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By Amine Bouchentouf

Sugar prices have jumped nearly 50 percent since May, driven by production concerns in Brazil, the biggest producer and exporter of this commodity. For investors, this creates an opportunity in an important commodity that may not receive as much attention as crude oil, but which is nevertheless as much of a global commodity as its slick counterpart.

Sugar is important because of its dual-use applications: It is a commodity used for both agricultural purposes (as a food sweetener, additive, etc.); and in the energy field, specifically as a feedstock for sugar-based ethanol fuel production. Whereas several decades ago 100 percent of sugar harvests went toward food applications, an increasing amount of harvest is currently used to produce biofuels.

In countries such as Brazil, almost 60 percent of cultivated sugar is now used toward ethanol production. This dual use has put additional strains on global production capacity. Investors should not ignore this development.

Sugar is produced from two sources: sugar cane and sugar beets. More than 70 percent of sugar is produced by refining raw sugar extracted from sugar cane, while the rest is produced by processing sugar beets.

Te main producers of sugar include Brazil, India, China, Thailand and the United States. But here’s what you need to know about the sugar industry: Just like Saudi Arabia dominates the crude oil market, Brazil is the dominant player in the sugar market.

Currently, Brazil accounts for roughly one-third of world sugar output and more than 50 percent of global exports. This means that any change in Brazilian sugar production will have an immediate consequence on sugar prices. Put simply, you cannot successfully trade the sugar markets without keeping a very close eye on Brazilian sugar production numbers since they are a key market driver.

When Unica, the Brazilian sugar cane industry association, announced lower production numbers the first week of July, prices jumped 7.8 percent. A combination of cold temperature and aging fields decreased production and sucrose levels, which was enough for the market to send prices higher.

For exposure to the sugar markets that does not involve trading the futures contract, I recommend you take a look at the following exchange-traded notes: the iPath DJ-UBS Sugar TR Sub-Idx (SGG) and the iPath Pure Beta Sugar ETN (SGAR). SGG tracks the sugar subindex component of the Dow-Jones UBS Commodity Index, thereby giving you direct exposure to the futures contract underlying the index. The more recently launched SGAR tracks the Barclays Capital Sugar ETN and also gives you direct exposure to the futures contract.

If you were to choose between the two, I recommend SGG since it provides you with more liquidity. Also, from a pure performance perspective, SGG is more reactive, having appreciated 35.96 percent between April 25 and July 25 to SGAR’s 29.62 percent over the same time period. Both ETNs have an expense ratio of 75 basis points.

Another way to get exposure to the sugar industry is through the equity markets. One company I recommended to investors this year is the Imperial Sugar Co. (IPSU), which was trading at $12.50 when I made the call.

Currently trading at $23.04, Imperial has already experienced a price appreciation of almost 90 percent in five months. Even with that run-up, the company still trades at a 2012 forward P/E ratio of 12.79, a discount relative to the industry average. Based in Texas, Imperial’s main assets include a sugar refinery in Georgia and a joint venture refinery complex with Cargill in Louisiana.

With net sugar sales of almost $1 billion in 2010, IPSU provides you with raw exposure to the sugar market. With year-over-over net operating cash flow growth of 162 percent and earnings growth of 112 percent (2010 to 2011), Imperial has demonstrated stellar growth capabilities.

The next value creation catalysts include the coming online of that Cargill joint venture refinery in Louisiana at the end of 2011 which will have a capacity of 1 million tons per annum. Additionally, expected increases in consumer demand for sugar products within NAFTA (Imperial’s main market) will serve as an additional sales accelerator. Further, Imperial is branching out into higher-margin products by developing a natural sweetener portfolio for consumers.

However, several risk factors exist that could derail EPS growth and affect earnings momentum. First, IPSU is a processor, refiner and marketer of sugar that does not directly own sugar cane plantations or sugar beet farms. In other words, it does not control its feedstock supply.

Not controlling its supply of raw materials means IPSU is subject to the price swings of the raw sugar market that can be extremely volatile. While the company can hedge its exposure using financial instruments, this is not enough. Until the company moves into a fully integrated, vertical model where it owns and controls its feedstock, it will continue facing volatile input prices that could eat into its earnings.

That said, IPSU is moving into a fully integrated model with supply chain ownership through its joint venture with Cargill in Louisiana; in that joint venture, Cargill and Imperial will own the feedstock production as well as the refining and the marketing assets.

In a period of major market turbulence relating to sovereign debt issues in Europe and the United States, it is necessary to think outside of the box and identify unique and overlooked opportunities to generate alpha. The sugar markets certainly offer that capability.

Source: The Commodity Investor: Finding Sugar's Sweet Spot