At the end of last year, Brazil achieved one of its most sought-after international trade policy aims: the opening of the U.S. ethanol market. But a host of short-term setbacks, including financing woes and the neglect of sugar plantations, mean that the country is not in a strong position to take advantage of this boon, according to Wharton management professor Felipe Monteiro. Over time, however, Monteiro predicts that the new policy is likely to be a game-changer for the Brazilian sugar industry, encouraging massive investments and opening up the path to ethanol becoming a global commodity.

The U.S. Congress allowed a series of subsidies and tariffs on imported ethanol to lapse at the end of last year. Most importantly, the hefty 54 cent-per-gallon tariff on imported ethanol, levied since the 1980s, was eliminated and a 45 cent subsidy per gallon of ethanol mixed into gasoline to U.S. producers that was worth US$6 billion a year was shelved. Support for domestic, corn-based ethanol has been waning because of its low levels of efficiency. Senators Tom Coburn (R-Okla.) and Diane Feinstein (D-Calif.) campaigned for the removal of the subsidies and in a letter circulated to fellow Senators last December, cited data from a U.S. International Trade Commission study, which found that “eliminating the protectionist ethanol import tariff will result in US$1.5 billion in economic benefits [and] … would also reduce our dependence on foreign oil by leveling the playing field between oil imported from OPEC, which faces no tariff, and more efficient sugar-based ethanol imported from Brazil, India and other democratic states.”

The end of the subsidies for U.S. corn producers should open up the path for sugar-based ethanol, which is cheaper to produce than corn ethanol but has not been competitive thanks to the tariff rates. Corn ethanol costs nearly 40% more than sugar ethanol to produce, according to Jeffrey Goettemoeller, author of the book Sustainable Ethanol: Biofuels, Biorefineries, Cellulosic Biomass, Flex-fuel Vehicles, and Sustainable Farming for Energy Independence.

In spite of the subsidies, the U.S. has been by far the most significant single importer of Brazilian ethanol, bringing in 664 million liters directly in 2011. In addition, much of the 343 million liters Brazil exported to the Caribbean and Central America is dehydrated and eventually transported to the U.S., according to data from the Brazilian Ministry of Development, Industry and Foreign Trade. Other importers of Brazilian ethanol include Japan, Nigeria, South Korea and Sweden, the data show.

Given the importance of the U.S. market, the reaction to the political coup of the end of barriers in Brazil was muted. That’s because Brazilian production has been falling with a drop of some 12% between the 2008-2009 harvest and the 2011-2012 harvest. Marcelo Junqueira, founder of Agrop, an agricultural service provider to the sugar industry based in Orlândia in São Paulo state, says it could take as much as five years for plantations to recuperate.

Brazilis not able to meet its own ethanol needs, notes Junqueira. Several years of under-investment and exploding demand at home have turned Brazil into a net importer of ethanol, he adds. Production through January 1 of this year compared to the previous year fell to 20.56 billion liters in the main sugar growing areas, a drop of 18.74%, according to official data from the Sugarcane Industry Association. Brazil imported nearly 1.1 billion liters of ethanol from the U.S., an all-time high, and way up from the 74 million liters imported in 2010. And ethanol is also losing ground to gasoline. A study undertaken in January by Brazil’s National Petroleum Agency found that in only one of Brazil’s 26 states — the agricultural heartland state of Goiás — was it cheaper to fill up with ethanol rather than petroleum. Last year, gasoline prices rose 6.92% compared to a 15.75% increase for ethanol.

Junqueira sees few short-term opportunities for Brazilian exports. Not only has the ethanol industry been hamstrung by the import restrictions, but the weakness of the U.S. dollar makes Brazilian ethanol less competitive abroad, he notes. He also worries that the U.S. move is less significant than it seems. Congress “may simply decide to reinstate the tariff when the dollar is stronger again and the ethanol supply out of Brazil bigger,” he suggests.

Stimulating Growth

The Brazilian government has been galvanized to act. Officials recognize that the ethanol industry is important as Brazil today produces much of the required machinery and equipment — not only in the cultivation and processing of the cane, but also in the use of bagasse to produce energy, José Carlos Grubisich, president of ETH Bioenergia said in a television interview with Brazilian journalist Miriam Leitão. And Brazil tends to export higher-grade ethanol and import only lower grade, dehydrated ethanol that is used for the admixture in fuels. That helps the country's balance of trade, he noted.

The federal government is seeking to boost the modernization of the industry and recently launched an expensive and ambitious plan via its controversial National Development Bank, the BNDES, says Junqueira. The Prorenova program has a budget of R$4 billion this year to stimulate the renewal and expansion of sugar cane in the country. The money could make it possible for 1 million additional hectares to come into production, boosting output by between 2 billion and 4 billion liters through 2014. Government officials will provide money in the form of loans to farmers that undertake expansion and efficiency improvements. The loans will come with a heavily discounted interest rate of 7.3%, notes Junqueira. This sounds sky-high, but must be put in context: Brazil has some of the world’ highest interest rates, with a base rate of 10.5% at the end of January.

Junqueira welcomes the aid, but points out that with Brazil’s creaky bureaucracy and slow moving commercial banks, the money available from the program will take time to filter through to small- and medium-sized farm operators. The granting of credit is made more difficult because many of the farmers have checkered credit histories stemming from the 2008 financial crisis and earlier, making banks reluctant to lend without significant guarantees.

According to the Worldwatch Institute, legislation in the U.S. is expected to increase the consumption of ethanol to 36 billion gallons by 2022 as it mandates a 10% ethanol blend and rolls out gasoline with a 15% ethanol blend. The Brazilian government encourages the uptake of ethanol through price stabilization and support to farmers and industry.Many other developed and developing countries are also encouraging the use of ethanol as a blend in gasoline to reduce oil dependency. Some Chinese states already mandate a 10% ethanol blend and there are plans to extend that policy across the country by 2020. Still, it’s early to say how much that will benefit Brazil as China is investing heavily in developing African ethanol.

Globalization of the ethanol industry with large-scale investments is key, according to Wharton's Monteiro. The elements for that are falling into place, he adds, noting that industries become more globalized when trade barriers are removed and Brazil is witnessing the entrance of major international players as evidenced by the tie-up between oil giant Shell and Brazil’s largest ethanol company Cosan.

The family-owned business model is no longer seen as appropriate because such small businesses are not able to sustain investment over time. Since 2008, there has been a lack of capital for small players and small-scale farmers did not plant enough sugar cane so that last year and this year there will be very low productivity. “The family model has proven its limits,” says Junqueira. With consolidation and the entrance of larger players, he predicts that over the next two years, production will increase — not so much by expanding the areas of plantation, but by better management of existing fields.

The lifting of the tariff barrier is likely to benefit the largest ethanol companies such as Cosan, ETH Bioenergia (a subsidiary of construction giant Odebrecht) and Petrobras, the state oil giant.Sérgio Gabrielli, the outgoing president of Petrobras, reaffirmed the company’s commitment to expanding its ethanol footprint when he ceded power to his successor in February. He has repeatedly noted publicly that the firm will continue to work with large national players and be proactive in enhancing distribution and transportation.

ETH Bioenergia is investing R$8 billion in its ethanol and energy company, not only in Brazil, but in other sugar growing countries of the region, including Costa Rica. Shell signed a US$12 billion deal creating a joint venture, to be named Raízen, with Brazil’s largest ethanol producer, Cosan, last year. The partnership will produce and distribute ethanol in Brazil and elsewhere. Mark Williams, Shell's downstream director, announced that biofuels will play a key role in energy needs over the long-term. “Over the next 20 years, sustainable biofuels are one of the most realistic commercial solutions to reduce CO2 emissions from transport,” Williams said in a news release. Raízen will produce more than 2 billion liters of ethanol each year and with Cosan’s 4,500 sites in Brazil, will be able to distribute some 18 billion liters of fuels.

Bringing Investments to Brazil

Foreign investments are also expanding rapidly and such long-term projects are expected to receive a boost from the opening of the U.S. market. The new president of the Brazilian Agribusiness Association, Luiz Carlos Correa Carvalho, told the newspaper group Estado that the U.S. move on tariffs and subsidies are an "invite to bring investments, mainly foreign ones, to Brazil.”

Overseas oil companies have been blazing a trail in that area as executives seek to diversify their energy sources. In addition to Shell’s large deal, BP inked a deal last year to acquire 83% of Companhia Nacional de Açúcar e Álcool (CNAA) for US$680 million. That should allow the company to increase production to some 1.4 billion liters a year, up from levels of 435 million a year. The company had already bought 50% of a mill based in Goiás in 2008 and had sought to buyethanol producer Cerradinho in 2010. But Cerradinho was ultimately purchased by Hong Kong’s Noble Group, which spent US$1 billion including the assumption of debts. Indeed, money is not just coming from developed countries. India's Shree Renuka Sugars took over troubled São Paulo-based producer Equipav in 2010, paying some US$330 million for a controlling stake and promising a further US$120 million in investments.

The other significant opportunity for Brazil lies in so-called third generation developments, which promise to significantly enhance yield. Embrapa, the highly-respected Brazilian agricultural research entity, has 190 researchers working to increase sugar yields through genetic modification and the better use of fertilizers, while private sector companies are experimenting with new applications, says Junqueira. He points to U.S. firm Amyris, which is producing renewable diesel from ethanol and has a pilot program that is being tested on a small part of the bus fleet in the city of São Paulo.

The question is whether all this will be enough to push ethanol into the limelight in a crowded marketplace for alternative fuels. There are many obstacles. As the United States withdraws from production of ethanol, can the political will for promoting ethanol blends in its fuel be sustained? And given the trade tensions that have existed between the two largest ethanol producers, will both Brazil and the U.S. be able to work together to create a global commodity market or drift into promoting their home industries?

Correa Carvalho told Estado that he sees potential for greater cooperation: “Brazil and the United States need to work together to stimulate global policies for the production and demand for ethanol,” he said. That is needed to overcome the lack of storage and the very illiquid trading markets for commoditization that have long hampered the development of the ethanol industry. Promoting ethanol as a global fuel would be of benefit to the U.S. and Brazil, which together accounted for 86% of global output in 2010, adds Junqueira.

But the agro trade relationship between the two countries has been thorny. A long-running World Trade Organization investigation instigated by Brazil into U.S. cotton subsidies was only resolved in 2010. In January, the U.S. sent the obscure world of orange juice futures into a tizzy when it banned imports from Brazil because of the use of fungicide. Still, Brazil is an increasingly valued partner by the U.S. and it has a growing role as a stabilizing influence in South America, observers note. That means the U.S. is likely to tread wearily in its dealings with its emerging agro rival.

Overall, the impetus for the development of the ethanol industry is more likely to come from the private than the public sector given these rivalries, says Junqueira. There are encouraging signs that is happening and that “the U.S. dismantling of barriers, coinciding with global investments in Brazil, will be the catalyst that turns ethanol into a global fuel," notes Monteiro.