World sugar prices soared to a 29-year high of nearly 30 cents a pound in early 2010 before falling back to half that level by early summer. Still, they remain 50 percent higher than average over the past 20 years. Was this price spike a temporary oscillation caused by a supply shock or does it reflect a more permanent fundamental shift in global market dynamics?

Evaluation of economic and policy factors driving production and trade in key global sugar markets supports both perspectives: underlying dynamics related to Brazil’s exchange rates and ethanol’s role in energy markets are putting upward pressure on global prices. However, the volatility of price movements in the past year was mostly the result of supply shortfalls tied to changing economic incentives, weather disruptions, and policy factors in other countries. The U.S. remains largely insulated from global sugar price movements, but external fluctuations are felt in the United States, particularly when prices are high.

Changing production, use, and policies affected global sugar market in 2009-2010

Global sugar production fell nearly 20 million tons (12 percent) in the 2008/09 marketing year (October 2008-September 2009) in response to lower acreage, weather disruptions, and policy developments. While prices of other commodities increased in 2007 and 2008, sugar prices remained relatively stable. As a result, sugar acreage declined in many parts of the world as producers switched crops in response to increased returns for competing commodities. Weather-related reductions in yields further hindered production in 2008/09. At the same time, consumption of sugar continues to increase, helping to boost average world raw sugar prices in 2009 to almost double the long-term average of 11 cents per pound.

Policies fostering the industrial use of sugarcane also increased demand. Brazil, the world’s largest sugar producer and exporter, uses a variety of tools to promote the production of ethanol from sugarcane, which has increased overall sugarcane production but introduced competition between the two uses—sugar and ethanol. Because Brazil is a major player in world sugar markets, policy and economic conditions that affect Brazil’s ability to produce and export sugar, such as ethanol use and changes in exchange rates, reverberate throughout the global market.

Brazil’s leading role as a sugar exporter was further heightened when the European Union (EU), which supplied as much as 20 percent of global exports in the 1990s, shifted from a net exporter to a net importer following sugar policy reforms in 2005. This shift removed a traditionally important supply source from global markets and has made sugar importers more reliant on Brazilian exports. In addition to exposure to supply and price developments in Brazil, sugar prices have become more susceptible to increasingly volatile production cycles in Asia’s large sugar-consuming markets. Production swings in these countries are tied to policies that ultimately create large oscillations between their exports and imports from year to year.

With the full implementation of the North American Free Trade Agreement (NAFTA) in 2008, the United States now relies on Mexico to supply a significant share of U.S. sugar demand. However, after exporting 1.4 million tons of sugar to the United States in the 2009 marketing year, Mexico was forced to import large amounts of sugar from the world market, thereby helping to support high world sugar prices. Despite the United States’ general isolation from the global market, developments within the United States still can affect world prices, albeit sometimes indirectly.

Brazil sets tone for world sugar prices

As the world’s leading producer and exporter of sugar, Brazil plays a leading and increasingly important role in establishing global sugar prices. Brazilian sugar exports have grown steadily over the past several decades—its share of global exports climbed from under 25 percent in 2000/01 to over 48 percent in 2009/10, with exports of just over 24 million metric tons.

Brazil, particularly the center-south region of the country, has a low cost of production, usually ranking first or second globally, with production costs of $265 per ton, compared with a world average of $353 per ton in 2008, according to LMC International. Brazil also has the world’s largest land base committed to sugarcane, which contributed to its rapid growth as the dominant exporter. Over the past 20 years, Brazil more than doubled cane production area, from nearly 3.6 million hectares to almost 7.5 million hectares, and continues to increase area each year. Sugarcane area among other leading exporters has remained relatively stable—Australia with 350,000-450,000 hectares and Thailand with 900,000-1.2 million hectares over the past 10 years.

Because Brazil is such a significant world supplier, both raw and refined world sugar prices are closely correlated with Brazilian production costs. A key factor affecting these costs is the exchange rate between the U.S. dollar and the Brazilian currency, the real, because sugar is traded in U.S. dollars in international markets. When the U.S. dollar is strong against the Brazilian real, Brazilian sugarcane producers’ costs are relatively lower, which makes exports more competitive. For instance, if Brazilian production costs remain constant in local currency terms and if the value of the U.S. dollar doubled, Brazilian production costs would fall by half when measured in U.S. dollars.

The real lost 50-70 percent of its value against major currencies between 1997 and 2003, which coincided with especially strong growth of Brazilian sugar exports and a decline in global sugar prices. However, the real began rebounding in 2003 and steadily strengthened through 2009. The real’s appreciation was modest enough to allow exports to continue increasing, but there was also a close correlation between the appreciating real and the increase in sugar prices after 2003 leading up to the 2009 price spike. The real has continued to strengthen through the first half of 2010, indicating that sugar prices could continue to remain elevated if the underlying relationship between exchange rates and world prices continues to hold.

Ethanol fuels expansion of Brazilian sugarcane area

Policy support for ethanol production in Brazil has stimulated dramatic growth in the use of sugarcane for ethanol, which now accounts for 55 to 60 percent of total Brazilian sugarcane production. A major source of transportation fuel in Brazil, ethanol links the oil and gasoline markets to the sugar and sugarcane markets. This relationship is particularly strong during periods of high oil prices, affirming that energy prices will be an important determinant of tradeoffs between sugar and ethanol production. However, the long-term pattern of growth in both sugar and ethanol production indicates that the relationship may be complementary over a longer time horizon, rather than competitive. Increased production and use of ethanol has generated an additional revenue stream for sugarcane producers and processors, added flexibility to switch between sugar and ethanol production depending on market conditions, and allowed the Brazilian sugarcane industry as a whole to grow.

Growth in the use of sugarcane for ethanol production dates to 1975, when the Brazilian Government established a national program to regulate alcohol levels in fuel to mitigate the impacts of oil price shocks at a time when Brazil imported over 80 percent of its oil. The result was a large expansion in sugarcane production and the development of anhydrous alcohol, used for blending in gasoline, and hydrous alcohol, used in a pure form in specially equipped cars.

From 1998/99 to 2008/09, Brazilian ethanol production nearly doubled to 27.5 million liters. Increased vehicle sales have raised demand for fuel and ethanol. The Brazilian Government mandates that all gasoline must be blended with 20-25 percent ethanol. Flex-fuel vehicles (FFV), commercially available since 2003 and now in widespread use in Brazil, have the ability to use either blended gasoline or pure ethanol as fuel. Consumers can purchase the fuel that is most cost effective given the energy differentials between the two, allowing for a greater ethanol capacity and improved substitutability for drivers. In addition, with sugar and ethanol production typically being made in the same facilities, producers can adjust the output mix substantially within each year in response to price movements in both markets, which provides flexibility in the supply of both goods.