* USDA faces large cost for sugar subsidies
* USDA likely to sell surplus sugar to make ethanol
* Other options may be costly
WASHINGTON, March 20 (Reuters) - The U.S. government is readying a tool created during last decade's biofuels craze - a never-used program to sell sugar at a loss to ethanol makers - as a way to whittle a looming sugar surplus down to an affordable size.
The sugar-for-ethanol program could be a lower-cost way for the Agriculture Department to meet its obligation, by law, to assure a minimum price for U.S.-grown sugar. Due to large crops worldwide, New York futures prices are below the federal guarantee of 20.94 cents per lb.
If markets remain weak, sugar processors could forfeit to USDA tens of thousands, or even hundreds of thousands, of tons of sugar used as collateral on USDA price-guarantee loans. In the last major glut, forfeitures cost USDA $465 million in fiscal 2000 on a program that is supposed to run at no net cost.
Other options to handle the surplus are on the table, including a buy-back from foreign nations of the right to ship sugar to the United States, payments to ship sugar to other nations and rules changes to curb the flow of "re-export" sugar that is processed in the United States, analysts said.
Some $864 million in loans was in danger of forfeiture by one estimate. The sugar supply at the end of this marketing year is forecast for 2.4 million tons by USDA. At 20 percent of annual use, it would be the largest carryover since 2001.
"One way or another, the government is going to spend some money," said Tom Earley, a sugar policy analyst at Agralytica.
The government has yet to settle on a course of action. Agriculture Secretary Tom Vilsack said this week it was inappropriate to talk about specific steps, such as taking surplus sugar off the market, "until we get the plan out."
"We will be in a position soon to put the structure for the Feedstock Flexibility Plan in place. The fact it's in place doesn't necessarily mean it's going to get triggered," Vilsack told reporters at a luncheon on Tuesday, using the formal name of the sugar-for-ethanol plan.
USDA will need approval from the White House budget office to operate the sugar-for-ethanol scheme, which has not yet been transformed from statutory language into federal regulation. White House review of proposed regulations can sometimes take months.
A sugar-for-ethanol program could buy 247,300 tons of surplus sweetener at a net cost of $66 million under a scenario outlined by USDA economist Steve Haley. He estimated ethanol makers, who mainly use corn as a feedstock, would pay 6 or 7 cents per lb for sugar acquired by USDA for 20.9 cents.
At a projected yield of 135 gallons per ton, the sugar would produce 33 million gallons of ethanol, a small amount of the biofuel that would be added to a market facing its own glut.
Bumper crops in the United States, traditionally a large importer, and Mexico, which is guaranteed free access to the U.S. market, are combining to create this year's huge surplus. Production in both countries is up by 20 percent in two years, and against that background U.S. sugar prices are down 50 percent from its high in 2011.
On Wednesday, U.S. sugar futures prices in New York closed at 20.8 cents.
If USDA wants to minimize forfeitures, it will have to begin work by June to reduce the sugar supply by as much as 500,000 or 600,000 tons and bolster prices, said two analysts.
The sugar-for-ethanol program was written into the 2008 farm law in part to encourage new biofuel feedstocks and in part as a safety valve with the opening of free trade in sweeteners with Mexico.
"One of the surprising aspects of the last four years is this (surplus) didn't happen sooner," said Jack Roney of the grower group American Sugar Alliance. He said Mexico should share the onus for alleviating the surplus in an integrated market.
When Congress created the sugar-for-ethanol program, skeptics warned it could be a costly and impractical program because U.S. price supports made sugar too expensive. A 2006 USDA study said sugar ethanol would cost three times as much to make as corn ethanol.