Soy Bean Price Hike Ices Prize Petrobras Biodiesel

H-Bio, an experimental variety of biodiesel presented with great pomp by Petrobras in May 2006, promised, according to the Brazilian state-owned energy company, to save the country USD240 million in 2007, with a 25% reduction in imports of regular diesel.

But the fuel, characterized by a “high conversion yield, at least 95% v/v to diesel, without residue generation, and a small propane production as a by-product”, has not been produced by the company since August 2007. Petrobras cites the incapacity to procure sufficient amounts of vegetable oil as the main obstacle to the program.

While Brazil has the largest soy oil industry in the world, the federal government has centered its policy on small, peasant-based farming and encourages Petrobras to source vegetable oil from single-family farms, thereby diverting assets toward small-scale projects and away from larger undertakings that could deliver more oil per unit of capital expenditure.

These small producers face not only production challenges, managing oil-yielding feedstocks they are unfamiliar with (these include sunflowers, cotton, jatropha, castor beans, and oil palms, as well as animal residue like tallow), but must also come together in cooperatives with other farmers to reach scope and scale for product creation and commercialization.

Little (and usually low-quality) schooling among peasants makes such an endeavor nearly impossible. Cooperatives that do show some degree of success tend to receive some form of aid from the government, usually in the form of technical assistance. Agronomists and engineers, from federally-funded universities, R&D centers, and companies like Petrobras, work with cooperatives and farmers to achieve the goal of simultaneously reducing both fossil fuel use and poverty – only to discover that the situation reverts to the baseline scenario when aid ceases (i.e., everything goes back to square one).

That is the case because Brazilian federal policy has adopted an ambitious goal for biodiesel, aiming, in one fell swoop, to alleviate rural poverty, to diminish inequalities between Brazil’s more developed Center-South and the drought-stricken North-East, and to reduce the country’s dependence on foreign oil.

This rather tall order led Sergio Gabrielli, president of Petrobras, to announce in 2007 that the company, the main agent for Brazilian federal energy policy, would hedge its bets for biodiesel development by not relying solely on small farmers to get the oil it needs. Instead, it would also develop alliances with the large, mostly foreign-owned agricultural concerns that operate in Center-West Brazil, where large swaths of the vast Brazilian wooded savannas, called the Cerrado, have been planted over with soy, creating the so-called “Republic of Soy”, which spills over into Bolivia, Paraguay, and Argentina, but has its heart in Brazil’s remote hinterlands south of the Amazon forest.

But heightened domestic and international appetite for soy beans and byproducts – in natura, as soy meal, as animal feed, or for biodiesel – predictably led to a price spike that has forced Petrobras to shelve its H-Bio plans. In May 2006, when the fuel was first announced, a 60-kg sack of soy beans sold for USD25, according to Brazil’s Cepea (Center for Advanced Studies in Applied Economics). In November 2007, the price was up 85%, at USD46.

Petrobras, which announced in October the discovery of the largest oilfield found anywhere on the planet in 2007, is widely seen as a leader and innovator in deepwater offshore drilling – but it is learning the painful lesson of the Law of Receding Horizons. Prices forecasted when a project is conceived do not stay put – they go up until supply can adjust to the new levels of demand induced by the project.

This and other setbacks led Ildo Sauer, a director removed from Petrobras in September 2007 for political reasons, to qualify the Brazilian biodiesel program as “a disaster”, prompting the Minister for Agrarian Development, Guilherme Cassel, to counter the assertion by stating that he believes it is, rather, “a success”.

Looming Power Crisis Poses Most Serious Near-Term Challenge to Brazil's Sugar and Ethanol Industry

As I have previously pointed out on this blog, Brazil faces a power shortage similar to the one that crippled the Brazilian economy in 2001. Back then, the federal government announced, as soon as the end of the rainy season, which lasts from October to March, made it clear that hydroelectric reservoirs had not been replenished, that all consumers - including homes, businesses, and factories - would have to cut their consumption by 20%, or face stiff fines.

This jolt came on the heels of the mini-recession associated with the burst of the tech bubble in the U.S. a year earlier and had Brazilians scrambling to eliminate whatever could possibly be seen as "waste". Commercial users, of course, in many cases had little choice but to scale back business - a course of action that may be in store for many of the companies in Brazil's sugar and ethanol industry now in 2008.

In November 2007, the utility company that supplies electric power to distilleries in the interior of Sao Paulo state, CPFL, contacted large consumers and notified them that it "may" have to rescind contracts locked in earlier, when power was abundant and cheap.

Dams supply 70% of Brazil's electricity. Because water levels in the hydroelectric reservoirs of Brazil's Center-South, which includes the states of Sao Paulo, Minas Gerais, and Rio de Janeiro, are close to the critical 60% level, CPFL may have to switch production to its more expensive thermal units, driving up the price to final consumers.

Even that may not suffice to stave off shortages and a cut-back on consumption may be, once again, mandated. This possibility would have a negative reinforcing effect for sugar and ethanol equipment companies located near the city of Ribeirao Preto, which manufacture boilers and other pieces of machinery used to burn bagasse and generate electricity from sugarcane residue - a surplus that is sold to the public grid and that today accounts for about 10% of the income of a large distillery.

With a looming shortage, these equipment makers face the prospect of being unable to meet the orders placed for the manufacture of new pieces or the refurbishing of existing ones, threatening to decrease total output and productivity levels in the industry and inflicting pain on established players and new ones alike.

Unless a deluge descends upon the river basins of Center-South Brazil between now and March, companies would do well to price in the cost of a power-down lasting several months, as was the case in 2001. Or they can hope for the best and, if that fails, point the finger at Saint Peter, the guardian of the gates of Heaven who Brazilians believe responsible for regulating the weather.

The federal government certainly will.

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 CVRD - 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.

In short, the rain that Brazil's hydroelectric system so desperately needs may fall, instead, on Lula's parade, dampening the confidence of investors and consumers as Brazil gets broadsided by a hard landing in the U.S. and Europe.

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.

Petrobras Invests in Ultra-Deep Offshore Exploration; Capital Base for Biofuels Diluted?

Petrobras, the Brazilian state-owned energy company, today announced the discovery of new reserves of light crude in the Santos basin. The company’s endeavors in the oil sector are of importance to the further development of the Brazilian biofuels industry, as projects in fossil fuel exploration, refining, and distribution will inevitably dilute the company’s capital base.

Today’s announcement comes on the heels of the massive find of the Tupi oilfield, with ultimately recoverable reserves of between four and six billion barrels, disclosed in early November 2007. The new discovery adds further momentum to Petrobras’ activities inside the traditional oil sector, a course supported by high oil prices, but constrained by rising costs and a global shortage of equipment and personnel.

Bloomberg reports that strong projected earnings for 2008 led Citigroup today to change its recommendation from “hold” to “buy” for Petrobras’ papers on the NYSE. Investors may take that recommendation as they wish, in light of Citigroup’s (ticker: C) dismal financial performance this year, which has seen shares of the nation’s largest bank tumble by 47.56% against their 52-week high – a fall with origins in the subprime imbroglio, but also supported by the quality of the bank’s financial judgment and of the leadership of the CEO formerly known as Prince.

On a separate but related note, the Emerging Markets Bond Index for Brazil was up 2.24%. The EMBI relates to the price of credit and is considered a reliable gauge of investors’ confidence in the Brazilian economy. It is prepared by New York-based JP Morgan Chase (ticker: JPM), whose shares are also significantly down – 18.63% from their 52-week high. JP Morgan Chase has recently announced that it will “cut about 100 subprime jobs”; Reuters reports that “JPMorgan (…) has reduced subprime originations and operations staff because of home price weakness and tighter credit standards”. Meanwhile, it will continue to rate the soundness underlying the financial securities issued by Brazil.

BRAZIL ETHANOL MARKET SURVEY PHOTOLOG 3

Pictures 1 and 2: Tom and I at a fueling station talking to the manager. Upon request, he tested a small sample of gasoline. All gasoline sold in Brazil (for any kind of Otto-cycle combustion engine - cars, boats, etc.) is required to have between 20% and 25% anhydrous ethanol. The exact amount is determined by government regulation and changes throughout the year, according to the supply of ethanol on the domestic market. Dishonest distributors and station owners, however, adulterate the product by adding ethanol above the legally-permitted limit (credit: Picture 1: Tom MacDonald).


Picture 3: In this case, the sample, which is always collected from the pump in the presence of the customer, contained 75% gasoline and 25% anhydrous ethanol, meeting government specifications.

From April to September 2007, I traveled around Brazil comparing the Brazilian and American biofuels market. In August I was joined by Tom MacDonald, senior alcohol fuels specialist with the California Energy Commission. All photos shown on Ethablog were taken during that time.