Three Reasons The Sugar ETF High Is Headed For A Crash

by on August 17, 2009 | ETFs Mentioned:

Sugar ETFs have continued their “almost vertical trajectory” in recent weeks, soaring higher on news that several major food producers sent a letter to the Secretary of Agriculture exclaiming that the U.S. could “virtually run out of sugar” if import restrictions on the sweetener aren’t lifted. Currently, quotas limit the amount of sugar U.S. companies can import (in accordance with NAFTA, there are no restrictions on imports from Mexico), meaning that U.S.-based firms often pay about twice the rate paid in other parts of the world.

Sugar Prices Have Soared In 2009Sugar prices has soared this year as a  “perfect storm” of conditions has brewed around the globe. India, the world’s second largest producer of sugar cane, has experienced its driest monsoon season in several years, forcing the nation to become a net importer of sugar in 2009. And Brazil, the world’s largest producer, is diverting a huge percentage of its cane crop to the production of ethanol fuel. A similar situation in the U.S. forced corn prices skyward in recent years.

As a result, sugar prices have reached their highest point in nearly 30 years. The iPath Dow Jones-AIG Sugar Total Return Sub-Index ETN (SGG) has gained nearly 60% so far in 2009. While there are some fundamental factors behind the huge increases, prices have reached an unreasonable level, and are due for a major downward correction. Here are five reasons why sugar prices will be coming back down to earth shortly:

  1. Flexible Farming In India: Although sugar production in India has plummeted this year, it isn’t as if the capacity has permanently disappeared. Rather, farmers who have traditionally allocated resources to sugar cane have turned to other crops in recent years, such as bananas. But with sugar prices rising so dramatically, many of these farmers are missing out on a big payday. Already, 2009-2010 sugar production is expected to rebound as farmers shift back to sugar cane. Likewise, Thailand, Asia’s largest exporter of sugar, is expected to see a huge uptick in sugar production in 2010.
  2. U.S. Fears Are Overblown: I suppose you can’t blame the major U.S. food producers for trying, but don’t expect much to come from their dramatic letter proposing that the country could run out of sugar. Ideally, the U.S. would lift (at least temporarily) its import quota, allowing U.S. companies to buy sugar from global suppliers and increasing global demand. While such a move would alleviate price pressures on food producers, it would sting domestic sugar farmers. In the current climate, siding with Kraft and ConAgra over the Southern cane farmers and and Northern Plains sugar beet farmers would be political suicide. While sugar prices have skyrocketed, prices of other commodities, such as grain and livestock, have plummeted this year (GRU and COW are down 17% and 21%, respectively, in 2009), providing raw materials offsets to many producers.
  3. Technical Indicators: While I’m not a huge fan of relying on exclusively technical analysis, I do believe it can be very valuable when used as a complementary analytical tool. According to Bloomberg, white sugar’s 14-day relative strength index, a gauge of momentum, has been above 70 since August 3, a signal that prices may drop. Of course, the presence of speculators complicates the short-term picture tremendously, and it appears that there is no shortage of speculative players in the sugar market at present. So in the short term, prices are likely to see some significant volatility, before eventually declining to historical levels.

Disclosure: No positions at time of writing.