The Sugar Crisis Spells Opportunity for Investors

When procrastinating husbands open their wallets to pay for decadent Valentine’s Day chocolate, they’re likely to wind up paying a little more than usual this year.

They can thank the growing worldwide sugar shortage for that.

StreetAuthority’s Anthony Haddad wrote about this problem in August last year, and the situation has worsened. Prices are at 29-year highs and don’t look to be letting up any time soon. A confluence of factors around the globe is creating a perfect storm that’s likely to hold prices up or even push them higher in the coming months.

The problem is global: A disappointing monsoon season in India has weighed on crop yields, while too much rain in Brazil has dampened production. India, the largest consumer of sugar, may have to import about two million tons to make up for the shortage in supply this year — almost 10 times what it imported last year. Pakistan, a major sugar producer and consumer in its own right, is expected to face a shortfall of 1.4 million tons. The story is the same for Egypt, Indonesia, the Philippines and a host of other countries.

#-ad_banner-#Altogether, it’s expected global demand for sugar will outpace supply by 13.5 billion tons — 38% of what Brazil will produce this year and more than enough to meet demand in Africa.

If these factors weren’t enough, there’s another problem: ethanol. It takes about three-fourths of a gallon of crude oil to make a gallon of ethanol from corn. Sugar is more efficient. The increasing demand for sugar-based ethanol is weighing on supply.

Demand for sugar-based ethanol is highest in Brazil. The country produces about 25% of the world’s sugar supply, making it the second-largest producer. There are about 30,000 ethanol fueling stations throughout the country, and nearly all vehicles run on ethanol.

Brazil is even beginning to turn to sugar for electricity. State-run oil giant Petrobras (NYSE: PZE) just opened up the world’s first ethanol-fired power plant, which will help meet demand for electricity during Brazil’s May-November dry season (most of Brazil’s power comes from hydroelectric dams). If the plan catches on, Brazil (and possibly other countries) could build more plants and drive further demand for sugar.

Standing at the forefront benefiting from all this is Cosan Ltd. (NYSE: CZZ), the world’s largest sugar cane processor and also a major ethanol producer. The Brazilian company has been on an absolute hot streak as sugar prices have gone up: it had $2.9 billion in revenue for 2009, an increase of +96% during the previous year. The shares are up +170% during the past year, yet they trade for only 0.4 times sales, suggesting Cosan may still be a good value.

Shares have backtracked in the past couple weeks primarily because of a labor dispute. In 2007, Cosan was placed on a government labor black list when substandard working conditions were found at one of its cane fields. The company was recently taken off the list, but the Brazilian attorney general’s office is fighting against its removal. Cosan says it hired a third-party cane cutting company for the site that it no longer uses at any of its fields.

Despite the situation, major customers such as Wal-Mart (NYSE: WMT) have already resumed business with Cosan. Brazil’s state-run development bank has said it will be available to continue making key loans to the company as well. These developments are a good sign for Cosan, and should be viewed as a green light for the opportunity presented by the pullback in the share price.

Sugar is an important staple for many developing countries. As world population continues to grow, demand will increase. This makes the prospect of sugar prices continuing to rise in the immediate term as well as the long term, strong.

As my colleague Amy Calistri has said before, “Investments fueled by speculation and momentum can fall back to earth with a vengeance.” With prices having doubled in the past year, sugar definitely has the wind at its back. With that in mind, investors should consider picking up shares of Cosan, but with a watchful eye on sugar prices.

P.S. Interestingly enough, one of my colleagues has a starkly different prediction on sugar than I do. He says “Sugar prices will plummet in 2010” and he thinks he’s found a safe and cheap way to play the move that can turn $3,000 into $27,000 in a matter of weeks. Some good due diligence never hurt anyone, so check out his sixth prediction located in this report.