due to reduced acreage & high incidence of viral diseases. Demand on the other hand is expected to be more or less flat compared to 2019-20.

 

The India Factor: 

 

Indian sugar Industry at a glance: 

  • World's largest consumer of sugar at 26 mn tons per annum (muted demand)
  • World's second-largest producer of sugar at 32 mn tons per annum (SS20-21 ISMA estimates)
  • Annual turnover in excess of ₹1 lakh crore
  • Around 52 lakh hectares of land area under acreage
  • Around 530 sugar mills under operation
  • Annual payments of around 85,000 crores to cane farmers
  • Per capita consumption at around 20.1 kilos compared to 23.5 kilos globally
  • Sugar prices in India trade at a premium of ₹7-8 to their global counterparts. 
  • The government decides the quantity of sugar to be exported
  • Indonesia may emerge to be the largest importer of Indian sugar overtaking Iran 

 

 

Unsold inventory or opening stock for the current sugar season SS 2019-20 is at an all-time high of 14.6 million tonnes. This is partly on account of a higher year on year sugar production in the previous two sugar seasons ( SS 2017-18 & SS 2018-19). 

 

Sugar is a cyclical industry. The demand for sugar in India is more or less stable at 26mn tonnes approximately. One must understand the supply side dynamics in order to predict the sugar realization.  It is the supply of sugar that is volatile & causes swings in its price. It depends on the following factors:

 

 

No match to global standards:

In India, politically sensitive sectors are at the whims and fancies of the ruling party. Indian sugar mills are financially paralyzed and lack modern machinery. It is almost impossible to export Sugar without the support of the government. The current price of cane is well above that of other crops (artificially high prices) which makes Indian sugar uncompetitive in global markets. Remember, International sugar prices trade at a discount. Here is a quick fact check to put things in perspective-Indian sugar mills pay 1.7x for cane than their Brazilian counterparts. 

 

 

 

 No wonder Indian production costs are much higher than current international prices. 

 

Trends shaping up: 

 

1) Bumper sugar production is here to stay - India has reached a new production threshold above consumption, signalling it will remain a net exporter in the medium term. A combination of various factors can explain the same.

 

Fixed cane prices support farmers' income. Call it vote bank politics or whatsoever, the price of cane is well above that of alternative crops. This scheme of things has a broader social objective that goes beyond the rationale of markets. Combine this with fixed minimum sugar prices way above international levels, the sugar acreage will be high & immune to price signals from the global markets. 

 

Indian millers are bound by law to crush all cane in their region. This guarantees farmers' revenue but puts sugar mills in a fix. Mills have to continue operations even if market prices fall below the cost of production. It is not possible for producers to collude and jointly reduce output in times of excess supply. 

 

High yielding varieties of sugarcane have been introduced in some of the key producing states. The Co 0238 cane variety has created ripples across Uttar Pradesh leading to an even higher inclination of farmers. These gains in production are likely to be maintained as farmers also have a strong incentive to raise yields, given the price dependency on sucrose levels in the cane. 

 

As long as these three factors do not undergo material changes, sugar production will most likely remain above 30mn tons, unless extremely adverse weather conditions hit agricultural yields.  ISMA estimates sugar production at 32mn tons for SS2020-21, assuming normal rainfall & other optimum conditions.

 

2) Ethanol- the potential game-changer- Ethanol, ethyl alcohol, drinking alcohol, spirits or simply alcohol are one & the same thing. Ethanol is a key by-product for Integrated sugar mills.  Ethanol is used for blending along with petrol/diesel to enhance cleaner burning & reducing fuel import. 

 

The NDA government introduced the National Biofuels policy in 2018 which was updated in 2020. The policy intends to achieve 10% ethanol blending by 2022 & 20% ethanol blending with gasoline by 2025 (five years ahead of its previous target). This is signified by the term ' E10' or E20' which means 10% & 20% blending respectively. For SS 2020-21, India plans to have 8.5% blending. 

 

India's current ethanol capacity is at 350 billion liters equivalent to a 7% blending rate roughly. This number underlines the need for rapid capacity addition.

 

 

Let us understand the government's agenda behind this move.:

 

a) Reduction in Import Bill-  India is dependent on other countries for around 80% of its crude oil requirements.  India imported 226mn tonnes of crude oil worth $112 billion in 2018-19.  The E20 regime if implemented successfully can result in annualized savings of around $22 billion. A huge number!

 

A more moderate assumption of the E10 regime would reduce the sugar production by 4mn tonnes which is also the global sugar surplus today. Undoubtedly, India is the trump card in the sugar pack. 

 

P.S. - Brazil is an ideal benchmark in this regard. The average ethanol blending in the country stands at 48%.

 

b) Breaking the decades-old jinx-  

 

 

 

The government aims to reform the sugar industry as well as avoid damage to its reputation amongst the farmer community. ' The Vibrant Ethanol ' policy strikes both these chords by diverting excess cane to the production of ethanol. The policy would also help sugar mills to diversify their sources of revenue beyond sugar & power generation. 

 

Outlook: 

Crawling crude oil prices & lower global output is expected to provide much-needed support to sugar prices. Nonetheless, huge inventories and robust output in the ongoing season coupled with near stagnant domestic demand will cap the price gains.

 

The biggest problem with regulated sectors is that you cannot predict the changing stance of government policies. This theory has been proved time & again. Renewable energy is one such example in recent memory. One must be very careful while taking any long-term positions in stocks belonging to these sectors. Such sectors are ideal only for short to medium-term investing. 

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