Brazil produces 20% of the world’s ethanol, much of which goes towards fuelling the country’s cars. However, in recent years a combination of poor harvests, gasoline subsidies and the global financial crisis have seen investment in the industry grind to a halt. Will it be revived by the elimination of trade taxes on sugar cane ethanol in the US?

Ask a Brazilian what kind of car they drive, and chances are that it will be a flex-fuel vehicle – a vehicle capable of running on either gasoline or ethanol or a mix of the two. Such cars represent 90% of new fleet production in the country and 50% of cars in circulation. Launched in 2003, flex-fuel vehicles were one of the key drivers of growth in sugar cane ethanol production in Brazil; prior to their creation, sales of cars running solely on ethanol was close to zero. The launch of these cars, coupled with a spike in oil prices, propelled ethanol production in the country.

“This triggered a huge expansion of the industry, beginning in 2005 and 2006,” says Giovana Araújo, head of the agribusiness equity research at Itaú BBA. “Since then, we [have seen] 112 new mills in Brazil.”

In the past few years, however, a number of factors have caused the industry’s growth to slow. Three consecutive sugar harvests have been blighted by bad weather, the subsidised price of gasoline has kept the price of ethanol low, and the global financial crisis has affected many producers. Between 2000 and 2008, production of ethanol increased by more than 10% annually, but between 2009 and 2011 output levels have remained flat, according to Unica, Brazil’s sugar cane industry association. The 2010 and 2011 harvests are estimated to have produced 620 million tonnes of sugar, while the 2011 and 2012 harvests are projected to produce an even lower 555 million tonnes – far lower than the industry’s capacity.

Rise and fall

The development of Brazil’s ethanol industry dates back to the 1970s – long before the discovery of pre-salt oil off the country’s shores – and the Pró-Álcool programme. The initiative created an alternative to fossil fuels and directed many producers of cachaça – the liquor made from fermented sugar cane juice, which is used in the renowned Brazilian caipirinha cocktail – towards the production of ethanol.

Typically family owned, these businesses started to attract attention from international groups, such as BP and Shell, and from Brazil’s state-controlled oil giant Petrobras, which wanted to diversify its production and required ethanol in its gasoline’s blend. Today, the largest exporter of the Brazilian green fuel is Raizen, a joint venture between Shell and local producer Cosan.

Brazil’s sugar cane sector contributes $48bn – or 2% – of the country’s gross domestic product. It comprises 430 mills and 70,000 sugar cane growers, and employs 1.2 million people. It accounts for 25% of the world’s sugar cane production and 50% of its exports, while Brazilian ethanol accounts for 20% of global production and 20% of exports. Nationally, it has become the second largest energy source after oil and ahead of hydroelectric power. Despite this, investment in greenfield projects in the country has almost ground to a halt, mainly due to lack of profitability.

With the elimination of trade taxes on sugar cane ethanol and the increase of ethanol blend in gasoline, [we look] at the US as a large potential market and as a partner to make ethanol an international commodity

Luiz Rapparini

Dry weather conditions have made things worse and drastically reduced recent output. “Due to climatic problems and lack of investment in the sector in the past few years, the production of ethanol did not meet the internal demand,” says Luiz Rapparini, Raizen’s executive vice-president. “Forecasts indicate that in 2020, 50 billion litres of ethanol will be required to provide for less than half the flex-fuel cars [predicted to be] in circulation [at that point].”

Price fix

The problem, clearly, is not on the demand side, but on the return on investment of the sector, which is now running close to cost of capital, says Ms Araújo. Unica’s outgoing president, Marcos Jank, agrees on the urgency of improving profitability. Unica, which represents 130 companies producing a total of more than 50% of ethanol and 60% of sugar produced in Brazil, says that to meet future demand, production of sugar should go from 2011’s 620 million tonnes to 1.2 billion tonnes in 10 years’ time, and the production of ethanol from 27.4 billion litres to 70 billion litres.

To achieve this, Mr Jank says that $90bn will need to be invested over the next decade. Petrobras plans to invest $2.5bn in the next three years to increase its production of ethanol and biofuels – ethanol will account for 76% of this. Meanwhile, Raizen plans to expand its current annual production to more than 70 billion tonnes of sugar and to invest in greenfield projects soon, according to Mr Rapparini.

But even with the backing of big companies such as Petrobas and Raizen, a number of issues still need to be addressed. The first is the regulation of gasoline prices in the country. Since ethanol is a less efficient fuel for cars, it is sold at less than two-thirds the price of the oil-based fuel, meaning that the regulation of gasoline prices has a direct impact on ethanol sales.

“If the oil price goes to $140 [per barrel] it doesn’t change things [in Brazil], because Petrobras has been keeping gasoline prices fixed for six years,” says Mr Jank. “[Ethanol producers] had an important increase of costs in this country: land prices, labour prices and environmental restrictions. In the past three to four years, most ethanol mills lost money because of the ceiling of 70% of the gasoline price.”

Unica’s data shows that while four years ago ethanol accounted for half of the fuel consumption of flex-fuel cars, it now accounts for just 36%. Ms Araújo says: “Despite the spike in global oil prices and gasoline prices, we saw a major appreciation of the real against the dollar. That left room for the government to leave gasoline prices flat in reais. We have now a discount [of gasoline prices at the pump of] between 20% and 25%, and we don’t have any prospects for increasing prices [in 2012] because of concerns over inflation.”

International growth

This limited ability to compete means that ethanol producers are highly exposed to any volatility in commodities prices, which would push the return on investment below the cost of capital. To fill the gap left by lower ethanol output, Brazil has had to increase the amount of the green fuel that it imports, with a record 1.5 billion litres imported from the US in 2011.

In December 2011, however, a decades-long tariff on the import of sugar cane ethanol into the US – as opposed to corn ethanol, which is produced in the US – was lifted, opening new opportunities to Brazilian producers. Furthermore, new standards accepted in principle by the US Environmental Protection Agency may increase the proportion of ethanol mixed with road fuel in the US, which at the moment is 10% – known as E10. A move to a higher ‘blend wall’ of 15% – E15 – would be good news for both US and Brazilian producers.

“[Raizen] is looking at international opportunities, such as the North American market,” says Mr Rapparini. “With the elimination of trade taxes on sugar cane ethanol and the increase of ethanol blend in gasoline, [we look] at the US as a large potential market and as a partner to make ethanol an international commodity.”

A further push to Brazilian producers may come from new technologies enabling them to generate cellulosic ethanol, an advanced biofuel, which is derived from the bagasse of sugar canes – the fibre remaining after the crushing process – and other materials, such as wood chips and switchgrass. Advanced biofuels bypass some of the limitations of the first-generation biofuels and can supply a larger proportion of demand without affecting the food chain, and with greater environmental benefits.

Their commercialisation is still a few years away, but the ethanol sector may be encouraged in the medium term by Brazil’s recent oil discoveries. The new pre-salt oil will make the country a net exporter of the carbon fossil fuel, but while new refineries able to process such type of oil are being built, demand for ethanol should remain strong. This, coupled with a growing local and international commitment to green energy sources, should keep Brazil focused on ethanol production.

“The big discussion today is ethanol against the pre-salt [oil],” says Mr Jank. “If you look at cheap fuels, the pre-salt is fantastic. But Brazil has an energy matrix that is very diversified and very clean. We did in the 1970s what the US or Europe never did: a diversification [of energy sources].”

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