The subsidy math is ambitious given low raw sugar global prices
The Indian government recently announced subsidies to export 6 million tonnes of sugar for the upcoming sugar season 2019/20. It starts the season with an opening inventory of 14.5 million tonnes.(equivalent to 7 months of consumption against a requirement of 2.0-2.5 months)
Considering the current international raw sugar prices and prevailing exchange rate, the quantum of subsidy per unit quantity of sugar is not enough to push exports by a majority of the Indian sugar mills who have a very high cost of production. Assuming raw sugar price = 11 c/lb; USD/INR = 72.00, the equivalent price is INR 17.50/kg. Add the subsidies = 10.44/kg, we get a total export realization of INR 27.90/kg which is much lower than the average cost of production for an Indian sugar mill (INR 34.84-35.59/kg). At the current exchange rate, 13.5c/lb is the break-even price for exports to be viable.
India's trade subsidies / policies are being challenged at WTO. Protectionist trade policies on the rise globally
Whether it is the recent sugar dispute lodged by Australia, Brazil and Guatemala for India's distortionary policies leading to sugar glut, or US threatening to withdraw from WTO citing countries like India and China misusing preferential treatment given to 'developing nations', it is time India need to realize (or perhaps it does realize) that sooner or later the other sugar producing/exporting countries would not tolerate India's trade policies that go against their respective domestic markets, in other words, these subsidies won't and can't continue for long. The trade protectionist disputes and policies seem to be a result of a general rise in populist sentiments across countries and in my opinion, will continue to persist for the foreseeable future. (at least next 2 years)
Without structural reforms, India is heading for a big inventory problem in the years ahead. Ethanol production a likely beneficiary.
As mentioned in my previous article, either India has to link sugarcane prices to sugar output prices at the expense of offending a sugarcane farmer voting bloc (who have priced in expectations of higher sugarcane prices year after year) and/or divert a substantial portion of this sugarcane crop to production of ethanol (at the expense of sacrificing sugar). I doubt there will be political will to do the former, so the latter's case become stronger than before.
Barring weather shocks, we are looking at a rough band of +5/6 million tonnes# of sugar surplus per annum in the years ahead. Given our high import fuel dependency, there is sufficient headroom for blending ethanol with petrol (gasoline) and cut down a portion of that dependency. Already in 2018, we saw various government policy measures (like the National Biofuel Policy 2018 which mandates EBP, ethanol blending program) to support ethanol production and capacity expansion and I expect more measures to come forward in 2019.
Select Indian players likely to benefit from a structural shift. Will investors reward these companies?
Efficiently integrated sugar mills with significant ethanol capacity expansion and companies around the ethanol eco-system (equipment and technology/service providers) likely to benefit from this structural shift.
For the sugar mills, the ethanol diversification will provide a stable revenue and profitability hedge (70-75% EBITDA margin*) against the more volatile and very low EBITDA margin* (3%-5%) sugar business. Currently the best of sugar mills get priced around 4-5x 1 year forward earnings. The dividend yields of some of these mills are also attractive. However, there is lack of genuine interest from investors (domestic as well as international) as the outlook and sentiment towards the overall industry is / has been poor due to government regulations (Essential Commodities Act), volatile earnings, poor corporate governance, political interference etc.
Having highlighted the risks, I still believe there are pockets of opportunity in the sugar mill space for investors with risk appetite to carefully bet long on this structural shift by selectively investing in sugar mills that - 1. are market leaders, have economies of scale and are efficient integrated low cost sugar producers 2. have good corporate governance and those which focus on appropriate disclosures, timely quarterly results/reports, conference calls/management guidance and 3) are expanding their ethanol capacity substantially.
# Assuming average production of 32 million tonnes and consumption of 26 million tonnes
Disclosure: I am/we are long india sugar millers.
Additional disclosure: This blog has been published in my LinkedIn page.
Disclosure:- This is an original article and sources have been cited wherever necessary. Any opinions expressed is clearly of the author himself and not be considered qualified professional advice. Reader is required to conduct own due diligence or seek professional investment advice before investing. This article can be cited elsewhere in an original work.