Managing the Risks of Sugar Milling and Exports Professor L. Rutten May 2001 Ana Cortez Will Davies Laurent Clarenbach Anne-Cecile de Planta

Overview  Physical Flows  Exposures Identification  Strategies  Recommendation

Physical Flows Purchase of catchment sugar cane at government determined minimum price 1500 kT Purchase of sugar cane at competitive price 500 kT March to June Processing Transformation of the 2000 kT of sugar cane into: 120 kT of raw sugar and 80kT white sugar Storage of raw sugar Export of raw and white storage under dock capacity constraint 120 kT raw | 68kT white Storage of white sugar Local consumption 12 kT April to July April-May to Dec

General Case: Processors Finished Product Revenues -Raw Material Costs -Raw Material Costs =Gross Margin =Gross Margin -Processing Costs -Processing Costs =Profits =Profits Processor Exposure: Change in Gross Margin (change in spread between raw and finished good prices) Processor Exposures

Raw Material Supply Sugar Cane Catchment Area1,500,000T Fixed Govt. Price Other Supply500,000T Competitive Pricing Mill Capacity2,000,000T Sugar Cane Major risks: 1. Must buy catchment Sugar Cane at fixed price 2. Known cost/Uncertain revenues (raw/processed sugar) Minor risks: 3. Uncertain Supply (bad harvest, etc.) 4. Basis Risk (quality/delivery)

Production Schedule Assumptions: 1. Sugar cane harvested steadily from March-June kT Sugar Cane = 200kT Sugar (10%) 3. White Sugar processed from Raw at 1-1 ratio 4. Raw / White Sugar produced steadily from April-July Finished Products Sugar Cane CatchmentOtherTotalRawWhiteTotal March April May June July Total

Raw Sugar Assumptions: 1. Export as fast as dock capacity permits 2. No domestic sales Issue: Inventory builds steadily until July => Price risk until Price is fixed or hedged InitialEnd InventoryProduceExportDomesticInventory April (13.3) May (13.3) June (13.3) July (13.3) August (13.3) September (13.3) October (13.3) November (13.3) December (13.3) - (0.0) January(0.0) February(0.0) March(0.0) - - -

White Sugar Assumptions: 1. Export as fast as dock capacity permits 2. Maintain adequate supply to meet annual domestic sales (especially as highest margins Jan - April) Issue: Inventory builds steadily until July => Price risk until Price is fixed or hedged InitialEnd InventoryProduceExportDomesticInventory April (1.0) 19.0 May (12.0) (1.0) 26.0 June (12.0) (1.0) 33.0 July (12.0) (1.0) 40.0 August (12.0) (1.0) 27.0 September (12.0) (1.0) 14.0 October (8.0) (1.0) 5.0 November (1.0) 4.0 December (1.0) 3.0 January (1.0) 2.0 February (1.0) 1.0 March (1.0) -

Summary of Major Exposures 1. Sugar Cane Purchase - Fixed Government Price on 75% of supply. Note, other 25% does not become an exposure until we purchase it. 2. Finished Product Inventory - exposed to Raw/White Sugar Price decreases until selling price is determined (remember Sugar Cane costs have already been incurred). RawWhite Domestic 12 kT – Usually high Margins Export 60 kT – SEO 30 kT – Option SEO 30 kT – Prevailing Mkt. Prices 68 kT – Fixed Price Forward delivery contracts Existing Sales Strategy / Commitments

Potential Strategy #1 - The Passive Strategy Sugar CaneRawWhite Do nothing Determine prices when production is complete. E.g. fix SEO price on day raw/white become inventory 75% of Sugar Cane is locked in at government fixed price Disaster if Raw/White prices decline before prices are fixed Result Result Action Action Pros/Cons Pros/Cons Gross Margin is known and fixed once SEO is set. But exposure exists during production on 100% of vol. (sugar cane price fixed ||| raw/white price unknown) Determine prices when production is complete. E.g. execute tender offer on day raw/white become inventory Gross Margin is known and fixed once tender offer is set. But exposure exists during production (sugar cane price fixed ||| raw/white price unknown)

Sugar CaneRawWhite Result Result Action Action Pros/Cons Pros/Cons Potential Strategy #2 - Lock-in Gross Margin Do nothingFix all prices the moment we purchase Sugar Cane e.g. fix SEO price on day of purchase and sell futures for balance of volume Enter into forward purchases tender offers at time of Sugar Cane purchase. Hedge domestic sales via futures 75% of Sugar Cane is locked in at Govt. fixed price Gross Margin is known and fixed at time sugar cane is bought. + Eliminates exposure on 25% bought at mkt. prices + Good news if Gross Margin is high on other 75% - Disaster if Gross Margin is Low - (Uncertain) margin calls Gross Margin is known and fixed at time sugar cane is bought. Disaster if Sugar cane or Raw/White Sugar prices decline

Sugar CaneRawWhite Result Result Action Action Pros/Cons Pros/Cons Buy a put option on Sugar Cane for 75% of volume If gross margin is too low buy a Put on all volume The moment gross margin is high enough: Fix prices via SEO and selling Futures If gross margin is too low buy a Put on all volume The moment gross margin is high enough: Fix prices via fwd purchase arrangements or selling Futures Minimum Gross margin ensured. Upside potential to increase gross margin Sets floor on Gross Margin Allows upside potential if Sugar prices rise Sets floor on Gross Margin Allows upside potential if Sugar prices rise - Requires (known) premium + Limit downside risk + Allows opportunity for gross margin improvement to offset government mispricing Potential Strategy #3 - Flexibility (Protection with Upside) + No margin call risk

Long put Long physical raw/white sugar price Revenues Hedged revenues payoff profile Strategy #3 - Long physical + Put Option

raw/white sugar price Revenues Hedged revenues payoff profile Gross Margin Sugar Cane Costs Potential Strategy #3 - Flexibility (Protection with Upside)

Why Strategy #3? 1. The company is cash constrained and must do some sort of hedging or face potential bankruptcy 2. Avoids two serious drawbacks of hedging with futures: a) Futures expose company to risk of (uncertain) margin calls b) Futures could lock in unattractive gross margin as Government fixed price is probably too high 3. Options provide three key benefits: a) Limit downside risk of decline in Raw/White Sugar prices b) Allows upside potential to improve tight margins (caused by gov’t price fixing) c) Allows flexibility to lock in gross margins at the right time Recommendation: Strategy #3 Flexibility

1. Opportunistically lock in long-term Gross-Margin a) Agree on acceptable long-term Gross Margin a) Agree on acceptable long-term Gross Margin b) Monitor market for opportunities to lock in spread b) Monitor market for opportunities to lock in spread Execution: Execution: - Long the Raw Material - Short the Finished Product - via Options or Futures - Similar to “crack spread” energy contracts 2. Examine Alternative Uses for Sugar Cane - Alcohol beverages - Gasoline substitute Long-Term Strategy

We would appreciate your agreement to Execute our recommendation: Strategy #3 This Concludes Our Presentation