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.