FEATURE: Brazil ethanol rally to stall if premium over sugar passes 1 cent/lb

New York — The recent surge in Center-South Brazil hydrous ethanol prices could meet resistance when ethanol commands a rapidly approaching 1 cent/lb premium over sugar production, which would spur flex mills toward the biofuel.

"Select Center-South flex mills could potentially switch to maximum ethanol production if the hydrous ethanol production premium increases above a 100-point premium, or 1 cent/lb, over sugar production," said a Sao Paulo-based trader. "The importance of the 100-point level is that flex mills will have to pay fines as high as 100 points to sugar buyers if they do not deliver in a timely manner on already agreed upon sugar contracts and these mills will need to be incentivized to accept paying these penalties."

S&P Global Platts assessed Center-South hydrous ethanol at Real 3,595/cu m on March 4, up Real 245, or 7.3%, on the week. The Center-South hydrous ethanol price is up 45% so far in 2021.

Although Brazil is in its intercrop season, a scenario of a potential hydrous ethanol supply shortage combined with hydrous ethanol production paying above a 100-point premium over sugar production could potentially lead to an estimated 20-30, or 5%-8% of the flex mills located in the Center-South to strategically produce enough hydrous ethanol to cover the shortfall in demand until the start of the 2021-22 harvest in mid-April, thus likely capping the recent rally in regional prices.

"Demand for hydrous ethanol will probably outstrip supply by an estimated 350,000–450,000 cu m during the second week of April," said a second Sao Paulo-based trader. "Twenty-30 flex mills located in the Center South could potentially initiate early crushing and produce the approximate 350,000-450,000 cu m of hydrous ethanol needed to cover the shortfall in demand."

Anhydrous stocks

The current supply of Center-South anhydrous ethanol will satisfy the demand for anhydrous until around the last week of April, according to multiple sources.

"Although there is an estimated comfortable cushion of 200,000-300,000 cu m of anhydrous ethanol available before the start of the 2020-21 harvest in mid-April, this amount will barely be adequate to cover the replacement demand for any potential shortfall in hydrous ethanol stocks in the Center-South during the second week of April," said a Rio de Janeiro-based trader.

Flex mills have the unique ability to make minute adjustments in the ratio of their ethanol and sugar production based on which is paying the highest market premium. Quick adjustments by flex mills in the Center-South can increase or decrease the potential supply of ethanol in the millions of liters and affect the future sugar supply in the thousands of metric tons.

Hydrous production premium

Real 3,900/cu m ex-mill Ribeirao Preto is the current price level required for hydrous ethanol production to start paying more than a 100-point premium over sugar production.

The 100-point premium induced ex-mill Ribeirao Preto price will be a fast-moving target given the current high volatility of two current underlying components of the ethanol production premium calculation: the Brazilian real to US dollar exchange rate and the ICE May NY11 sugar futures contract price.

If there is further depreciation by the real or an increase in the ICE May NY11 sugar futures contract price, the price of hydrous ethanol ex-mill Ribeirao Preto would need to increase beyond Real 3,900/cu m for ethanol production to start paying more than a 100-point premium over sugar. On the contrary, an appreciation in the real to the dollar or a decrease in the ICE May NY11 sugar futures contract will reduce the ex-mill Ribeirao Preto price needed for ethanol production to start paying more than a 100-point premium over sugar production.

The recent rally in Center-South hydrous ethanol prices has caused the sugar production premium to narrow to a 0.48-cent premium to hydrous ethanol in raw sugar equivalent as of March 4. Sugar production paid a recent high of 4.32-cent premium to hydrous ethanol in raw sugar equivalent on Jan. 15.

Sao Paulo state back to strictest quarantine level

Sao Paulo state announced March 3 the return to the red phase of coronavirus quarantine, the strictest level for the state. Under the two-week quarantine phase, starting March 6, only essential sectors of the economy will function, such as pharmacies, supermarkets, gas stations and public transportation. The anticipated decrease in light-duty vehicle use resulting from the lockdown and the associated drop in ethanol demand caused a pause in the recent price rally for ethanol prices.

If Sao Paulo state remains in the red phase of its quarantine there is a low probability that the hydrous ethanol premium over sugar increases above 100 points because of a decrease in the demand for hydrous ethanol.

"If Sao Paulo state extends the time it remains in the red stage of quarantine beyond the planned two-week period, hydrous ethanol prices should remain under pressure until the start of the 2021-22 harvest," said a third Sao Paulo-based trader.

Hydrous ethanol futures in steep backwardation

Since the start of February, the Brazilian Commodities and Futures Exchange's front-month hydrous price has risen in a far greater magnitude than later contract months due to fears over an ethanol supply shortage in the spot market in early April, leading to a steep backwardation of the hydrous futures curve.

Backwardation is the market condition where prices of later dated futures contracts are trading below prices for near-term contracts. The steeper the hydrous ethanol backwardation curve, the greater the immediate demand is for hydrous ethanol accompanying tighter supply.

The silver lining to a steep backwardation curve is that the current acute demand and supply fundamentals driving prices to extreme levels should prove temporary and prices should fall in the coming months, thus bringing needed price relief to Brazilian consumers.