By Paul Kiernan –

–Government forecaster Conab further cuts forecast for Brazilian sugarcane production

–Conab outlook remains higher than private estimates, and sugar market doesn’t react

–Nearly all of center-south region sugarcane already harvested

(Updates throughout with details, background, reasons for drop in sugarcane, comparison with private forecasts).

SAO PAULO (MarketWatch) — Brazil’s agricultural forecasting agency on Thursday slashed by 3% its estimate for the country’s 2011-12 sugarcane crop to reflect a weak harvest in the main center-south region, though the official outlook remained optimistic next to private forecasts.

The agency, known as Conab, expects Brazil to harvest 571.5 million metric tons of cane in 2011-12, down 8.4% from a year earlier and 3% below Conab’s August forecast. Sugar output from the world’s largest producer and exporter is seen falling 3.4% to 36.88 million tons, while ethanol fuel production is forecast to tumble 17% to 22.86 billion liters.

Conab’s outlook for Brazil’s closely watched center-south region, which produces near 90% of the country’s sugarcane, was more than 2% higher than the latest estimates from private groups such as Unica, the top sugarcane industry association. As a result, Conab’s report was received with a yawn in New York, where raw sugar futures were up around 4% intraday.

Nearly all of the center-south region’s sugarcane has already been harvested. Brazil’s weak 2011-12 crop has been anticipated for months and was years in the making.

The 2008-09 financial crisis strained producers’ finances and forced them to hold off on routine investments in renewing canefields, which rapidly lose productivity after about five harvests. Further complicating things for the 2011-12 crop were a number of somewhat unlikely weather factors, including drought in 2010 and frost this year.

With Brazil’s output long priced in, the world sugar market’s attention in recent weeks has increasingly turned to the Northern Hemisphere, where producers such as Thailand, India and Russia are gearing up for strong crops of sugarcane and sugar beets. Some analysts expect the sugar market to reach surplus territory within the next year or so and see prices falling below 20 U.S. cents a pound, from the current levels around 24 cents.

Many in the Brazil are skeptical, however, citing Brazilian mills’ ability to choose between supplying the international sugar market and the booming domestic market for ethanol fuel.

As sugarcane yields have fallen, Brazil’s cost of producing sugar has quietly risen to around 20 cents a pound, analysts say. Though relatively high sugar prices in 2011 led mill owners to use almost 50% of their cane for sweetener–up from 46% last year–a sharp drop in prices could just as easily prompt a shift toward ethanol production.

Around half of the cars on Brazilian roads have flex-fuel engines that can run on pure, hydrated ethanol or on gasoline, which in Brazil is a blend containing 20% anhydrous ethanol.

Faced with a shortage of sugarcane in 2011-12, the local sugar and ethanol industry has opted to increase anhydrous ethanol production by about 13% in order to meet Brazil’s basic gasoline blending needs, while hydrated ethanol output has slumped 30%, according to Conab.