Inside SGG’s Impressive Rally

by on October 14, 2010 | ETFs Mentioned:

Over the past few months, most asset classes have risen on hopes that the global economy would be able to avoid a return to recession thanks to increased growth from emerging markets. Unfortunately, back in the U.S., GDP growth is much harder to come by, as high budget deficits have combined with minimal levels of job creation to create a gloomy investment climate. This pessimism, along with continued speculation over the Federal Reserve’s second round of quantitative easing, has helped to push the dollar down sharply over the past few months, which has led to large gains in a variety of currency ETFs. But the real winners of the greenback’s sustained weakness have been commodities, as everything from crude oil to gold to zinc has skyrocketed in recent weeks.

A weakened dollar is generally good news for commodities traded in dollars, since a sliding U.S. currency makes goods more affordable for international buyers, pushing up their appetite for raw materials. So commodity prices will rise in dollar terms to meet international growers/producers expectations such that they receive the same economic benefit from sales. While many commodities have done well in this environment, few have been able to match the dramatic rise of sugar. And few exchange-traded products have performed as well as the iPath Dow Jones-UBS Sugar ETN (SGG), which has been on an absolute tear over the past few months; SGG has now returned more than 65% to investors since the middle of July. This incredible surge is even more impressive when one looks at a longer-term chart of SGG; the fund was down almost 40% during the first half of the year, and SGG had even broken below the $40 a share level. Currently, SGG is trading right around the $80 mark suggesting, a near-unprecedented turn of events for this popular sweetener during the summer. Below, we take a look at some of the factors that have pushed sugar higher–as well as some of the additional drivers behind SGG’s rise [also read Inside Five Surging Commodity ETFs].

Supply Shortage

SweetnessThe primary reason for sugar’s steady rise is the massive supply shortage that is predicted in one the world’s major sugar-producing regions. Brazil, which as of 2008 exported five times more sugar than any other country, has seen its sugar crop cut numerous times thanks to poor weather, including a drought across much of the South American nation’s top sugar growing regions. According to a recent USDA report, Brazil’s harvest will be about 3.2% smaller than previously estimated. While this might not seem like a substantial decrease, it represents a cut of close to 1.3 million tons in total production, which analysts expect will translate into a roughly a 1.55 million ton reduction in exports from the country.

Supply issues are also starting to appear in Thailand, the world’s second largest exporter of the crop. Some are expecting that exports will decline by as much as 20% from the Southeast Asian nation, which would likely put additional strain on an already tight market. Some believe that this could decrease exports to 4.7 million tons, down from an initial estimate of 5.9 million tons earlier this year [see An Unexpected Hurdle For The Food & Beverage ETF].

Corn Prices Surging

The steep climb in corn prices may not seem like a logical driver of sugar’s recent climb, but a closer look reveals that the two commodities are indeed connected. Like sugar, corn is used both as a sweetener and in ethanol production around the globe. With corn prices surging to their highest level in years–thanks in large part to dramatic reductions in the U.S. harvest–many are beginning to take another look at sugar as a possible substitute. It also doesn’t hurt that sugar-based ethanol generally produces more energy than a comparable amount of corn, a fact which could spur even more ethanol producers to make the switch. “For each unit of energy expended to turn cane into ethanol, 8.3 times as much energy is created, compared with a maximum of 1.3 times for corn,” writes Larry Rohter. Now that the government has allowed an increase to gasoline blends containing 15% ethanol, a sugar based compound might make the most sense for producers planing on tapping into this increasingly large market [see Three ETFs To Play Jim Rogers' Advice].

Sweet Backwardation

Much has been made in recent months about commodity ETFs “underperforming” a hypothetical return on the spot price of the commodity. Contrary to the opinions of some, this lag isn’t the result of a flaw in the products, but rather some of the nuances of futures-based investment strategies. When markets are contangoed, the “roll yield” incurred to avoid taking physical delivery can eat into returns. But there is another side to that coin; when futures markets are in backwardation, futures-based strategies may have a nice wind at their backs.

The market for sugar futures is currently in steep backwardation; in other words, futures contracts further out are less expensive than contracts closer to expiration. That means that as the index to which SGG is linked rolls over into next month’s contracts, it can essentially sell high and buy low. Sugar futures traded on the ICE and expiring in March 2011 contracts are priced around $27.45, while October 2011 contracts are trading at just $20.99. That represents a 30% premium for having the contract that expires seven months earlier. While this might seem odd to most investors who are used to paying a premium for time, for food manufacturers and ethanol producers concerned about running out of sugar, paying a premium is far better than the alternative. You can’t sweeten cookies or produce ethanol with futures contracts, only the physical commodity. With users willing to pay a premium to secure short-term supply, SGG has been one of the primary beneficiaries [also read Sugar ETF: Hello Backwardation!].

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Disclosure: No positions at time of writing, photo is courtesy of the AP and the NFL.