As sugar prices fall, Brazil’s cane industry will need to re-invigorate its domestic ethanol market, says Toby Cohen, director at Czarnikow, a sugar and ethanol trading, advisory and supply chain management firm.
Brazil is a dominant force in global bio-ethanol. However in recent years, cane has been diverted from ethanol production towards sugar and ethanol output has fallen behind. This has led to a reversal of the spectacular demand growth experienced from 2007 to 2009, as demand has had to be rationed on a large scale. Today, with ethanol prices falling, demand should start to return. However, it appears as though consumption patterns have also shifted as demand has remained weak despite hydrous ethanol becoming competitive again. High corn prices and falling sugar prices have also made Brazilian ethanol competitive internationally and Brazil has experienced a renaissance in exports.
The harvest in Centre South Brazil has rebounded in 2012/13, with the volume of cane crushed expected to exceed 525 million metric tonnes (mt), an increase of 6% year-on-year, while total ethanol production has risen by just 1.2% to 20.8 billion litres. However, cumulative ethanol production remains short of record levels, and is currently 18% lower than the volume produced in 2010/11. Superior sugar returns for the fourth consecutive crop have resulted in the sugar production mix shifting from 40% in 2008/09 to 51% in the current season. As a consequence of reduced supply, hydrous ethanol demand in Brazil has had to be constrained.
Since the introduction of the flex fuel vehicle (FFV) in 2003, over 17.5 million cars have been sold, while the FFV has an 85% share of new car sales in Brazil. Now that around 60% of the Brazilian car fleet is able to operate on either hydrous ethanol or gasohol, there is significant potential for domestic ethanol demand in Brazil. However, this is not being realised today.
In Sao Paulo state, the largest fuel market in Brazil, hydrous ethanol has been priced at around 67% of the gasohol (a motor fuel blend of gas and ethanol) price for over three months. At this price level, motorists should be keen to switch away from gasohol and into hydrous ethanol given the cost saving. However, discretionary demand for hydrous ethanol has been hugely disappointing during this period, falling by 9% when compared with the corresponding period of last year. Taking a longer-term view, we can see that current hydrous demand is around 40% lower than the record volumes seen during 2009.
This development points to a possible shift in the consumption patterns of the Brazilian motorist and a clear need for the sector to rebuild the positive momentum around Brazil’s clean fuel programme. Worryingly for the Brazilian producer, this is happening in an environment where, after three years of high sugar prices the global sugar outlook is becoming more depressed, but discretionary hydrous ethanol demand has yet to emerge.
Lower demand has also been a factor for the anhydrous market, although this has been driven by regulation rather than price, with the blend expected to remain at 20% for the entire 2012/13 season. This has resulted in increased demand for gasoline in Brazil, and when this is combined with higher overall gasohol use at the expense of hydrous, the tightness in the gasoline balance in Brazil has been exacerbated.
As a consequence, Petrobras has swung from being a net exporter of gasoline to an importer. As the ex-refinery price of gasoline is controlled by the government in order to manage inflation, Petrobras has effectively been obliged to sell gasoline at a loss. So far this year Petrobras has reported losses of R$17.3bn in its refining business, of which around 12% are from gasoline.
The political challenge
Bio-ethanol is very much caught up in the politics of energy pricing within Brazil, which are complex. However, one thing today is very clear: the relationship that the sector has with government is not what it was under the previous Lula administration. The days of the Brazilian government under President Luiz Inacio Lula da Silva lobbying hard to open up international trade routes for bio-ethanol are a distant memory, with the Dilma administration today taking a much less supportive position.
The change can probably be attributed to the fall in ethanol production in response to recent high sugar prices, the 200% spike in anhydrous ethanol prices in 2010 and the subsequent strain on gasohol, which took place during President Dilma Rousseff’s first year in office. However, it also reflects a lack of recognition of the economics of the sector, or perhaps an unwillingness to identify with these challenges given the government’s aim of using energy prices to manage inflation, which has led to falling energy prices in real terms.
Though the Dilma government has modified its approach and shifted from coercive threats, in the form of possible sugar export taxes, to support in the form of soft loans from the Brazilian Development Bank BNDES (but within a regulator framework now managed by the petroleum regulator ANP), the key issue of price remains unresolved. While there is speculation about changes to the gasoline price, inflation remains of critical importance and any change in price is unlikely to be dramatic enough to incentivise a switch in consumer behaviour in favour of hydrous ethanol.
In 2012 we heard suggestions that the government was considering pushing for a reduction of taxes on hydrous ethanol and the widely rumoured increase to the ex-refinery gasoline price, but as yet the only change expected with any certainty is the rise in the inclusion rate of anhydrous ethanol in gasohol from 20% to 25% in June. We believe that unless there is a significant shift in consumer behaviour, domestic hydrous ethanol use could continue to decline.
The sugar surplus could alter the scenario. While the outlook for hydrous demand has been disappointing, the relationship between sugar and ethanol could shift through changes in the sugar balance sheet. During the 2012/13 season we project a global surplus of 7.8 million mt, which follows on from a stock build of 7.7 million mt in the previous 2011/12 season. With the global sugar market de-risking, as stock levels rise, the weight of this additional sugar could prove difficult for the sugar market to accommodate. In this scenario, price would have to reallocate cane away from sugar to ethanol, primarily via the domestic hydrous market, where there is huge untapped demand. Unfortunately for Brazilian producers, prices would have to fall a lot lower than current levels to stimulate that demand. Hydrous values are already at the lowest level seen since the start of 2011 and have threatened to breach the R$1/litre mark. Though these are still high prices in nominal terms, cost inflation in Brazil has meant that at these levels it will prove difficult for Brazilian producers to cover opex, service debt and generate sufficient cash to support ongoing capex requirements in cane.
While the domestic market for ethanol has been a large concern in 2012/13, Brazil has started to return to the export market in greater volume and this is likely to continue to help alleviate the problem of growing supplies domestically. Brazil had been on course to become a net importer of ethanol but the reduction in the blend last year transformed this scenario in the 2012/13 season.
Brazilian export flows to the US have grown significantly in 2012 and are at the highest level since 2009. In the summer of 2012 the US corn crop suffered from a catastrophic drought, which severely damaged yield potential, resulting in a structural shift which pushed up corn prices and reduced US export competitiveness. However, the increased flow of ethanol from Brazil to the US has not been driven by these price dynamics but by legislation.
Demand for ethanol in the US is mandated under the Renewable Fuels Standard (RFS). Within the RFS there is an obligation for cellulosic biofuels. However, as the development of commercial-scale cellulosic biofuels has been much slower than originally hoped for, the obligation was reduced from 500 million gallons (gn) to 10 million gn, while the advanced biofuel obligation for 2012 was left unchanged. This effectively created an opportunity for 490 million gn of undifferentiated advanced biofuels, of which cane-based ethanol, imported from Brazil, is the most viable large-scale source of supply.
The supply issues facing the corn market have led to a number of requests for the 2013 RFS to be repealed or lowered. As a result the proposed RFS has yet to be announced. Even if the RFS is lowered, we do not believe that it would have any impact on aggregate ethanol demand. Although the margin for blending ethanol over gasoline has narrowed, it still remains the cheaper fuel, while its properties as an octane enhancer and oxygenate place a considerably higher value on ethanol than just its relative value to gasoline. At this point in time it is unclear how any RFS adjustment would change the obligation for advanced biofuels.
As it stands we see limited commercial cellulosic ethanol production being available in 2013, and if the EPA follows a similar methodology as in 2012 the undifferentiated advanced biofuels obligation could reach 800 million gn in 2013. Of this, cane-based ethanol would be the dominant supply source. With the Brazilian blend expected to move to 25% in the middle of 2013, there could be significant pressure on Brazilian anhydrous ethanol supplies for the 2013/14 season.
We expect to see improved ethanol supplies coming out of Brazil in 2013/14. Our cane crushing forecast for the 2013/14 season is for up to 580 million mt, a record volume, though with cane quality improving this could well be higher which would support supply. However, the returns from the sugar market still remain above those from ethanol and consequently the production focus will stay with sugar until these dynamics change. Limits on anhydrous capacity will be a key variable, while the weather and length of the season will also play a critical role in how much cane will finally be harvested. All of these factors will be major drivers in the global trade of fuel ethanol going forward.
The Brazilian cane sector is likely to reaffirm its focus on ethanol in the 2013/14 season though is set to do so in a difficult domestic environment. Over the past few years hydrous ethanol has effectively been seen as a by-product and, unless there is a significant shift in consumer behaviour, this could cost the sector as it seeks to re-build demand.
The political challenge is also large and the sector needs to re-establish its credibility with the government if it is to recreate the growth environment of the Lula era.