Brazil´s ethanol and sugar (E&S) producers are no stranger to market volatility. From political and economic turmoil, to poor harvests and abrupt regulatory U-turns, crises have been a feature of the ethanol sector since its government-led launch almost half a century ago.
Global pandemic should now be added to this list. In April, the sector was plunged into crisis as measures to prevent the spread of the COVID-19 novel coronavirus shuttered vast swathes of the Brazilian economy and confined people to their homes.
E&S companies are not alone in feeling the pain from a crisis that is expected to plunge the country into one of its worst ever recessions. But producers found themselves particularly exposed to plunging demand and prices for its products.
Travel restrictions and social distancing measures directly impacted domestic demand for both the hydrous ethanol that fuels Brazil´s vast and unique fleet of flexible-fuel vehicles and the anhydrous ethanol mixed into gasoline.
By late April, the spot price for a liter of hydrous ethanol in São Paulo state had plummeted almost 40% to BRL1.30 ($0.25) from a high of BRL2.14 at the end of February, according to data collected by the Center for Advanced Studies in Applied Economics (CEPEA-Esalq) at the University of São Paulo.
Several E&S producers were also impacted by the sharp fall in electricity usage. Among these is Raízen, which is the largest producer of electricity generated from waste known as sugarcane bagasse.
The joint venture between Anglo-Dutch oil company Shell and Brazilian conglomerate Cosan claims it can produce enough energy this way to power a city the size of Rio de Janeiro for a year. “We had a great impact mainly through the reduction in demand and we are now seeing [energy prices] well below the levels of the past, but the product that has suffered most from this severe environment is ethanol,” said Francis Vernon Queen Neto, executive vice president for ethanol, sugar and bioenergy at Raízen in São Paulo.
Ethanol competes directly with gasoline at the pump given the ability of drivers to easily switch between the fuels and must be around 30% cheaper to remain competitive on mileage. By late April, the price of Brent crude oil had plummeted by more than 70% to below $30 per barrel putting a further drag on ethanol prices. At BRL1.30 per litre, Raízen was producing ethanol below cost, said Queen.
International sugar prices fell alongside ethanol and Brent on the international market.
Neither could the timing been worse for the sector. Sugarcane is mostly harvested between April and May in Brazil, so E&S companies were facing negative profit margins just as the sector was due to begin harvesting a bumper crop.
In desperation, Brazilian sugarcane industry association Unica led a group of agricultural and industry associations in penning an open letter to President Jair Bolsonaro warning of the imminent collapse of the industry and requesting government intervention.
Among the demands was an increase in the federal CIDE tax on gasoline to make ethanol more competitive and an exemption of ethanol producers from PIS/Cofins social security taxes.
The proposals sparked howls of protest from state-owned oil company Petrobras, which claimed the measures would make gasoline less competitive precisely at a time when the oil major was also facing plummeting demand and low prices.
“The [ethanol] industry faces a perfect storm, with downside risk to current ethanol prices if the measures designed to help the sector…do not go through,” wrote Credit Suisse analysts Victor Saragiotto and Felipe Vieira in a report in May.
By June, the measures were still being considered by the government and those that were introduced have had a more limited impact. Pointing to the launch of a BRL3 billion credit line for ethanol producers by Brazil´s national development bank BNDES, Claudio Miori, a credit analyst with Fitch Ratings in São Paulo, said the additional financing will largely benefit producers that are already seen as less of a credit risk.
“The credit facility itself is attractive…but benchmarked companies have alternative funding sources that they can use for their working capital requirements, so I would say the financial aid came too late and the portion that will come from private banks will make access more difficult,” he said.
By the end of May, 4.63 billion liters has been placed in storage, representing a record 82.2% increase since the same time last year, according to S&P Global Platts, an energy and commodities information service.
E&S producers have also diverted more of their feedstock away from ethanol and towards refined sugar where prices have held up better.
By mid-April, the price of refined amorphous sugar in São Paulo had declined by just 4% to BRL1.92/kg from BRL1.99/kg in February, according to CEPEA-Esalq.
“Sugar proved to be very resilient even when the price dropped because we also saw the [BRL-US$] exchange rate rise,” said Raízen´s Queen.
Brazil´s largest mills are expected to divert around half their available sucrose into sugar production this year. For some, such as Usina Santo Angelo and Jalles Machado, this could reach 65% and 55% respectively in 2021, according to a Fitch Ratings report. While prices on the international market have held strong, there was a softening in late June.
“Companies that can divert a large portion of their sugarcane to sugar instead of ethanol… are better positioned to face the challenges in 2020. Companies in Brazil cannot hedge ethanol prices, they have to sell ethanol on the spot market, but they can hedge sugar through a combination of sugar prices and the FX rate,” explained Miori, a co-author of the report.
One company, Copersucar, for instance, said in late June it had already hedged the bulk of its sugar production for the 2020/21 season.
For those E&S companies unable hedge their ethanol production, some relief finally came when oil and ethanol prices started to rebound in May.
State-owned oil company Petrobras has increased gasoline prices five times since early May, resulting in a 58% average increase in prices ex-refinery that has helped pull up ethanol with it, according to S&P Global Platts.
“Ethanol prices have recovered much, much faster than expected…The price we see currently for hydrous…I did not expect to see until around August,” said Erick Rodrigues, lead analyst for sugar and ethanol in Latin America at Moody’s Investors Service in São Paulo.
Structural issues
Rising prices may have brought temporary relief for ethanol producers, but it will have little impact on the structural issues that continue to weaken the sector.
The industry is highly fragmented with more than 300 producers varying in size, profitability and financial flexibility.
The majority of these ethanol mills are concentrated in the state of São Paulo which produced more than 53% of all sugarcane during the 2019/2020 harvest, according to data published by Unica.
“The market is very fragmented in Brazil. The largest player has less than 10% of the market, the second largest player has less than 5%,” explained Fernanda Cunha, an equity research analyst for oil, gas and agribusiness at Citibank in Rio de Janeiro.
Moody´s Rodrigues said E&S producers can be divided into “two worlds”: those with a good capital structure, hedging ability and financial flexibility, and those with low productivity, large dollar-denominated debts and less capacity to hedge or store ethanol.
“Companies that have good financial flexibility can invest in their sugarcane plantations, they can hedge for 12 or 24 months ahead to protect margins, they have a level of indebtedness that is supported by their capital structure, and they have access to banks and other financing lines, so those players tend to weather best the volatility of the market,” he said.
Companies with greater financial liabilities accumulated much of their dollar denominated debt during two recent ethanol booms when high prices and rising demand encouraged many producers to invest in expanding capacity.
In 2018, scores of mills bet heavily on ethanol in the face of depressed global sugar prices and the promise of higher demand due to the government’s approval of the RenovaBio carbon-reduction program.
For some, this debt added to liabilities accrued from an ethanol boom a decade earlier. Between 2007 and 2009, scores of producers invested heavily in expanding production capacity by investing in sugarcane fields in the less productive regions of Brazil.
“With the traditional sugarcane areas already occupied, especially in the countryside or São Paulo, they started to invest in other regions…that take a long time and where the marginal cost is much higher,” explained Thiago Duarte, an associate partner at Brazilian bank BTG Pactual.
In 2010, the sector was sent into a tailspin by the government’s decision to fix gasoline prices to control inflation. At the same time, international sugar prices reached a 30-year high, which encouraged producers to switch production away from ethanol, leading to supply shortages.
Higher marginal costs and the lower ethanol price ceiling caused by artificially low gasoline prices spelled disaster for E&S companies that had bet heavily on ethanol. By January 2017, 87 mills had filed for bankruptcy protection and many other were left struggling to meet their debt obligations before the government loosened the policy later that year, according to research by MBF Agribusiness, a consultancy, cited by local media.
The legacy of this period is still evident today. BTG´s Duarte estimates gross debt could be as high as BRL100 billion currently across the sector.
In May, Atvos, formerly Odebrecht Agroindustrial, finally reached an agreement with its creditors to restructure its BRL11 billion debt after filing for bankruptcy last year.
Several other large mills also look vulnerable. Grupo USJ avoided bankruptcy through a bond swap in 2016 and recently failed to pay the coupon on 2023 notes in May. Instead, it opted to pay part of the coupon with accrued interest at maturity having previously swapped 2019 notes for the 2023 notes last year.
Another is Biosev, which is facing large debt maturities in 2021 and 2022. The Louis Dreyfus-controlled company has liabilities totalling BRL6.91 billion with BRL3.13 billion due within the next 12 months. In 2018, it sold three mills in a bid to pay down its debt, but was downgraded by Fitch earlier this year.
“I would not say that they will go bankrupt, but the refinancing risks for this company are escalating because they will have to face these large repayments next year and in 2022 and we don’t believe they will be able to generate quick cash flow,” said Fitch´s Miori.
What’s next?
Consolidation within the sector would help efficient producers gain scale and reduce debt. In 2019, oil major BP and commodities trader Bunge combined their operations in Brazil to form BP Bunge Bioenergia. The joint venture took on $700 million in debt from Bunge and Bunge received a $75 million in cash from BP.
However, further consolidation is unlikely given the most efficient E&S companies are already operating below maximum efficiency and would prefer to add productive sugarcane fields rather than additional crushing capacity, say market observers.
São Martinho may be an exception given it has less than 10% spare capacity while Raízen has between 15 and 20% and Adecoagro around 25%, said Citi´s Cunha.
By contrast Atvos, which is undergoing judicial a restructuring, had spare capacity of just under 28% in the last two crop seasons and almost 30% the previous season, according to the company´s most recent quarterly statement for 2019/2020.
“Many [producers] are in a bad financial situation and they haven´t been investing in their sugarcane in order to save money,” explained BTG´s Duarte.
Atvos’ debt restructuring plan includes a pledge to plant 55,000 hectares of sugarcane and invest an additional BRL350 million in its sugarcane fields, agricultural equipment and industrial processes.
Some producers may also be forced to rethink their predictions about the impact the RenovaBio program will have on ethanol demand. In June, the government said it is considering a 50% reduction in decarbonization targets for 2020 due to the impact of coronavirus and lower overall targets for 2030.
Nevertheless, many market participants said they are optimistic about the long-term prospects for the sector. Raízen’s Queen, for example, argued that the RenovaBio program will be an important framework for increasing the financial value of sustainable products.
“The world is increasingly recognizing these products and we are managing to export our products at a premium. In fact, we are seeing this shift intensifying,” he said.
Similarly, Moody’s Rodrigues said Brazil´s crisis-scarred E&S companies could prove to be the sector´s greatest asset.
“There is no other country that has the same structural ability to build and ramp up production of ethanol so quickly and sustainably [as Brazil]. So long as companies are aware that they need to be ready for these volatilities, there is a lot of growth to come out of these markets,” he said.