12 August, 2011

The trouble with Brazilian ethanol

Sergio Abranches

For the third consecutive year Brazilian sugarcane harvests will be affected by adverse climatic factors. The latest estimates from the producers’ association, UNICA, is that it will be 8.4% smaller for the season 2011-2012. Over the last three years demand for sugar has been very strong and prices even higher than ethanol’s. As a result, producers have been calibrating their production mix to yield more sugar than alcohol.


Brazilian sugarcane production will be around 510.24 million tons, 4.4% less than the previous estimate of 533,50 million tons. These estimates are 8.4% less than the actual yield of the 2010/2011 harvest of 556.95 million de tons.

Intense frost and early blossoming have reduced sugarcane productivity far more than expected. Harvesting will be anticipated, aggravating the problem leading to a six-month interval between harvests. Besides, Brazilian sugarcane plantations are getting old, loosing productivity. Adverse climate conditions, as well as uncertainty about the future prevent producers to accelerate crop renewal.

As a result there will be a shortage of ethanol for the domestic market. The price of sugar, and the fact that Brazilian sugar faces far less barriers in the global market than ethanol, lead producers to continue giving precedence to sugar over alcohol production. This has an obvious impact on ethanol prices, that are expected to rise and stay high for at least the next three years. Brazil has a significant market for ethanol. In 2010, the industry produced 3.3 million light motor vehicles (cars, SUVs and light trucks) of which 72% carried a flex fuel engine. Only 18% had gasoline engines, and slightly less than 10% were diesel vehicles. Flex fuel vehicles represented 35% of the total fleet of  light vehicles in 2009. It is estimated that in 2020 flex fuel vehicles will be 80% of the total fleet of light vehicles. Every gas station in Brazil has an ethanol pump since the 1980’s.

The price of ethanol is currently around 70% of the gas price at the pump, and it will keep rising. Consumers will start preferring to fill their tanks with gasoline only, when ethanol prices pass this threshold for the simple reason that flex fuel engines consume 30% more when running on ethanol. State owned company Petrobras sells almost 100% of the gasoline consumed in the country, and has kept gas prices to wholesalers at the same level since 2009. Gas prices increases at the pump only pushed by the 25% ethanol mix, and the margins of wholesalers and retailers. Thus, ethanol prices increase faster. This dynamics totally undermines the once successful policy to stimulate ethanol as a substitute for gasoline, and the production of flex fuel vehicles.

The Brazilian government has been responding with ineffective measures to this dilemma. It has recently been considering reducing the ethanol mix of the gasoline. A clear mistake that would represent no solution at all, and would have very negative environmental consequences: it would lead to poorer air quality in dense urban metropolitan areas that already face serious public health problems related to air pollution. Besides, it would further discourage ethanol producers.

Brazil has arduously acquired two advantages regarding biofuels, particularly ethanol, apart from the higher energy conversion rate of sugarcane, its cost advantage, and the very low to zero-carbon footprint of sugarcane ethanol production. The first one is the fact that the distribution infrastructure is already 100% adapted to use biofuels from the mills to the pump. The second one is the high and increasing share of flex fuel vehicles. With flex fuel engines and the ethanol addition in the gasoline, 40% of gasoline consumption in Brazil has already been replaced by ethanol. In the US substitution is less than 10%.

To recover the coherence of the flex fuel policy, the government should target two areas: incentives to increase the ethanol efficiency of flex fuel engines, and to research and development of second generation biofuels.

Instead the government is encouraging Petrobras to buy sugar/alcohol companies, with the expectation they’ll produce more ethanol than sugar, and lead the way to market equilibrium. Such an intervention will more likely alienate private partners because of falling profits, and lead to total control of the companies by Petrobras. The state owned company would be entering the agricultural sector, an area of activity too far away from its core business. Additionally this move will aggravate, rather than ease, market imbalances. It should rather invest to develop second generation biofuels as part of a long-term strategy to diversify its activities in the energy sector. Many oil companies are already diversifying into other non-fossil energy areas.

Brazil will have to import gasoline and ethanol to supply the growing domestic demand. Its main ethanol supplier has been the United States. Right now estimates for corn harvests in the U.S. are moving downwards because of heat waves and severe drought in the South and the Midwest. Domestic demand for ethanol is also increasing. This will reduce U.S. ethanol export capacity and push ethanol prices even higher. Importing more expensive ethanol will further aggravate the present imbalances in the Brazilian domestic market. Petrobras will also import gasoline at a price higher than it will sell to wholesalers. Its CEO, José Sérgio Gabrielli, told Brazilian journalist Miriam Leitão on a talk show at Globonews, Brazil’s largest cable all-news TV, that Petrobrás will only correct gasoline prices when the exchange rate, global oil prices, and fuel prices in the U.S. markets are in relative stability. That is unlikely to happen in the near future. Therefore gasoline prices will be kept at current low levels, and Petrobrás will continue subsidizing fossil fuels.

Consumers will move towards gas, abandoning ethanol. Air quality will worsen. The environmental advantage of flex fuel vehicles will disappear. Petrobrás discretionary expenditures will increase, harming its minority but numerous private shareholders. Ethanol producers will receive the wrong signals from the government, and continue to bet in the more predictable, less arbitrary sugar market.

This is a scenario that typically requires strategic, comprehensive, and long-term solutions through technological innovation and structural change. The government should encourage investment in productivity gains and research and development, and the diversification of biofuel sources. The government, however, seems to be able to look only through the rear-mirror, not to learn from past errors, but to repeat them.

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