VZCZCXRO8934
RR RUEHRG
DE RUEHSO #0092/01 0421830
ZNR UUUUU ZZH
R 111830Z FEB 09
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 8948
INFO RUEHBR/AMEMBASSY BRASILIA 0104
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RUEATRS/DEPT OF TREASURY WASHDC
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RHMFIUU/DEPT OF ENERGY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 04 SAO PAULO 000092 
 
SIPDIS 
SENSITIVE 
 
STATE PASS USTR FOR KDUCKWORTH 
STATE PASS EXIMBANK 
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE 
STATE PASS NSC FOR ROSSELLO 
DEPT OF TREASURY FOR LINDQUIST 
DEPT OF AGRICULTURE FOR ZIMMERMAN 
DEPT OF ENERGY FOR RDAVIS, CGAY 
 
E.O. 12958: N/A 
TAGS: ECON EAGR ENRG EFIN EINV BR
SUBJECT: BRAZILIAN ETHANOL SECTOR AND THE FINANCIAL CRISIS 
 
REF: A. 08 SAO PAULO 0443; B. 08 SAO PAULO 0423; C. 08 SAO PAULO 
0590 
 
SENSITIVE BUT UNCLASSIFIED--PLEASE PROTECT ACCORDINGLY 
 
¶1.  (SBU) Summary: The effects of the global financial crisis are 
visible within Brazil's sugar and ethanol sector with industry 
experts estimating that about 20 percent of Brazil's ethanol mills 
are suffering financial difficulty.  Even though the fundamentals 
for the sector remain positive, and sugar prices and internal demand 
for ethanol should fortify the sector this year, the outlook for 
2009 is mixed.  Some ethanol producers have good cashflow, others 
are saddled with debt, and many lack viable financing.  Although 
some consolidation is inevitable, experts do not foresee a major 
increase in market dominance by individual companies.  The biggest 
impact from the crisis going forward will be postponement of new 
projects; however, this is temporary as demand for ethanol continues 
to grow.  Internationally, countries that had planned to develop 
ethanol industries could review or suspend them given the scarcity 
of financing as well as the lower price of gasoline.  Over the 
long-term, Brazilian producers still anticipate that international 
markets (including the U.S.), in addition to high internal demand, 
will increase demand for Brazilian ethanol.  End Summary. 
 
 
In Crisis Before the Financial Crisis 
------------------------------------- 
 
¶2.  (SBU) While the global financial crisis hit Brazil in September 
2008, Brazil's sugar and ethanol sector had already been suffering 
since 2007 from falling commodity prices.  Many sugar and ethanol 
mills took on huge obligations from 2005 to 2007 when the euphoria 
over biofuels brought a wave of private investment.  At that time, 
mills had high profit margins, easy access to credit, and immense 
future domestic demand growth.  Bank credit was easy to access, 
though mostly short-term rolling credit lines as bridge loans until 
funding from the Brazilian Development Bank (BNDES) could be 
disbursed, leading many mills to take on large debt burdens and 
assume repayment based on future revenue streams on the assumption 
of continued access to cheap credit.  In 2008, however, excess sugar 
supply worldwide led to a decline in prices that abruptly cut 
revenues to pay rolling credit lines.  Production costs, especially 
for inputs such as diesel and fertilizers, rose as well.  Mills 
began to renegotiate with banks, at higher rates, to postpone debt 
payments.  This scenario reverberated throughout the sector 
affecting established ethanol producers as well as new operations. 
Jose Luiz Oliveiro, Vice-President for Technology and Development at 
Dedini, the world's largest capital goods producer for sugar and 
ethanol mills, told Econoff that by March 2008 the company was 
already experiencing a deceleration of new business. 
 
¶3.  (SBU) Already overburdened, the global crisis deepened the 
financial problems for many in the sector.  Rolling over debt 
payments became difficult (at much higher borrowing costs) or 
impossible given credit risk.  Because mills often financed 
improvements and expansion with their own cash savings, and then 
sought financing from banks and BNDES, many were left without 
savings to draw upon.  Bradesco Corretora sugar and ethanol analyst 
Auro Rozenbaum estimated that approximately 20 percent of the sector 
has been affected by the crisis.  According to Antonio de Padua 
Rodrigues from the Brazilian Sugarcane Association (UNICA), mills 
that lacked financing began flooding the ethanol market to generate 
cashflow, thus exacerbating the problem for all by forcing down the 
price of ethanol in the market.  Five of the 402 sugar and ethanol 
mills in Brazil have already filed for bankruptcy, and many in the 
industry are closely following ongoing bank negotiations and 
possible buy-outs to signal future developments.  (Note: It is hard 
to estimate the extent of financial difficulty across the sector. 
While most contacts suggested a figure around 20 percent of mills 
have been seriously affected by the crisis, a few bank estimates 
were much higher, up to 70 percent.  End Note.) 
 
SAO PAULO 00000092  002 OF 004 
 
 
 
Financing Options Limited and More Expensive 
-------------------------------------------- 
 
¶4.  (SBU) The biggest current problem for the sector is access to 
financing.  One consequence of the crisis, according to Jose Carlos 
Giachini from Rabobank, is that foreign denominated debt payments 
grew with the depreciation of the Brazilian currency relative to the 
US Dollar.  (Note: The second largest mill is expected to have net 
losses of USD 26 million from October to December 2008 explicitly 
due to the negative foreign exchange impact.  End Note.)  He noted 
that spreads are up significantly across the sector, driving up 
interest rates despite the recent rate cut.  Average interest rates 
in Brazil for companies as of December 2008 were 30 percent per year 
and likely higher for the ethanol sector given higher delinquency 
rates.  Furthermore, Banco Modal analyst Roberto Nogueira told 
Econoff that "everyone in the sector" had taken on the toxic foreign 
exchange derivatives to help hedge against dramatic currency 
fluctuations, which also put them in a weaker financial position. 
(Note: In a separate meeting, the Head of Business Development for 
Cosan told Econoff that Cosan was one of the few mills that had no 
exposure to derivatives.  End Note.) 
 
¶5.  (SBU) With few financing alternatives, a quick recovery for the 
sector is unlikely.  Padua outlined three major areas where 
financing was needed:  1) BNDES, which provided approximately USD 
350 million to the sector in 2008, excludes sugar and ethanol from 
its pre-shipment loans which are badly needed to help finance 
exports, 2) creating financing instruments to cover production costs 
would help stabilize prices between seasons and limit the incentive 
for mills without access to credit to flood the market to generate 
cashflow, and 3) a price-stabilizing warrantage system that pays 
producers to store excess production.  (Note: Warrantage is a credit 
system in which farmers/growers stock their production at harvest 
when prices are low and receive cash on credit.  End Note.)  Despite 
clearly defined financing solutions, Padua told Econoff that he did 
not expect any widespread GOB action in the near term because it 
served the government politically to keep prices as low as possible. 
 He believes a solution would be on a company by company basis, with 
small adjustments within the market. 
 
Widespread Consolidation Unlikely 
--------------------------------- 
 
¶6.  (SBU) As with many sectors in Brazil, interlocutors expect some 
consolidation, but do not expect a major systemic change in the 
concentration of market share within the sector.  The largest 
producer, Cosan, has 18 mills and crushes 10 percent of the 
country's sugarcane.  Cosan's Head of Business Development Marcelo 
Martins told Econoff that some companies be forced to sell mills 
because they cannot survive.  Despite Cosan's privileged financial 
position, the company is maintaining a more conservative approach 
when considering the potential acquisition of any one of these 
failed mills in order to maintain a healthy balance sheet.  CEO of 
ETH Bioenergy, Odebrecht's ethanol subsidiary, said despite the 
waiting list of companies wanting to sell, the company would 
carefully evaluate any potential acquisitions. 
 
¶7.  (SBU) Rozenbaum explained that the sector was unique and that 
the limited opportunities for vertical integration meant that it was 
not a driving force for consolidation.  In fact, Cosan is one of the 
few mills in Brazil that operates throughout the entire value chain, 
from its recent land acquisition to its purchase of the Esso 
gasoline distribution network from Exxon Mobile last year. 
Rozenbaum noted that the majority of small family operated mills own 
land, grow sugarcane, and produce sugar and ethanol, but would not 
venture beyond these activities.  Padua told Econoff that he 
expected consolidation among the bigger producers that were 
overleveraged rather than the smaller family producers that he 
believes will weather the storm.  Martins agreed, noting that Cosan 
was targeting large mills for potential acquisition rather than 
 
SAO PAULO 00000092  003 OF 004 
 
 
small family producers.  (Note: Brazil crushed 500 million tons of 
cane last year.  "Large mills" are generally defined as more than 
two million tons of cane; however, hundreds of mills crush only one 
to two million tons of cane per year. End Note.) 
 
Postponement of New Investment Likely 
------------------------------------- 
 
¶8.  (SBU) The most obvious near-term impact from the international 
crisis on the sector is likely to be a decline in the rate of 
production growth.  Padua said that some 15 of the 35 mills 
projected to open in 2009, each requiring an investment of USD 200 
million, would be delayed.  According to press reports, investment 
in sugar and ethanol mills is expected to decline by 40 percent this 
year.  Now that well-capitalized start-ups will have the option of 
purchasing overburdened mills at discounted prices, some expect 
delays in new greenfield projects.  Fernando Moreira Ribeiro from 
ETH told Econoff that the company is reviewing its investment 
strategy and that many of its planned greenfield projects for 2010 
and 2011 could be replaced by purchases of existing mills.  He 
expected delays on construction of mills that were scheduled for 
2010 and beyond. 
 
¶9.  (SBU) The crisis, however, did not figure into the production 
delays in 2008.  Many mill openings delayed in 2008 were due to low 
sugar prices, backlogs for equipment, and slow disbursement of BNDES 
financing.  Dedini's Oliveiro noted that projects where significant 
investment had already been made, including equipment purchased (36 
months lead-time), growing sugarcane (60 months lead time), and 
building a mill, would be completed regardless of the crisis.  Padua 
estimated that projects with 80 percent investment completed would 
be concluded because of the need to generate cashflow. 
 
Prospects for 2009 and Beyond 
----------------------------- 
 
¶10. (SBU) Industry contacts all agreed that the outlook for the 
sector was positive, based on strong fundamentals over the next few 
years.  Many opined that the major difference now versus the last 
crisis in 1996 is the positive outlook for demand.  Despite the 
global slowdown, demand for sugar should remain constant because it 
is the cheapest sweetener and not generally affected by economic 
downturns.  Sugar prices in 2009 should recover because of a decline 
in production in India due to weak sugar prices, which Rabobank 
calculated would result in some three to four million tons in 
additional Brazilian exports.  As a result, flexible mills (those 
that can alter their ratio of sugar to ethanol) will probably 
produce more sugar than in 2008.  Cosan CFO Paulo Diniz said the 
company was preparing to produce 60 percent sugar and 40 percent 
ethanol in 2009.  (Note: The Brazilian mix in 2008 was 60 percent 
ethanol and 40 percent sugar because of low sugar prices and strong 
internal demand for ethanol.  End Note.) 
 
¶11.  (SBU) At the same time, most in the sector assume that internal 
demand for ethanol will continue to increase.  Industry consultant 
Julio Martins Borges of JOB Consulting expects a deceleration in 
internal ethanol demand, but continued growth.  Industry expert 
Plinio Nastari's consulting firm Datagro estimates growth of 
approximately five percent in sugar cane milled for the 2009 season. 
 Rabobank's models show a 2.4 billion liter increase in ethanol 
consumption (12 percent) even with a 50 percent reduction in car 
sales in Brazil.  (Note: Brazil's ethanol consumption in 2008 was 
19.6 billion liters of ethanol. End Note.)  Furthermore, all 
industry contacts with whom Econoff met judged that Petrobras was 
unlikely to cut Brazilian gasoline prices.  Despite a decline in 
world oil prices (after a peak in July 2008), Petrobras has 
maintained gasoline prices fixed in Brazil since 2005.  As of 
February 10, the price of Brazilian gasoline is being sold at a 32 
percent premium over the market price for gasoline with oil at USD 
40 per barrel.  As a result, consumers still prefer ethanol over 
gasoline.  (Note: The generally understood price point for choosing 
 
SAO PAULO 00000092  004 OF 004 
 
 
ethanol over gasoline is when ethanol is less than 70 percent of the 
price of gasoline.  Ethanol in Sao Paulo, where 37 percent of 
Brazil's cars circulate, sold for 55 percent of the price of 
gasoline in January.  End Note.) 
 
¶12.  (SBU) Rabobank estimated that ethanol exports, especially to 
the United States, would decline in 2009 by about one billion liters 
from 2008 (Ref B).  Unlike Brazil, lower gasoline prices in the U.S. 
reduce incentives for distributors to increase the ethanol blend in 
gasoline.  However, industry contacts expressed a more positive 
outlook for the external market over the longer term.  Dedini's 
Oliveiro told Econoff that the U.S. market remains a positive future 
growth opportunity for many ethanol producers, but infrastructure 
projects to facilitate exports would be delayed due to the global 
financial crisis, limiting that market until financing returned to 
the sector.  Private sector plans to build an ethanol pipeline and 
port terminals for ethanol exports have been put on hold.  Giachini 
told Econoff he did not expect large scale new investments from the 
private sector until capital markets returned to normal functioning. 
 
 
¶13.  (SBU) Financing will continue to be scarce for the sector over 
the next few years until ethanol producers can show healthy balance 
sheets.  Rabobank expects company balance sheets will be bad in 
¶2009.  Giachini explained that cashflow would recover in 2009 due to 
a better pricing for sugar and ethanol, but that debt and interest 
payments would increase with the currency depreciation.  He 
indicated this fact would continue to plague financing.  Because the 
fiscal year for many mills ends in March, Giachini suspected that 
weak balance sheets would limit financing until 2011, when the 
sector would recover. 
 
Comment 
------- 
 
¶14.  (SBU) The effects of the financial crisis on the sugar and 
ethanol sector are real, though opinions are mixed as to the extent 
of the impact.  There seems to be general agreement that Brazil's 
domestic ethanol demand is assured, and should continue to absorb 
all additional ethanol production even with falling oil prices. 
Domestic ethanol demand combined with the stable global demand for 
sugar, will likely pull the sector along despite the lack of 
financing.  However, the lack of financing is likely to cause some 
plants to fold.  In the short term, the growth of ethanol exports 
will likely be constrained, due to internal consumption of most of 
the available ethanol supply, as well as infrastructure challenges 
inhibiting large scale exports of ethanol, the solutions to which 
may be delayed by lack of available financing.  In the long term, 
producers will look to overseas markets to complement the 
anticipated increase in domestic demand.  While the sector overall 
appears to be positioned to fare the crisis without too much damage, 
it is clear growth will probably slow in the near term.  Despite 
somewhat reduced growth expectations for domestic industry, the GOB 
is likely to continue its drive to build a global ethanol industry, 
both as a tool for development aid and to increase the potential 
international ethanol market with an eye towards creating future 
buyers of Brazilian ethanol.  However, the ability of third 
countries to find financing for these projects in the wake of the 
global financial crisis and the precipitous decline in oil prices 
remains to be seen.  End Comment. 
 
¶15.  (U) This cable was coordinated/cleared by Embassy Brasilia and 
the Agricultural Trade Office in Sao Paulo. 
 
WHITE