Sunday, 14 December 2008

Keep an Eye on Brazilian Ethanol Producers

The credit crunch first hit Brazilian food and cellulose producers that placed wrong wagers on the direction of the currency. The losses were huge: it was about $3 billion (and the number may grow bigger.) As time goes by and the crisis hits the biggest emerging market countries, investors scour for new victims. 

The ethanol sector in Brazil is, in the view of some knowledgeable insiders, the next casualty. Many of these found in the liquidity boom that the world economy enjoyed since 2003 a easy and cheap source of funding -- hopeful that the feast would last for a few more years. But the winds changed direction, and now credit has dried up. In the past weeks, three ethanol producers filed for debt restructuring in state courts. The figure, although similar to Chapter 11 in the U.S., allows these companies to present a refinancing plan for the equivalent of 60% of their debts. For banks and other creditors, the prospect of this is not good at all, for it will be a local judge who will decide whether the companies can file for bankruptcy or not. Judges in recent years have been favourable to the bankruptcy-bound agents, in detriment of banks, bondholders and trade lenders. The derivatives scandal that I referred to in the first paragraph has created also some legal void and now banks are being punished by court rulings that want to annul those contracts -- making the financial system vulnerable to further losses. 

Part of the irrational exuberance that benefited the industry in the past three years is now backfiring. The sector's capital deadly sin was using for years short-term credit facilities (such as trade loans) to finance long-term expansion projects -- many of these companies were expecting that demand for ethanol as a substitute for gasoline would soar, and invested heavily on greenfield plans and acquisitions. The three companies above were hit by a rising cost of borrowing, while another (Santa Elisa Vale) is said to have lost a lot of money in the derivatives front. 

Bottom line is, will the credit crunch hamper the upcoming harvest? The most probable outcome is no. The current harvest will actually be quite good. An industry executive told me last week that the problem may appear next year, when the lack of credit may make it unaffordable for a number of mills to pay for maintenance costs. The cost of producing raw sugar is still above costs (and the currency depreciation is still helping a lot.) If the government decides to trim gasoline prices, ethanol will be the first victim: let's remember that it is still a domestic-oriented industry. Another thing that could actually help the sector would be that global supply dwindles along 2009.  

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