Investing in Brazil’s sugarcane sector

As the agricultural world waits for confirmation of ADM’s proposed takeover of Bunge, attention is turning to Bunge’s sugarcane business. ADM doesn’t seem to want it; nor, apparently, do other potential buyers. Brazil’s sugarcane industry was once considered the El Dorado for investment in agriculture. Here are ten reasons why it all went pear-shaped.

1/ The exchange rate moved against investors. At the start of the inward investment boom into Brazilian sugarcane in 2005, one US dollar would buy 2.36 Brazilian Reais. Investment inflows, accompanied by widespread optimism over Brazil’s economic future, pushed the Brazilian Real higher – so high in fact that by the peak of the boom in 2008 one US dollar would only buy 1.56 Brazilian Reais. Today, one US dollar will buy you 3.25 Brazilian Reais. So if you are an international, dollar based company, that converted US dollars into Brazilian Reais in 2008 at an exchange rate of, say, 1.6 Reais to the US dollar to buy a sugar mill in Brazil you would today be looking at an exchange rate loss of close to 50 per cent.

2/ The Brazilian economy stalled. We all committed an error in believing that President Lula’s good governance would continue in terms of the macro-economy and the exchange rate. As long as China continues to grow, we argued, Brazil would grow with it. China continues to grow, albeit at a slightly lower rate, but Brazil’s economy has stalled.

3/ Costs rose significantly. Whenever there is a gold rush, costs will rise: the price of a shovel can multiply many times over. Brazil experienced its own “gold rush” between 2005 and 2010 with the rapid expansion in its ethanol and sugar sector. This led to a shortage of just about everything, including qualified labour and machinery, and led to a considerable increase in production costs. A shortage of qualified labour also led to an increase in costs elsewhere. Field inputs such as fertilizers, herbicides and pesticides were not applied in an optimal way, resulting in a drop in agricultural yields.

4/ Bad weather hit production at a critical time. Although the new, or expanded mills, urgently needed cane to crush it takes time to prepare the land, to plant the cane and then to let the cane grow to maturity. A series of bad weather events slowed this expansion in the cane area and mills were forced to run at substantially reduced capacity, sharply increasing unit costs further.

5/ New cane varieties had to be developed for new areas. Agricultural (land and climatic) conditions in the new areas that were coming under cane were not the same as in the existing areas. The cane varieties that thrived in Sao Paulo State did not necessarily thrive in the new areas.

6/ Government intervention handicapped the sector. Back in 2005 a friend of mine was warning of the danger of investing in an industry where the price of half of your production (in this case the ethanol part) was effectively fixed by the government. As long as the Brazilian government set the gasoline price, the government also caps the ethanol price. At the time, however, it was inconceivable that the government could set the domestic gasoline price below both the international price of oil and the production cost of ethanol. But that is what the Brazilian government did for a prolonged period of time, severely damaging both the national oil company Petrobras and the domestic ethanol industry.

7/ Ethanol lost credibility. The vision we all had back in 2005 was that ethanol was a green renewable fuel that had a significant role to play in the battle against global warming. We imagined Brazil exporting this renewable green energy throughout the world. We did not foresee that ethanol would fall out of favour and that the media and consumers would push back against using food for fuel. Nor did we anticipate the push back against expanding sugarcane plantations into Brazil’s underused cattle-ranching areas.

8/ Oil prices crumbled as the shale oil sector grew in the US, mineral, undermining the economic rationale for alternative liquid fuel. We all want to protect the environment, but how much are we willing to pay to do so?

9/ Finance for the sector dried up as things stated to go sour—a situation aggravated by the global financial crisis of 2008. Planting and crushing cane is hugely capital intensive. With the exception of Raizen’s parent Shell, the new owners and operators of the sugar mills found it difficult to provide the finance necessary to keep going.

10/ Traders don’t make good farmers  (or do they)? Processing cane is not the same as crushing soybeans. With cane you have to get actively involved in growing the cane; with beans they just turn up at your factory gate. Traders tend to concentrate on the short term; farmers on the long term. Traders like to quickly get out of a losing position; farmers don’t sell their farm just because of one bad crop. 

However, this is a controversial issue (and will be one of the points of discussion at our June conference.)  Trading companies have learned some hard lessons in Brazil over the past ten years, and they are putting what they have learnt into practice. This is helping a turnaround in the sector; Bunge’s sugarcane business, for example, is now profitable. 

But there other reasons why now may be the time to invest in Brazil’s sugarcane sector.  Here are five (of them.

1/ Brazilian ethanol once again has government support.The Brazilian government has recently taken its foot off the neck of the domestic ethanol industry. It has allowed domestic gasoline prices to fluctuate in line with world prices and helps the competitiveness of Brazilian hydrous ethanol as an alternative domestic fuel. At the same time, the government’s ambitious RenovaBio programme sets out guidelines for future support.

2/ Food prices have fallen over the past couple of years and ethanol has largely dropped off the radar screen of public opinion. Poor weather and poor harvests were the main drivers for the increase in food prices that we saw a few years ago. The fact that corn prices are low even with 40% of the US corn crop going to ethanol takes the sting out of the food versus fuel debate.

3/ Global warming isn’t going away. Ethanol is a green renewable fuel with a much lower carbon footprint than mineral oil and as such could see a revival of interest, or a reduction of opposition, from the environmentalists. As for the farming lobby in the US, ethanol is an important alternative outlet for corn when food prices are low. Political support may once again grow within the US for ethanol.

4/ Electricity co-generation from bagasse is profitable. The country is short of electricity and returns are likely to remain high. Brazil should also have an advantage in terms of green plastics. With world oil prices low it will be hard for green plastics to compete but (for the moment at least) consumers seem willing to pay a premium for a “green” bottle. Brazil already has a couple of green plastic plants.

5/ Ethanol in Brazil currently gives millers a better return than sugar. This should result in a shift within Brazil towards making more ethanol and less sugar and may result in sugar prices bottoming. This flexibility gives Brazilian sugarcane sector gives operators valuable optionality, something that traders love! Brazil is not only the price regulator in the world sugar market. It is the lowest cost producer for the next marginal tonne of sugar that the world will need as consumption expands. If the Brazilian Real remains weak it will be difficult for other sugar producing countries to compete.

So there are some strong reasons to be optimistic. Are they strong enough for someone to make a stand and purchase Bunge’s Brazilian sugarcane business? We will soon find out.

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