25/9/2014 [10-Sep-2014] Low Global Sugar Prices And Domestic Drought Are Souring Brazil's Sugarcane Industry

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Low Global Sugar Prices And Domestic Drought Are Souring Brazil's
Sugarcane Industry
10-Sep-2014

If Brazil's worst drought in decades has a bright side, it's that the absence of seasonal rains this year has made it easier
to move heavy equipment and accelerate the sugarcane harvest that started earlier, resulting in a 15% hike in
production volumes year to date. Still, that's likely a one-time sugar rush for Brazil, the world's largest sugarcane
producer and sugar exporter, because future harvests, while tough to predict, will likely face major declines. While we
originally expected the producers to almost reach full capacity this year, the drought and consequent insufficient level of
raw material will lead them to stop crushing earlier, most likely in early November (as opposed to mid to late December,
when the rains usually start). As a result, the production volume will probably be somewhat lower in the 2015 harvest
compared to the one in 2014.

Indeed, the Brazilian Sugarcane Industry Association, Unica, cut its sugarcane production forecast to 546 million tons in
2014-2015 from an earlier forecast of 580 million tons for the critical center-south region, which produces more than
90% of the country's sugar output.

But for sugar, a tradable commodity, production among global powerhouses--India, Thailand, Mexico, and othersand
demand--mainly from Asia where sugar consumption has risen--are what affects the prices. So, a decline in Brazil's
output is compounded by a surplus in other countries, keeping global prices low in the short term. Standard & Poor's
Ratings Services believes the global glut in sugar is a result of producers having invested in planted acreage during
boom times, combined with government incentives among the world's largest producers such as in India.

For Brazil, of course, global sugar market dynamics are just one aspect that contributes to a complex, volatile industry
that's undergoing vast changesa revolution, in factbecause Brazil converts some 55% of its sugarcane harvest into
ethanol fuel. Massive investments into biofuels during the past decade to counteract Brazil's oil needs have slowly
created a huge ethanol market. The country's sugarcane-based ethanol fuels about 20% of road transportation in Brazil,
sucking up the bulk of domestic ethanol production. However, like sugar, ethanol suffers from low prices because it's
economically viable only if its price is up to 70% of gasoline price, and gasoline prices have been fairly stable.
Government-owned oil company, Petrobras Brasileiro S.A., sets the gasoline price, which doesn't fluctuate as much as
global oil prices. Brazilian cars run either on a gasoline and ethanol mixture, hydrated ethanol, gasoline, or diesel.

As a result, Brazil's sugarcane industry has been struggling, as many mills have gone bankrupt and shuttered in recent
years. Those that remain have engaged in significant capital expenditures to expand their sugarcane fields for the day
those dry, cracked acres yield sweet harvests once again. In the meantime, they're suffering from negative free cash
flows, and perhaps more ominously, the prospect of high debt refinancing costs down the line.

While producers will obviously have much opportunity to capitalize when prices reflect the potential lack of global sugar
supply, prospects for the sector are currently discouraging, with 30.8% of Standard & Poor's Brazilian sugarcane
producer ratings carrying a negative outlook, while 61.5% have stable outlooks. One company is in default.

Moreover, underlying this challenging environment of low sugar and ethanol prices is a continuing need to carry high
debt loads for investments and working capital needs. The consequence is that 53.8% of the issuers in this sector hold
what we view as "less than adequate" liquidity scores and 7.7% have a "weak" score, while just 38.5% have "adequate"
liquidity positions.

How Could Producers Enhance Their Futures?

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25/9/2014 [10-Sep-2014] Low Global Sugar Prices And Domestic Drought Are Souring Brazil's Sugarcane Industry

Given the drought and continuing low ethanol and sugar prices, the outlook isn't exactly promising for the coming 12
months. Along with high debt interest burden that continues to limit companies' cash flow generation, these factors have
lowered their ability to pay down debt and meet short-term maturities.

In our view, a sustainable increase in sugar prices is the chief factor that could improve cash flows, potentially stabilize
credit ratings, and result in positive outlooks. Even as Brazil's cane production declines, global supplies are still in
surplus because India and other big sugar producers have large harvests. According to the International Sugar
Organization, this is likely to keep prices weak. Raw sugar prices are at seven-month lows (at less than 16 cents a
pound), and the low end correlates to the premium for white sugar output as well.

The global sugar prices and trading dynamics also result from international sugar barriers. Europe, for example, has a
regulated market that defends its sugar-beet producers, and Brazil exports sugar to the U.S. only through pre-defined
quotas. Sugarcane ethanol does have a promising export market, given its reputation as a clean energy source that can
substitute the more expensive and polluting fossil fuel, but most of it is currently consumed domestically.

Additionally, given that gasoline is combined with ethanol to fuel cars in Brazil, hikes in gasoline prices, which are
expected to occur in the next few quarters, would bolster the anhydrous ethanol price. Also, the Brazilian government
has been discussing a potential increase of the blend to 27.5% from current 25%, which, if it were to materialize, would
further boost demand for ethanol.

Also in the short term, though to a lesser extent, companies can improve their cash flow generation if they sell their
excess energy cogeneration capacity in the spot market to benefit from current record high prices of electricity.
Sugarcane processors' energy cogeneration businesses carry huge margins because the raw material is a by-product of
their sugarcane crushing (the cane bagasse). Some processors are opting to sell their cogeneration businesses to utility
companies rather than engage in commercial energy production, helping some to improve their balance sheets as they
use the sale proceeds to reduce debt.

Merger Potential
Brazil's sugarcane sector is highly fragmented. More than 300 players operate in an industry with the capacity to crush
almost 700 million tons of cane, and the largest company, Razen, has just around 10% of market share.

While the sector faced massive consolidation between 2000 and 2007, led by Cosan which established Razen, when
many international companies flooded the sector, the 2008 financial crisis slowed merger activity. We believe there's a
big potential for another wave of consolidation, particularly because many companies struggle with high costs, debt, and
capital expenditures amid low profitability.

Low Sugar
It's tough to predict when Brazil will pull out of this drought and return to richer harvestsalong with an overall
stabilization in the sugarcane industry as prices for sugar and ethanol recalibrate higher. In any event, as long as Brazil's
sugarcane ethanol remains in strong demand, the domestic sugarcane industry has at least the hopes for a rebound.

Primary Credit Analyst: Flavia M Bedran, Sao Paulo (55) 11-3039-9758;

flavia.bedran@standardandpoors.com
Secondary Contact: Patricia R Calvo, Mexico City (52) 55-5081-4481;
patricia.calvo@standardandpoors.com

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