Sugar bubble ready to burst

Over the past few weeks, sugar has been on such upward spiral, hitting a 28-year high. Growing demand in Brazil for sugar to be turned into ethanol, coupled with a sharp fall in Indian and Brazilian production, have both sent sugar prices sky high. Many think that the supply shortfall will extend through 2010. Then from fundamental perspective valuation current sugar valuation may be correct as the supply fall short behind the demand. But to speak of supply and demand as if they were determined by forces that are independent of the market participant’s expectations is quite misleading.

It’s true the situation is not so clear cut in case of commodities where supply is largely dependent on production and demand on consumption. But the price that determines the amounts produced and consumed is not necessarily the present price. On the contrary, the market participants are more likely to be guided by future prices, either as expressed in future markets or as anticipated by themselves. In either case it is inappropriate to speak of independently given supply and demand curves because both curves incorporate expectations about future prices.

Those expectations may become self-referential which will lead to the positive feedback process (the higher the price or the price return in the recent past, the higher will be the price growth in the future). Positive feedbacks, when unchecked, can produce runaways which beyond a certain point become unsustainable ending in crash. In short LPPL models developed by Sornette aims, at detecting the transient phases where positive feedbacks operating on some markets or asset classes create local unsustainable price run-ups. The result of the analysis is summarized bellow in figure 1.

I analyzed sugar#11 future time series between September 2007 and September 3 2009. The y axis is logarithmically scaled so that the exponential function would appear as a straight line. LPPL fit exhibit upward curvature which is clear evidence that the prices were growing “super-exponentially”. The projected crash dates are September 5-15 .It must be noted that a good fit of the model to the data series is not a 100% certainty for a crash, but it clearly points at a bubble formation.