Commodities 2023: Brazilian ethanol price drivers to remain volatile

Sugar's strong price premium over ethanol, unknown changes in the ICMS tax rate, and volatility in the Brazilian real/US dollar exchange rate will remain key drivers for Center-South ethanol prices in 2023.

Sugar premium over ethanol

"Crushing during the 2023-24 crop will be primarily focused on sugar production in the first few months of the crop cycle because our forward-looking guidance is pointing toward a market environment where sugar production will be paying a premium over ethanol production," according to S&P Global Commodity Insights. "The sugar production premium over ethanol should trend downward from current levels as the 2023-24 harvest picks up the pace and especially if crude oil increases above $100/barrel and if the Brazilian real strengthens against the US dollar."

NY11 front month sugar futures provided an average premium of 1.25 cents/lb to the Platts-assessed hydrous ethanol ex-mill Ribeirao Preto converted into raw sugar equivalent including CBIOs during 2022.

Decarbonization credits or CBIO -- the equivalent of 1 mt of CO2 not released into the atmosphere -- is an instrument that biofuel producers and importers are issued to ensure Brazil attains its decarbonization targets.

When Center-South mills maximize their sugar production over ethanol production, a monthly average of around 1.7 billion-2 billion liters of ethanol will be produced. On the other hand, if mills maximize their ethanol production, a monthly average of around 2.5 billion-3 billion liters of ethanol will be produced.

Given the current monthly ethanol demand of around 1.9 billion-2.4 billion liters, this ability to add or subtract around 1 billion liters per month to the supply of ethanol is a huge factor in the price discovery mechanism for ethanol prices throughout the year.

Brazilian mills, which are flex mills, have the unique ability to make minute adjustments in the ratio of their ethanol and sugar production based on which product is paying the highest market premium. These quick adjustments implemented by hundreds of flex mills situated in the Center-South can increase or decrease the potential supply of ethanol in the billions of liters and affect the future sugar supply in the millions of metric tons.

PIS and COFINS taxes to be reinstated on Jan. 1

The PIS and COFINS taxes are set to return to Real 131.9/cu m on ethanol effective Jan. 1.

The Brazilian government lowered the PIS and COFINS taxes on ethanol to Real 0/cu m from Real 131.9/cu m from June 24 until Dec. 31, 2022, to help reduce the negative effects of rising inflation in the country.

"The reinstatement of PIS and COFINS taxes will make ethanol more competitive against gasoline because the PIS and COFINS taxes are higher for gasoline at Real 790/cu m compared with Real 131.9/cu m for ethanol," said a Rio de Janeiro-based broker.

PIS (Program of Social Integration) and COFINS (Contribution for the Financing of Social Security) are taxes on the federal level.

ICMS tax cap a wild card

The current ICMS tax cap on fuels is expected to remain in place during the first quarter of 2023.

ICMS is a state tax charged on the circulation of goods and services including fuels.

The Biofuels bill (PEC 15/2022) implemented on July 15 lowered the existing ICMS tax on ethanol by the same ratio as the tax savings for gasoline in all states, that is decreasing the current 13.3% tax on ethanol to 9.58% in São Paulo state.

"The ICMS tax on ethanol will most likely return to the levels seen before the Brazilian government reduced its tax rate on July 18, but a 90-day notice must be announced before any changes are made," said a second Sao Paulo-based trader.

Brazil real/US dollar exchange rate volatility

Volatility in the exchange rate between the Brazilian real and the US dollar will continue to drive Brazilian ethanol mills' decision-making in 2023 to prioritize sugar or ethanol production.

The Brazilian real against the US dollar exchange rate will also decide the volumes of ethanol imported into Brazil from abroad and ethanol volumes exported from Brazil due to arbitrage opening and closing of international ethanol markets.

The current export arbitrages for ethanol to profitably flow from Brazil to Europe and from the US to Brazil are currently closed but could swiftly open at any moment in 2023.

"A depreciation of the Brazilian real closer to 6/$1 will most likely open the arbitrage for Brazilian ethanol to flow to Europe and a depreciation of the Brazilian real closer to 4/$1 will open the arbitrage for ethanol from the US to profitably flow to Brazil, assuming sugar and ethanol prices remain relatively stable," a Sao Paulo-based trader said.

The most recent price data of the Brazilian real/US dollar exchange rate has a current 100-day historic volatility of 18.32% compared with the US Dollar Index having a 100-day historic volatility of 11.14%.

An 18.32% 100-day historical standard deviation points to the probability that the Brazilian real within the next 100 days could potentially experience an 18.32% price move, either an appreciation or depreciation against the US dollar. This would mean a real-to-dollar exchange rate with a potential trading band of Real 6.15/$1 to Real 4.25/$1 in the next 100 days.