LATIN AMERICAN EQUITY RESEARCH 3 FEBRUARY 2015 Strategy, Utilities and Economics | Brazil ELECTRICITY RATIONING IN BRAZIL THE NEVER-ENDING PROBLEM Tatiana Pinheiro* Maria Carolina Carneiro* Fernanda Consorte* Brazil: Banco Santander S.A. Brazil: Banco Santander S.A. Brazil: Banco Santander S.A. +5511-3012-5179 | [email protected] +5511-3012-6682 | [email protected] +5511-3012-6682 | [email protected] Daniel Gewehr* Joao Noronha, CFA* Brazil: Banco Santander S.A. Brazil: Banco Santander S.A +5511-3012-5787 | [email protected] +5511-3012-5734 | [email protected] Net/Net: The risk of a rationing scenario is high, in our view, given the bleak rainfall prospects for February (52% of historical average). In this report, we present a model (based on the BCB’s model) of the potential effects on GDP: the model suggests that if 5-10% rationing occurs, 12-month GDP growth could be reduced by 0.6-2.0 p.p. In the rationing scenario, we expect sectors that are short energy (i.e., not self-sufficient) and with cyclical or energy rationing exposed demand to be hardest hit. These sectors include: (1) materials (steel); and (2) industrials overall. The risk of a rationing scenario is high, in our opinion, given the bleak rainfall prospects for February; consequently, we expect pressure in March 2015 to be higher than in 2014. Water inflow as low as 52% of the historical average for February would necessitate a demand cut close to 10%, in our opinion, in order to alleviate low reservoir levels and guarantee supply for 2H15 and 1H16. Alternative measures, such as providing incentives to lower consumption and increase backup generation, could help offset pressure. However, we believe that reservoirs have reached critically low levels; thus, we estimate a larger demand cut will be needed to assure supply. We reproduced the a Brazilian Central Bank (BCB) model for measuring the effect in GDP growth of electricity energy rationing adopted in 2001; the model suggests that if 5-10% rationing occurs, 12-month GDP growth could be reduced by 0.6-2.0 p.p. We do not see a direct impact on inflation or fiscal costs, but we expect rationing to be inflationary (secondary impact of tariff hike). However, we believe that the monetary policy decision will be biased in favor of the economic activity level; we maintain our view that the Selic rate is cut throughout 2016. In the rationing scenario, we expect sectors that are short energy (i.e., not self-sufficient) and with cyclical or energy rationing exposed demand to be hardest hit. These sectors include: (1) steel (Usiminas and Gerdau); (2) industrials (capital goods) overall: with Mahle and Randon (higher share of production in Brazil) the most exposed to a potential energy shortage and Weg the least exposed; and (4) appliance and apparel: based on historical data, during 2001's energy rationing, appliances declined on average by 3.7% while apparel grew only 0.5% in nominal terms. If rationing occurs, we believe that the industries that will be least affected will be: (1) asset-light service-related such as banks and other financials (Itau, Bradesco, BB Seguridade, and Cielo); and; (2) self-sufficient energy users exposed to foreign or noncyclical demand: (a) pulp producers (Fibria and Suzano); (b) agribusiness (Sao Martinho and Cosan); (3) defensive names such as healthcare (Qualicorp). (See pages 9-11 for further details.) IMPORTANT DISCLOSURES/CERTIFICATIONS ARE IN THE “IMPORTANT DISCLOSURES” SECTION OF THIS REPORT. U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 583-4629 / (212) 350-3918. * Employed by a non-US affiliate of Santander Investment Securities, Inc. and is not registered/qualified as a research analyst under FINRA rules. ELECTRICITY ENERGY RATIONING: THE NEVER-ENDING PROBLEM Rationing is coming . We acknowledge that the risk of an electricity rationing scenario is increasing, given lower-than-expected rainfall in January. Water flow data from February has become more important in determining whether our bear-case scenario will materialize. The drought also constrains water supply in the most important metropolitan areas of Brazil, further restricting an already pressured economy. if rainfall and water inflow is meager. We are in the rainy season in Brazil, which occurs in the October-April period. In January, rainfall was below 50% of the long-term average, and Brazilian reservoir capacity reached an ultra-low level of 20% on average, which pressures the amounts needed from February onward to minimize the size of rationing and/or of a possible extraordinary tariff hike (mentioned by regulator as the application of a “tariff realism”). According to our utilities equity analysts team, the more likely scenario is rainfall around 52% of the long-term average in February; however, and in order to reduce the probability of a rationing scenario, it should exceed 80% of the long-term average. Considering this shortfall risk, the possible lack of water flow could have a negative impact on economic activity and inflation, particularly since the government has indicated recently by local press and official speeches from the ministry of finance that no fiscal resources will be available to the electric sector this year. We present a rationing model for economic activity. The following analysis presents our estimates for reservoir levels with restriction of consumption and lower inflow, as well as a sensitivity analysis for GDP growth, inflation, and the fiscal impact of possible electricity energy rationing in 2015. We reproduced the BCB model for measuring the effect in GDP growth of electricity energy rationing adopted in 2001 in order to estimate the possible impact on GDP growth if rationing is adopted this year. For this purpose, we maintain the BCB assessment presented in June 2001 that if a bear-case scenario materializes, the economic segments most affected by a electricity rationing would be (1) mining, (2) manufacturing, (3) civil construction, and (4) utilities, followed by (5) retail, (6) transportation, and (7) financial institutional services. MIND THE GAP Rationing too probable to be ignored. We estimate that with rainfall @ 52% of the long-term average in southeast region, our reservoirs would reach levels well below the security threshold of 10%, putting at risk not only supply for 2015 but also for 2016.We believe that if low February data are confirmed, the chances of a turnaround by March decrease—as the initial months of the rainy season disappoint, the conversion ratio of rainfall to water inflow and reservoirs decline. In order to achieve reasonable reservoir levels, assuming rainfall would be close to 80% of the long-term average from March to December, we believe a demand cut of ~10% would be needed by the end of April in order to avoid depleting reservoirs below the 10% level and to recover reservoirs to levels closer to the risk aversion curve. 2 Assumptions underlying our 10% demand cut scenario: (i) we included volumes increasing an average 1.5% YoY from February to April as a result of high temperatures; (ii) 2.2 GW capacity addition in 2015; (iii) stoppage for maintenance in thermals; (iv) full usage of transmission capacity in all systems; (v) February rainfall according to ONS’s recent estimates (January 30)—rainfall at 80% from April to December; rainfall in March at 80%, but lower conversion ratio based on depletion of reservoirs in January/February; and (vi) friction/losses in the conversion of rainfall to water inflow/reservoir capacity from March to May, as we assume the recovery slope from some large reservoirs should be slow. Figure 1. Brazilian Water Reservoir Levels (%) Figure 2. Rationing Model Output—Base Case 90% 60.0% 80% 50.0% 70% 40.0% 60% 50% 30.0% 40% 20.0% 30% 20% 10.0% 10% 0.0% 0% jan feb mar apr may jun jul ago sep oct nov dec 1-Jul-14 1-Jul-15 1-Jan-14 1-Jan-15 1-Jun-14 1-Jun-15 1-Oct-14 1-Oct-15 1-Apr-15 1-Apr-14 1-Feb-14 1-Sep-14 1-Feb-15 1-Sep-15 1-Dec-14 1-Dec-15 1-Aug-15 1-Aug-14 1-Nov-14 1-Nov-15 1-Mar-14 1-Mar-15 1-May-14 1-May-15 2001 2008 2013 2014 2015 NO RATIONING CAR (%) 5% CUT IN DEMAND 10% CUT IN DEMAND Sources: ONS. Sources: ONS and Santander estimates. Where could we be wrong? Our analysis is focused on the following parameters that, if changed, would impact the model. (i) Rainfall data—we assume that February rainfall will be as bad as the 52% estimate from ONS; therefore, there should be a negative impacts on the March rainfall conversion ratio. However, if February rainfall and water inflow is close to 90%, with a positive impact on the remaining months of the year, the likelihood of rationing drops considerably. (ii) Demand estimates—we assume that volumes from the residential and commercial segments would continue to sustain volumes/growth in positive territory; if the yet to be announced tariff increases have a negative impact on demand or weak economic activity takes a toll on overall consumption, a natural reduction in volumes could help relieve pressure on hydro production. (iii) Additional supply sources—after our recent visit to the Energy Research Bureau, we believe the government is seeking alternative supply additions to the system, a total of 930 MW (2 GW from Argentina at peak hours, 360 MW from alternative transmission line connection to Teles Pires plant, 150 MW from anticipation of construction of turbines in Santo Antonio project, 500 MW additional volume from Itaipu or usage of inefficient thermal capacity).