Sugar Price Risk: A Tale of Two Mills

Sugar Price Risk: A Tale of Two Mills

Introduction and Background Sugar is part of our everyday lives. It livens our food and lights up smiles on our festivals. India is one of the largest consumers of sugar in the world. It is also one of the world s largest producers. Sugarcane is largely grown in the states of Uttar Pradesh, Maharashtra, Karnataka and Tamil Nadu. The sugar mills are also concentrated in these states. In India, sugar mills begin to procure their sugarcane from around November every year. The payments for the sugar procured from the farmers is generally paid over the next several months. The payment to farmers needs to be completed before the beginning of the next season. Once the cane begins to be available to the mills, the crushing of cane begins, undertaking the process to convert sugarcane to sugar. This is a continuous process over the next few months where the harvested sugarcane enters mills and is processed into sugar. While bulk of the sugar is manufactured in the 5-month period of November to March, the sale of sugar stocks generally takes place over a longer period. 1

The Mills New Sugars is a Maharashtra based sugar mill and produced around 100 thousand MT of sugar during the 2014-15 season. Nearly 60% of that sugar was produced during January and February the peak months. India Sugars is also a Maharashtra based sugar mill, almost identical in size to the New Sugars and similar procurement and crushing cycle with around 100 thousand of sugar produced during the 2014-15 season. These mills had planned to procure around 1 million MT of sugarcane for the season. Sugarcane support prices were announced at Rs 220 per quintal by the government, a rate at which the mills must procure cane from the farmers. Thus at the beginning of the season, this clearly provided each of these two mills with a sugarcane procurement cost of Rs 220 crores. Further, both New Sugars and India Sugars had a recovery rate of around 10%, which can be considered to be average by industry standards, and would result in production of around 100 thousand MT of sugar. With the procurement cost to both mills becoming clear at around Rs 220 crores, now it was all about generating revenue from sales. Depending on how they sold their produce, the profitability would vary. The physical market prices of sugar had been soft of late. In the 3 month period from beginning of July-14 to beginning of October-14, the prices had fallen by 6% to around Rs 3000 per quintal. Which meant that a production of 100,000 MT would fetch Rs 300 crores at current prices. But Rs 3000 per quintal is current price and is no indication of where the prices will be when sugar actually begins to get sold in the market. There could be a gain from current levels, if prices moved in favour and if not, then it would result in lower realization compared to current level of Rs 3000 per quintal. Add to the cane costs, another Rs 75 crores, not relating to raw material, but coming from interest costs, wages, power bill etc. Thus, just at the beginning of the season, the costs, sale proceeds and profits: Costs In ` Crores Sugarcane Pro curement Other costs Total costs 220 75 295 Sales realization In ` Crores Sugarcane sales Profits In ` Crores PBT?-295=unknown 2

New Sugars Believed firmly that prices of sugar are at an artificial low and will recover soon. Farmers have to be paid for the cane prices within a stipulated time, failing which these will turn into arrears and an interest will have to be provided to the farmers on the arrears. Even as procurement started on full swing along with the production of sugar, New Sugars decided to wait before beginning to sell the piling inventory. The physical market prices of sugar however continued its downward trend and lost another 9% from beginning-october levels, to Rs 2717 per quintal by mid-december. Meantime, need for liquidity was rising as running costs had to be paid off. On top of it farmers needed to be paid soon. New Sugars management now decided that as and when the market situation improves, good amount of sugar will be offloaded in the market to gain liquidity. On gaining liquidity from sale proceeds, the farmers dues will be paid off as a first step. New Year could hold reason to cheer after all. But by end-january 2015, even such optimism waned with prices remaining depressed. The farmers arrears had accumulated to a large figure by then. The management decided that now it could not wait any more and needed to sell sugar stock to generate the cash needed to pay creditors. In February, 15000 MT was sold at an average price of 2686 per quintal, to generate 40 crores. But as southward movement of prices persisted, there was fear that if more was NOT sold immediately, the sales realization would not be sufficient to pay-off the farmer dues of Rs 220 crores, ignoring any interest payable thereupon. Thus sugar was sold aggressively over the next 3 months as well. Sale of Sugar (MT) Average Price (Rs. per quintal) Realization from sales Feb-15 15,000 2686 40 Mar-15 20,000 2539 51 Apr-15 40,000 2537 101 May-15 20,000 2495 50 Jun-15 5,000 2318 12 Total 1,00,000 Total 254 New Sugars could get a sales realization of Rs 254 crores, while costs were of the order of Rs 295 crores. New Sugars ended in a loss of Rs 41 crores. 3

India Sugars Held a belief similar to the New Sugars and started the season thinking that the prices would recover. India Sugars had been stung by a rocky ride of physical sugar prices in the preceding year 2013-14. This year it had lower appetite for a loss. The management wanted a guarantee of minimum level of profitability and said that it particularly wanted no loss, even if that meant having low profitability. It was planned in early-october to sell the entire sugar s physical stock in the 7-month period from December-14 to June-15. Month Physical Sales Planned (MT) Dec-14 10,000 Jan-15 10,000 Feb-15 15,000 Mar-15 15,000 Apr-15 15,000 May-15 15,000 Jun-15 20,000 Total 100,000 This schedule of continuous sales would give the necessary liquidity to meet farmers payments, debt servicing and other costs. But one major concern still remained. That the actual prices may continue to fall during this period. This poses a problem. So prices need to be frozen in such a way that the objective of guaranteeing India Sugars of protection from a loss this year is achieved. After hectic discussions, it was decided to put in place a massive Hedge Programme. A programme to cover all of its sugar selling price risk, by going short in futures market. This was to be achieved by selling sugar futures on the NCDEX futures platform. At this point in time sugar futures available on NCDEX were contracts with expiries in December-14, March-15, May-15 and July-15 and so on. It was planned to enter into futures contract over the next few days and for physical sales in a given month, square-off an equivalent quantity of futures contract i.e. futures sale positions to be discontinued as and when physical sales took place. To avoid complications and to maintain control on execution, it was decided to do square off related to a month s quantity, in the middle of the month i.e. on 15th of every month. Sugar s physical sales would happen in bits through the month, giving an average price. The futures could be squared-off in the middle of the month. This would leave a few days worth of price risk open anyway as physical sales date and the cancellation date in a month do 4

not match, but it was preferred because such risk would be small and at the same time would facilitate ease in execution. were to be sold for different quantities for various expiry months. Starting October 20, the mill started selling futures contracts on the Exchange, and completed selling futures for a quantity of 100,000 MT by end of October as follows: Contract Quantity (MT) Price at which contract entered* ( ` per quintal) Dec-14 Mar-15 May-15 Jul-15 Total 10,000 2,795 40,000 2,842 30,000 2,891 20,000 2,940 100,000 *rates from hedging between 20-oct to 31-oct, as contracts entered The mill kept producing sugar every day in season and inventory accumulated. Simultaneously, the sales and hedging plan was executed with discipline at India Sugars. On the 15th of December 2014, it squared-off the December-14 futures contract entirely (10,000 MT) at a rate of Rs 2538 per quintal, giving an MTM gain of Rs 2.6 crores. Physical sales were made through the month of December at the going physical market prices, for 10,000 MT, earning Rs 27.5 crores. On January 15th, 10,000 MT of March-15 futures position was squared off to coincide with the plan of physical sales of sugar of 10,000 MT. The physical sales earned Rs 27.3 crores, while the futures cancellation provided a gain of Rs 96 lacs. In the same way, 15,000 MT of March-15 futures were squared-off on 16th February and another 15,000 MT on 16th March to coincide with actual physical sales of 30,000 MT of sugar in those months. This exercise was completed as follows: Quantity (MT) Earning From Physical Sales* (Inr Cr) (A) Cancellation Date Contract that is being cancelled Cancellation quantity (MT) price at cancellation (Rs per quintal) price at entry (Rs per quintal) Gain(+)/loss (-) from futures hedges (INR Cr) (A) Total realisation (INR Cr) (A)+(B) Dec-14 10,000 27.52 15-Dec-14 Dec-14 contract 10,000 2538 2,795 +2.57 30.09 Jan-15 10,000 27.29 15-Jan-15 Mar-15 contract 10,000 2746 2,842 +0.96 28.25 Feb-15 15,000 40.29 16-Feb-15 Mar-15 contract 15,000 2664 2,842 +2.67 42.96 Mar-15 15,000 38.08 16-Mar-15 Mar-15 contract 15,000 2481 2,842 +5.42 43.50 Apr-15 15,000 38.06 15-Apr-15 May-15 contract 15,000 2435 2,891 +6.83 44.90 May-15 15,000 37.42 15-May-15 May-15 contract 15,000 2290 2,891 +9.01 46.43 Jun-15 20,000 46.37 15-Jun-15 Jul-15 contract 20,000 2166 2,940 +15.49 61.86 Total 255 Total 43 298 5

The physical sales took place from December-14 to June-15 as was planned by the management in October-14. The physical sales took place at the going rates in the physical markets, ranging from 2,752 per quintal in December-14 to 2,318 per quintal in January. However, even as physical rates fell from December-14 to June-15 resulting in lower cash realization, the futures hedges when squared-off provided gains to offset the lower realization. India Sugars could get a sales realization of Rs 255 crores (similar to New Sugars), but adding to it Rs 43 crores of gains from futures hedges gave it a total inflow of Rs 298 crores, while the costs were of the order of Rs 295 crores. New Sugars made a minor profit of Rs 3 crores, achieving its objective of NOT making any losses. New Sugars 254 India Sugars 255 Realisation from Physical sales Gain(+)/loss (-) from hedges - +43 Total inflow (INR Cr) (A) 254 298 Raw Material (Sugarcane) Costs 220 220 Other Costs 75 75 Total Profit (+) Costs /Loss(-) (B) (A) - (B) 295-41 295 +3 CONCLUSION In the end, with both the mills having similar procurement, production and costs, ended up with very different profitability. One ended in a loss as market prices worsened. The other averted losses even when market prices fell by hedging its sugar price risk. Disclaimer: Neither NCDEX nor its affiliates, associates, representatives, directors or employees shall be responsible for any loss or damage that may arise to any person due to any action taken on the basis of this publication. All information, descriptions, examples and calculations contained in this publication are for guidance purpose only and should not be treated as definitive. No part of this publication may be redistributed or reproduced without written permission from NCDEX. 6

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