Growing Pains

Brazil’s sugarcane ethanol industry hits a snag
By Kris Bevill | June 10, 2011

In some ways, Brazil represents what the United States aspires to become in terms of ethanol use. While U.S. producers continue to fight for expanded infrastructure, Brazilian companies are building a pipeline to more easily transport ethanol from one region to another. The U.S. industry is banking on promises from auto manufacturers to crank out a greater number of much needed flex-fuel vehicles in the coming years. Brazil’s highways are already loaded with vehicles that use ethanol-blended fuel or even pure ethanol. The U.S. EPA approval for E15 to be used in some American vehicles has yet to scale legal hurdles before it can be put to the test. Brazil currently has in place a nationwide E25 mandate.

But everything is not coming up roses in the Brazilian ethanol industry, as illustrated by supply shortages this year, which were alleviated in some part by U.S. imports. Considering the envious progress made by Brazil throughout the past few decades in implementing ethanol usage, how did this situation develop and does it represent possible things to come for the U.S.?

Make-up of the Market
Brazil began developing its domestic ethanol industry in the 1970s in response to the worldwide oil crisis that hit countries with little to no oil production, including Brazil, extremely hard. Country leaders tasked the state-owned integrated energy firm Petrobras S.A. with developing new domestic oil production capacity, but also focused heavily on Brazil’s agricultural opportunities for alternatives. Sugarcane ethanol, which could be produced at the nation’s existing sugar mills, quickly rose to the front of the pack as a desirable fossil fuel replacement. Automakers began producing ethanol-fueled vehicles and the government provided incentives for consumers to purchase the new vehicles. Additionally, retailers installed hydrous ethanol pumps to distribute pure ethanol to consumers in response to growing demand for the alternative fuel. 

The program appeared to work well for the country until about 1990 when oil prices dropped and demand increased for gasoline-fueled vehicles. Demand for ethanol waned and mills converted more of the sugarcane crop to sugar. It wasn’t until the early 2000s that ethanol experienced a rebirth of sorts, brought on by the introduction of flex-fuel vehicles and spiking oil prices. Like the U.S., Brazil’s ethanol industry enjoyed substantial growth through the middle part of the decade. According to UNICA, Brazil’s Sugarcane Industry Association, sugarcane production in Brazil grew 10.3 percent every year between 2000 and 2008, ultimately doubling the nation’s historical output levels. But in 2008, Brazil’s ethanol industry, like its U.S. counterpart, took a nosedive. The global economic crisis took its toll on financing options and mergers and acquisitions began to occur, effectively shrinking the sugarcane industry’s growth from the expected average of 10.3 percent down to only 3 percent.

This stunted growth was compounded by undesirable weather conditions for the sugarcane crop—too much rain in 2009 and a drought in 2010—leading to a nationwide shortage of ethanol stocks during the harvest off-seasons last year and earlier this year. American producers happily stepped in to supply some of the ethanol needed by Brazil, exporting more ethanol to the country earlier this year than had been brought in since the mid-1990s. It filled a gap, but Brazil has no desire to become a habitual importer of U.S. ethanol. Determined to regain control of its own domestic supply, the industry must now weave its way through a complicated set of issues that need to be resolved so that it can return to its prior pattern of growth.

Contracts and Pricing
“Every year there’s a big challenge to have enough stocks to comply with the off-season period,” says Marcos Sawaya Jank, CEO and president of UNICA. “What we have learned from these last two years is that we needed to have more stocks. We needed to have more strategic stocks and need to be more prepared in terms of storage.” Currently, gasoline is marketed separately from anhydrous ethanol in Brazil and is controlled by Petrobras, the only gasoline producer in the country. In order to prevent future stock deficiencies, one of UNICA’s main goals is to convince ANP, Brazil’s national petroleum, natural gas and biofuels agency, to begin requiring contracts for ethanol that are linked to gasoline contracts. Jank says this will help to assure supply from ethanol producers, who currently can’t be certain whether anhydrous ethanol they produce will actually be used. Requiring contracts for ethanol to be blended with every liter of gasoline sold throughout the year will also alleviate uncertainty surrounding the E25 mandate, which the government has been known to temporarily lower in the past in response to reduced supply, he says.

Fixed gas prices are another issue of major concern to the ethanol industry. Hydrous ethanol, which can be used in Brazil’s flex-fuel vehicles, makes up 75 percent of Brazil’s ethanol market, according to Jank. However, because consumers with those vehicles are able to switch between ethanol and gasoline to suit their needs, the ethanol industry needs to be able to price its product competitively with gasoline. Currently, hydrous ethanol is getting beaten out by low gasoline prices because Petrobras has not raised ex-refinery gas prices substantially since 2005. “There’s a monopoly here because the only supplier is Petrobras,” Jank says. “This is what makes investors not confident to invest in new plants right now.”

Raphael Hudson, Hart Energy’s director of Latin American Research and Consulting, says frozen gas prices are one concern of several facing Brazil’s ethanol industry. He believes that while Brazil’s gas prices have remained largely unchanged since the end of 2005, they have responded somewhat to market volatility, although not enough to compare to the inflating cost of ethanol production and subsequent higher price at the pump for hydrous ethanol. “My impression is their costs are going up, they have loans that they have to pay for and they’re having a hard time keeping up,” he says. “When you’re competing against gasoline and the price hasn’t moved much, that’s a problem.”

Petrobras says its market price for gasoline reflects two things: the product’s value and state and federal taxes. As it heads down the distribution chain, ethanol prices, distributor and retail costs and marketing margins are factored in and ultimately are reflected in the price paid by consumers for C-grade (ethanol blended) gasoline. Sugarcane mills, meanwhile, are facing high land costs, competition for feedstock, and high input costs. Hudson says the pressure put on ethanol producers by Petrobras to lower their prices will likely require government intervention. ANP recently announced plans to review its pricing policy and is in discussions with ethanol industry representatives and Petrobras to explore solutions, according to Jank.

Financing and Expansion
Brazil needs more sugarcane mills to meet its growing demand for ethanol and right now that’s just not happening, Jank says. “What we see in terms of investments since 2008 is companies buying other companies,” he says. “Mergers and acquisitions. The big discussions we are having with the government is how to grow 8 to 10 percent a year again, which is the number we would need to comply with the demand we believe will grow in the next years.”

Jank predicts that 130 new mills need to be built in Brazil by 2020, ramping up sugarcane crushing capacity to 1.35 billion tons by that year. “It’s not impossible,” he says. “In 2005, we had more than 10 new mills per year. We need to grow again at the same levels we’ve been growing in the mid-2000s.” The expansion of the industry could be more solidly accomplished now as compared to around 2005 because of the recent consolidation of the industry, he says, and the government is participating in talks with UNICA to achieve the industry’s expansion goal.

One of the industry’s relatively new players is Petrobras. The firm entered the industry when it established its biofuels arm in 2008 and now holds stakes in 10 plants, representing a combined capacity of 900 MMly. It also recently announced plans to increase its investments in the coming years in order to expand its ethanol output capacity. Hudson also views this as a potential positive for the industry. “As you get bigger players like Petrobras itself moving into the sector, you’re probably going to have larger-scale players that can access other sources of financing, not exclusively in Brazil, and that could help build up the scale of crushing capacity and feedstock production,” he says. But Hudson also sees the need for the Brazilian government to play a role in the industry’s expansion. “The availability of financing needs to improve to a certain extent, that’s something on the private backing sector, but a lot of it can be addressed by the government because it still has a pretty significant role as a provider of rural credit and also through the provision of agro-industry credit through BNDES, its development bank,” he says. “If people in the sector can get better access to financing that will definitely help things.”

U.S. Impact
Even if financial conditions improve and the government gets its pricing mechanisms under control, there is about a two-year lead time before the first set of new mills can be constructed and begin operating. The U.S. has played a small, but very important role in providing ethanol to Brazil this year when it came up short. Will those opportunities continue? Probably not, Hudson says. “It’s a difficult situation now and it’s a good relief valve for them to be able to use,” he says, adding that once the sugarcane harvests are in full swing in July and September, Brazil should be able to get back on its feet in terms of ethanol supply. Jank, who never misses an opportunity to address the U.S. ethanol import tariff issue, points out that Brazil’s lack of import tariff made it easier for U.S. exports to enter the country when it was needed this spring. “We really think this was extremely good and helpful and we hope that the U.S. people would understand that this would also be good for the U.S.,” he says. “What we imported was extremely important during this off-season period. We really believe open markets are extremely important for ethanol markets everywhere because it makes us more independent of oil, it makes our industry much more competitive, it’s important for the environment and it’s important because of the weather problems. This year it was in Brazil, next year it could be in the United States. Climate problems happen everywhere.”

Of course, Brazil still believes its sugarcane ethanol is superior to U.S. corn ethanol, a sentiment that was echoed by the U.S. EPA when it classified sugarcane ethanol as an advanced biofuel. But because of the import tariff, Brazilian producers say they are locked out of the market. Jank doesn’t buy the argument that a tariff is necessary in order for the U.S. to establish its own advanced biofuels industry. “The U.S. could be a very important market for us, but never gave us any signal that it could happen,” he says. “We are now exporting 70 percent of our sugar and only 10 percent of our ethanol. We could increase that very easily, but only if there is a clear signal that this could happen. Who would benefit from a reduction of the tariff? U.S. consumers, because they would be diversifying from oil imports. There would be more competition at the pump level. There would be less risk in terms of weather conditions. Of course, we would benefit, too, but I think there are many reasons why it would benefit the U.S.” An opportunity to export product to the U.S. would invite greater investment in the Brazilian industry, he says, adding that many U.S. companies have already begun to invest there.

Hart Energy consultants recently conducted an analysis on issues facing the global ethanol industry over the next five years. One of the issues addressed in the report, titled “Renewable Ethanol: Navigating the Rapids: 2011-2015,” is whether Brazil will be able to supply sugarcane ethanol to the U.S. to meet its advanced biofuels requirement under the renewable fuel standard. Hudson says they anticipate the amount of Brazilian ethanol available for exports to remain small over the next few years, but the situation should improve over time. “We don’t expect the exportable surplus that UNICA and others in Brazil have forecasted, but we expect enough where if purchasers in the U.S. are ready to pay a surplus for it, there should be enough to meet that need,” he says.

A complex set of issues faces the Brazilian industry, but once they are resolved, the industry is believed to be primed to contribute an even larger role to Brazil’s economy and the global ethanol markets. Jank firmly believes the country is at a point of opportunity, rather than crisis. “We are not talking about a country that is facing a depression or something like that. We are talking about a country that is growing 5 to 6 percent a year and our industry is growing 3 percent when we should be growing 8 to 10 percent, which is very good news actually,” he says.

Hudson also views the current situation as a potential positive. “Because of the very nature of flex vehicles and because of the greater sensitivity to the carbon intensity of fuels, that is going to create an additional potential demand for ethanol,” he says. “If these problems are dealt with properly, it can be read as an opportunity. This current situation is merely a bump in the road.”

Author: Kris Bevill
Associate Editor, Ethanol Producer Magazine
(701) 540-6846
kbevill@bbiinternational.com