October 1, 2008

Brazilian Sugar Cane Ethanol – Private Equity, Investors Move in

Following the collapse of global trade talks in Geneva, Brazil threatened to issue a formal complaint to the World Trade Organization regarding the U.S. tariff of 54 cents per gallon on Brazilian sugar cane ethanol. This dispute has added a powerful dimension to the ongoing debate in the U.S. Congress over the controversial tariff, where several bills are already in circulation.

The bills seek to either lower or remove the tariff on Brazilian ethanol (which is derived from sugar cane) because of its productivity far superior to corn ethanol. The existing tariff is designed to protect U.S. corn producers from competition, but with the prices of food and gasoline reaching record highs, some U.S. lawmakers are echoing the demands of Brazilian officials for the tariff to be scrapped.

Meanwhile, private equity and other investors continue to eye the potential market for this powerful alternative fuel. Ethanol made from sugar cane packs 8.2 times the amount of energy used in its production, compared with just 1.5 for corn ethanol.

In the Q&A below, Pedro Seraphim sheds light on the many issues surrounding Brazilian ethanol and the implications for investors. With over 15 years of experience in the Brazilian energy industry, Mr. Seraphim has been closely involved in the development of Brazil's expanding (and converging) energy and ethanol sectors.

Why is Brazil's ethanol industry of interest to foreign investors?

The Brazilian sugar cane industry has been attracting tremendous interest from both local and international investors for the past several years, including private equity, pension funds, and institutional investors. Just recently, the Organization for Economic Cooperation and Development (OECD) stated that ethanol from Brazilian sugar cane had the greatest environmental impact when compared to gasoline, cutting greenhouse gas emissions by about 80%, while corn ethanol only reduced emissions by about 30%. As a result of this and the potential for new international demand, interest in the sector is mounting. Virgin Atlantic founder Richard Branson, for example, always a harbinger of the 'next big thing,' is already involved in transactions with local producers. And just recently, Louis Dreyfuss Commodities, one of the top three sugar cane merchandisers and traders in the world, announced a $433 million investment to open a new mill in Brazil's Mato Grosso do Sul state.

What questions do you get from private equity and other investors in this area?

Investors ask, of course, about potential returns, as well as possible obstacles to get into the market (discussed below). A question we frequently get is whether an investor should build a new sugar cane processing facility or invest in an existing one. Investors usually choose the latter option, as the process of establishing oneself as a 'Greenfield' company can be long and complex, as it depends on the development of the sugar cane crops.

Investment opportunities in existing sugar cane ethanol facilities are plentiful, but one potential drawback is that some are old and have problems which may hamper results down the line. Proper due diligence is imperative. But even where problems exist in past practices, new investors have the opportunity to change the paradigm and set a new path of development and growth for their acquired targets.

Despite sector challenges, the current international quest for renewable energy, the incredible potential of sugar cane as a source of fuel and electrical energy, and the availability of arable land in Brazil pose unique opportunities for long term investors.

What are some other pitfalls in the sector right now?

The domestic ethanol market in Brazil is already mature, so the most significant opportunity for growth is the market for exports (Brazil plans to increase exports by 25%), but there are two primary challenges: tariff (such as the U.S. import tariff mentioned above) and non-tariff barriers and deficient infrastructure; Brazil is not yet equipped to transport large amounts of ethanol - for example, the country does not have ethanol pipelines yet or sufficient tanker ships - so there is logistical work to be done.

What are the opportunities for growth in this market?

A most interesting area of potential growth in the sector is the use of sugar cane byproducts/waste to produce electric energy. Known as bagasse, many Brazilian ethanol facilities burn this waste to generate electrical energy for their operations; but the potential for this energy goes way beyond just powering the plants.

A recent study by the Brazilian government found that ethanol plants currently investing in generation facilities could add a capacity of up to 9,000 MW to the system (in comparison, one of the world's largest power plants, the Itaipu hydroelectric facility at the Brazil/Paraguay border, has a capacity of 14,000 MW, providing 19% of Brazil's power supply). Plus, the study did not include the potential for power generation from future bagasse burning facilities, thus the prospects for deriving energy from bagasse are tremendous. In fact, it is so promising an area that it could become a "power generation industry" in-and-of-itself, with sugar and ethanol as its (valuable) byproducts. Perhaps most encouraging is the fact that the power generation side of the Brazilian ethanol industry is free from the tariff and infrastructure pitfalls discussed above, as power is essentially a domestic market with high demand and good logistics, with most of Brazil's transmission system fully interconnected.

About TozziniFreire Advogados

TozziniFreire Advogados is a full service law firm, engaged in a multidisciplinary legal practice since its foundation in 1976. Headquartered in Sao Paulo, the firm has regional offices in many of Brazil's state capitals, as well as a representative office in New York. In addition, the firm provides its clients with comprehensive integrated services through strategic alliances with foreign law firms and other non-legal services providers.

About Pedro Seraphim

Mr. Seraphim is the head of the Energy Practice Group at TozziniFreire. He has extensive experience in the Brazilian ethanol industry and works closely with Brazilian ethanol plant owners and energy producers, as well as local and international investment firms. These include Infinity Bio Energy Ltd. and Brazil Ethanol Inc., two special purpose companies established with the sole target of investing in Brazil's ethanol industry, Tropical Bioenergia, which is the first investment of an international oil company (British Petroleum) in the sector, and Usina Sao Martinho S.A., one of the largest ethanol and sugar producers in Brazil.