The sugar industry, battered over the past couple of years by the growing divergence between sugarcane and sugar prices, has reason to cheer as sugar prices have started increasing this year.

We expect domestic sugar prices to remain firm over the next 12-18 months, fuelled by a decline in production in the current season and the resumption of raw sugar export - made viable by the recently announced export subsidy of Rs 3.30 a kg.

For sugar companies, this upswing in prices could not have come at a better time. They are already reeling under the weight of high sugarcane cost - at the all-India level, average sugarcane cost as a percentage of sugar prices is expected to reach nearly 100 per cent in the current season from 86 per cent last season.

We estimate average ex-mill sugar prices (Maharashtra) will be Rs 30.2-30.7 a kg during sugar season (SS) 2013-14 (October to September), at least Rs 4 a kg higher than in end-January 2014. This will be a welcome relief for millers, who watched in dismay as domestic sugar prices plummeted from a high of Rs 33.8 a kg in August 2012 to a 27-month low of Rs 26 a kg by end-January 2014 because of excess supply since SS 2012-13,

coupled with virtually no export (because of relatively lower international prices).

This boost to prices will be propelled by a fall in inventory in SS 2013-14 on account of a 1-1.5-million-tonnes decline in production (due to lower sugarcane output). The subsidy on raw sugar export will support this rise in prices. There has already been a northward movement in sugar prices since the Rs 3.30 a kg subsidy on export up to four million tonnes of raw sugar over the next two years was announced in February. Because of this subsidy, losses on raw sugar export will be lower than on the sale of white sugar in the domestic market.

However, we do not anticipate export to shoot through the roof. In SS 2013-14, only 1.5 million tonnes of export is likely because of a glut in the global market. Any surge in export from India will only drive global prices further down and domestic prices will soar if export rises appreciably. This will, in turn, widen the gap between domestic and international prices substantially in favour of the former and make export unviable.

Over the past few years, the relentless rise in cane prices has left mills bleeding and saddled them with high cane payment arrears. Due to continued losses, the cash flows of mills are expected to remain stressed in SS 2013-14. This will result in further increase in cane arrears, translating into reduced cultivation. Consequently, we expect a decline in sugar production and inventory levels, ensuring firm sugar prices even in SS 2014-15. Global sugar production, too, will decline in SS 2014-15 and provide support to domestic prices.

Our analysis indicates the rise in sugar prices will halve companies' losses on domestic sales in the second half of SS 2013-14 from Rs 6 a kg in January 2014. The losses will decline further in SS 2014-15 with firm prices.