Economic Hard Landing Abroad Threatens Expansion of Brazil's Ethanol Industry

The issue of whether the Brazilian economy can decouple from the fate of the economies of the U.S. and Europe remains a nagging one, with many economists and academics arguing that other countries would pick up the slack in the event of an OECD-led economic slowdown. However, as any contraction in money markets abroad would directly impact the dozens of joint ventures and greenfield projects currently being developed in Brazil's ethanol and sugar industry by foreign companies, understanding the extent to which the Brazilian economy and those of the more developed countries are connected seems prudent.

The Ministry for Development, Industry and Foreign Trade points to the diversification of Brazil's portfolio of trade partners and to the increase of commerce with China as a counterpoint. But the United States still took in an estimated 15.8% of Brazilian exports in 2007, while China acounted for 6.9%. Further, in the case of dampened demand in the U.S. for Chinese products, the Brazilian commodities sector - which has seen massive capital expenditures over the past few years, including a number of acquisitons abroad by companies like Vale - would probably take a hit. Risky undertakings in Brazilian biofuels would likewise feel intense pressure, as it is not clear whether financing from abroad would be forthcoming.

In fact, Unialco, a well-run sugar and ethanol operation in the interior of Sao Paulo state, attempted to float USD150 million dollars in bonds, but gave up when Standard and Poor's gave the company a B ("Very speculative") rating. While recognizing that the long-term prospects for Brazil's sugar and ethanol industry look good, Standard and Poor's also noted that the cyclical nature of Unialco's business, which generates weak cash flows during the off-season (November-April) and requires substantial increases in working capital during the harvest (May-October), raises the riskiness of the business - a problem, notes S&P, inherent to all commodities.

The need for electricity produced by distilleries from burning bagasse (crushed sugarcane) should also bode well for the medium term - Brazil faces a looming power shortage, the result of a complex set of factors that includes natural gas disruptions from Bolivia, shortages in Argentina, and less-than-expected precipitation that resulted in low levels at the dam reservoirs that account for approximately 70% of all the electricity generated in Brazil. However, it is not clear that all the investments in bagasse-based generation will come on-stream in time to stave off shortages.

A modern refinery today derives around 10% of its income from the sale of excess power to the public grid. As most sugar and ethanol companies are located in the state of Sao Paulo, also home to the bulk of Brazil's industry, disruptions to ethanol projects would affect the delicate balance of (electric) power that keeps both mill owners and industrialists happy. Their support is essential to the stability of the administration of President Lula, who started out his political career as a union leader on the industrial outskirts of the city of Sao Paulo in the late 1970s. A power shortage now would tarnish his economic credentials, which have never shone as brightly.

Estimates Vary for Total Investments in Brazil Ethanol Sector

When summing up expected investments in new ethanol- and sugar-producing capacities in Brazil, the numbers shift from day to day and from source to source. Dow Jones reports that, in April 2007, BNDES, Brazil’s national development bank, put the figure for the 2008-11 period at 89 projects requiring USD13.1 billion in investments. Unica, the Association of Sugarcane Growers of Brazil’s Center-South, talks of 86 plants, with slated expenditures of USD17 billion. The Vice-President of Morgan Stanley’s research division, Subhojit Daripa, on his turn, speaks of a total of USD33 billion in new investments planned both for the development of greenfield projects and for the expansion of existing plants.

Looming over the sector, Petrobras, the Brazilian state-owned energy company, is a wild card that may sway the development of the industry one way or the other. It has announced a partnership with Japan’s Mitsui to build forty “bioenergy complexes”, as well as two dedicated ethanol pipelines from Goias state, deep in Brazil’s interior, through traditional sugarcane-growing regions in the northwest of Sao Paulo state and on to terminals on the Atlantic.

However, as a cursory examination of Brazilian history shows, talk is cheap and the way things turn out will be determined by the economic fundamentals of Brazil’s energy sector. Petrobras recently announced the discovery of a massive ultra-deep offshore field with ultimately recoverable reserves of between four and six billion barrels of light, 28-degree API oil. That the company will be tempted to shift assets – especially human resources – to this project and away from ethanol and its incipient biodiesel program should not come as a surprise to anyone.

In 2007, according to the Ministry of Agriculture, Brazil produced just under 15.8 billion liters of ethanol – a number that works out to approximately 182,407 barrels of gasoline equivalent per day. Before the announcement of the discovery of the new superfield, Petrobras already produced 2,000,000 boe/day, or about eleven times more than all the ethanol produced in Brazil.

No further math required to figure out what tops the list of priorities of Brazil’s federal energy policy, of which Petrobras is the best-known, and most active, instrument.

A further degree of uncertainty is added by the fact that producers could easily switch from ethanol to sugar production, if the prices of sugar were high enough (right now, they aren’t). But unforeseen circumstances in Australia, India, and other big sugar exporters can change the picture and leave ethanol consumers – in Brazil and abroad – high and dry, as happened in 1989, when the sector became deregulated and an ethanol shortage ensued on the domestic market. The fiasco led millions of motorists to queue up at fueling stations and to lose faith in the federal fuel ethanol program, begun in 1975.

Not only can the switch to sugar alter the numbers for ethanol, but a "black" and "gray" market, caused by unequal tax regimens between states and lax surveillance in most parts of Brazil, severely distorts the playing field by encouraging tax evasion and product adulteration. Sindicom, the Brazilian national association of fuel retailers, estimates that this “informal” market may comprise as much as 40% of the total of fuel ethanol sold in Brazil.

So the announcement of new investments in Brazil's sugar and ethanol industry must be weighed against the marginal cost of talk (zero); only a thorough examination of all the underlying political, economic, and social factors can result in a rough understanding of how much ethanol Brazil produces right now. How much it will produce in a few years’ time is anybody’s guess.

Consolidation in Brazilian Ethanol Industry Aided by Low Asset Prices

Ethanol prices traditionally fall in April, when the harvest season in Brazil’s main sugarcane-growing region, the Center-South, picks up. This year, the drop was more severe and lasted longer than in previous seasons, as capital expenditures in installed capacity, a bumper crop, and a shift away from sugar to ethanol production all kicked in to send the price of the fuel from USD0.55 to USD0.35 per liter over a six-week period between April and June.

Now the season has come to a close in Brazil’s Center-South, which includes the states of Sao Paulo and Minas Gerais, responsible for 75% of all ethanol produced in the country. Prices have once again gone up, allowing companies to take profits – but the damage done by the very low prices that prevailed throughout most of the year, coupled with even-lower sugar prices on the international market, may have long-lasting effects. For one, they meant drastically-reduced cash flows - bad for all producers, but lethal for smaller entrants to the market, many of which had hoped to finance the next year of activities with cash raised by selling ethanol produced this year.

Consequently, many properties are up for sale. Gazeta Mercantil, one of Brazil’s leading financial dailies, reports that prices for installed distillery capacity are about 25% of what was being asked just a few months ago, when prices were at their peak. As many owners did not have the financial heft to wait out the slump, and are not willing or capable of sticking around to see what ethanol and sugar prices will be like in the coming two years, they are now forced to sell for pennies on the real.

Also, according to Gazeta Mercantil, PriceWaterhouse Coopers says that 34 deals involving distilleries were executed in 2007 – nine of which were acquisitions (i.e., either a controlling stake or the entirety or the company was transferred to the new owner) and fifteen, joint ventures. This total was twice the number tallied in 2006, when 19 deals were closed, according to Fabio Niccheri, Director of M&As at Pricewaterhouse.

The highly-fragmented industry, in which 200 companies own about 400 distilleries, is thus undergoing a process of consolidation that may lead the sector to look very much like the soybean-growing region of Center-West Brazil, located at the very geographic center of the South American continent. According to The McKinsey Institute, the Brazilian soy industry is the largest in the world; however, vital products, such as seeds, pesticides, and machinery, and services, like financing, distribution, and logistics, are dominated by a chain with few key players.

The Center-West became an agricultural powerhouse when Brazilian agronomists, centered at Embrapa, a federally-funded R&D facility, developed a method to correct the highly-acid soil underneath Brazil's vast savannas, called the Cerrado. An influx of small farmers built the economic bases of the vast soy economy, so large that it straddles the Brazilian border and spills over into Bolivia and Paraguay, forming the so-called "Republic of Soy".

As the soy industry consolidated throughout the 1980s, a few Brazilian groups emerged at the head of the pack. After the Brazilian economy opened up in the early 1990s, these groups teamed up with large foreign agricultural concerns, sparking fears associated with overdevelopment and prompting a litany of protests, litigation, and judicial action in remote corners of the country.

Many lessons can be learned from the recent development of the soy industry, chief among them the necessity to adopt strict corporate governance and environmental standards to enhance the capacity of the industry for growth. As the pace of consolidation picks up in the sugar and ethanol sector, getting companies in the much more visible Center-South to adopt such codes is a prerequisite for a successful expansion.