THE ETHANOL DILEMMA - INADEDQUATE SUPPLY VS GROWING DEMAND

UNCLAS SECTION 01 OF 02 BRASILIA 000788

SIPDIS

SIPDIS

DEPT FOR EWHITE OES/EGC AND PKELLY OES/STC; OES/ETC GTHOMPSON
USDOE FOR SLADISLAW
DEPT PLEASE PASS TO USTR FOR MSULLIVAN
DEPT PLEASE PASS TO USAID FOR LAC/AA
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRSICOLL/MWAR D
USDOC FOR 3134/ITA/USFCS/OIO/WH/RD/DANDERSON/SHUPKA

E.O. 12958: N/A
TAGS: TRGY SENV ENRG KSCA ETRD EAGR BR
SUBJECT: THE ETHANOL DILEMMA - INADEDQUATE SUPPLY VS GROWING DEMAND


1. Summary: As countries worldwide search for alternatives to
increasingly expensive petroleum, not to mention green fuel
alternatives that help meet Kyoto Protocol targets, Brazil finds
itself in an enviable position. The world's largest producer of
both ethanol and sugar is the purveyor of technology, infrastructure
and processes that could help fuel a biofuel revolution. In fact,
Brazil's ethanol program is so successful it has drawn the likes of
Bill Gates and Google's founders, Sergey Brin and Larry Page, into
the fray, promoting expanded ethanol production in the United
States. Yet, despite the monumental success of ethanol in Brazil,
it is not happening without some growing pains.


2. Brazil now finds itself in the unforeseen position of not having
enough supply to satisfy demand. The unanticipated flex-fuel boom in
Brazil coupled with increasing international demand for ethanol is
exerting serious pressure on Brazil's domestic production apparatus.
Sales of flex-fuel cars reached approximately 80% of new vehicle
sales in 2005. The resulting increase in demand for ethanol
necessarily led to price increases. Moreover, ethanol exports
increased by 1.8 billion liters in 2005 (a 269% jump over 2004).
This facet of increased demand is compounded by the fact that
foreign importers are offering a price 8-10% higher than Brazil's
internal market. During the current interharvest period supplies
are limited and prices have skyrocketed, leaving Brazilian consumers
and officials with little hope for price reductions until production
renews at the end of April. Taken as an omen, one of the most
pressing questions facing Brazil is how to create an infrastructure
which can deal with the escalated demand for ethanol.
End Summary


3. The question of how Brazil intends to address this supply and
demand issue is still up for debate. In conversations with Scioff,
Angelo Bressan, Director of the Ministry of Agricultures
sugar/alcohol division, noted that the GoB has only two ways to
regulate ethanol. The first involves adjusting the requisite amount
of ethanol to be mixed in gasoline. The GoB recently utilized this
approach dropping the percentage from 25 to 20%. (reftel) Although
this measure increased supply, it had little to no effect on prices.
A second option would be to regulate ethanol exports by, for
example, linking exports to domestic stocks via a system of quotas,
but leaving prices free. This argument has been negatively received
both by industry and free market advocates within the GoB. Unica
(the Sao Paulo Sugarcane Industry Association) believes that this
mechanism would not be able to function without government
interference in pricing. Bressan noted that the GoB and industry
have had an open dialogue focusing on how to address the problem of
supply but without any decisive outcomes as of yet.


4. The sugar/alcohol industry, for its part, is looking to expand
both the area of planted cane and the industry's capacity to refine
it. Preliminary estimates are that US$ 14 billion is going to be
invested into refineries that can crush and produce sugar/alcohol by

2011. Meanwhile, another US$ 7 billion is being invested into
expanding cultivated land. Bressan added that 11 new refineries are
already under construction with an additional 16 planned for 2007.
That said, the analgesic effects of these investments are still some
years away. Because it is not cost-effective to transport cane long
distances, refineries and agricultural lands must remain in close
proximity. Once a distillery is completed, there will still be a
12-15 month lag time (the crop cycle for cane) before production
commences. Moreover, the upward swoop of land prices in cane
producing regions (49% over the last year, compared to the national
average of 2%),is certain to become an obstacle to the expanding
industry.


5. This, of course, does not address the GoB's principal concern of
how to maintain competitive prices for ethanol during the
interharvest period. Bressan has stated that the GoB and industry
are discussing palliative measures but failed to expand on what they

BRASILIA 00000788 002 OF 002


were. They are simply "discussing the issue." The most prominent
idea, reflected in numerous media accounts, is to create stockpiles
of sufficient size to guarantee supply. While the industry and
government agree to the idea in concept, both sides dispute who
should be responsible for creating mechanisms and supplying the
necessary funding for the stocks. While Roberto Rodrigues, Brazil's
Minister of Agriculture, initially said that the government was
studying inexpensive financing mechanisms for creating stocks, he
later retracted those comments affirming that stocks are the
responsibility of the productive chain.


6. In terms of Brazil and the United States, and the growing
attention exhibited by parties like Gates, Brin and Page, and rising
interest in California, Bressan noted that the Ministry would like
to see U.S. tariff barriers dropped on combustible ethanol. But, he
stated, it needed to be done in a systematic fashion. He fears that
when the U.S. market opens, Brazilian consumers will be adversely
affected by a dearth in supply resulting from profit hungry
exporters. Bressan further maintained that the GoB has an interest
in creating a world market and that the U.S. and Brazil should work
together to achieve that goal. He added too, that countries,
including the U.S., have a vested interest in working with Brazil
because of the "know-how" they have regarding the production and
processing of ethanol.


7. A crucial link in this process, from his perspective, will be
spreading the supply chain throughout the developing world,
especially in Africa and Asia. The U.S. and Brazil, he stated
emphatically, are not capable of sustaining a world ethanol market
on their own. That, of course, has not stopped the likes of
Petrobras from signing a contract in February to build a pipeline
from Goias (one of Brazil's principal cane producing regions) down
to Brazil's largest port in Santos. A portent of how industry views
the future role of ethanol.


8. Comment: In the short-term, it is clear that alcohol induced
euphoria will continue the industry's ascension. As the world's
largest producer of sugar and alcohol, Brazil is taking measures to
increase production and at least discussing how to satisfy supply in
the boom time. In response to the crisis over the last four months
and the elevated prices, the GoB has recognized its impotence and is
"throwing in the towel", waiting for the new harvest. This is
currently underway, and greater supplies of ethanol are expected in
filling stations by early May. End Comment

LINEHAN