One year ago, investor hysteria for all things ethanol related was at frothy peak.  Wall Street bankers combed the villages of Nebraska and Kansas scouring for new potential investment deals.  With oil prices rising by the day and gasoline prices following suit, no wonder that ethanol project financing quickly became the energy sector’s new dot com craze.

Fast forward to today, and US ethanol producers are struggling between a rock and a hard place.  Not only has the credit crunch and risk aversion kicked in, the fundamental economics underlying a possibly flawed business model have finally sunk in.  The US ethanol industry may have been a politically inspired pipe dream all along or, as several prominent scientists proclaimed in a famous scholarly research paper published in the journal Science: “from a technical and scientific prospective, the US ethanol industry is loosing proposition from the start”.

Problems with volatility and spiraling corn prices, a deeply flawed logistics system for distribution, and a highly inefficient nascent industry still decades away from the highly developed state of gasoline production have squeezed profits and stressed the US ethanol industry for much of this year.

In June, VeraSun Energy, one of the country’s largest ethanol producers, recently delayed opening three new ethanol plants because of “volatility in the market”.  Energy analysts at Citigroup Global Markets predicted in a research note to investors that nearly three-quarters of US ethanol plants could face a possible shutdown this year as profit turns negative, cash flow dips into the red and short-term financing dries up.

However, hop on a plane for an eight hours flight from Miami to Brazil, by far the largest ethanol producer in Latin America, and the industry is alive and kicking with the financial deal flow hardly missing a beat due to the fall-out in the north.

“The Latin American market, unlike the US and European markets, has real potential take on biofuels in a big way. The region is endowed with abundant raw materials, and vast tracts of land that are a prerequisite for biofuels,” explains Gaurav Kumar, senior analyst at The Smart Cube, a Chicago-based independent investment research firm.

“Over the last twelve months, this has translated to biofuels plants being set up as well as planned and financed in other Latin countries – such as Argentina and Peru.  However, Brazil is and will continue to lead the investments in this sector on account of its proven success in the last 30 years.”

Clearly, investor appetite towards Latin America, both on the debt as well as equity side continues to be strong – although the global credit crunch and widespread anticipation that US Libor rates will eventually creep up has certainly cast some shadow over how long the enthusiasm will continue.  Nonetheless, there are several key differences between the highly uncertain outlook for the US industry and the robust and global footing supporting the Brazilian industry.
Enter the dragon – Asia takes up the slack
Global investor interest in funding Brazilian ethanol production has been driven by several factors.  For one, with the weakening of the greenback and concerns that the US is now well and truly a slow or no growth economy compared to the BRIC tigers (Brazil, Russia, India and China), it only makes sense for foreign direct investors to diversify away from funding dollar-based projects and move more towards increasing exposure to emerging markets.

Another key factor, and one also driving the US government investment in the sector, is that investment in alternative energy resources is a key political priority for many governments, notably Japan.  The state-owned Japan Bank for International Cooperation (JBIC), for instance, is mandated to pursue financing of any projects that will lead to an increase in the supply and diversity of global energy production.  Headquartered in Tokyo, JBIC has only three international offices – one of which is in Rio de Janeiro whose main activity is funding Latin biodiesal projects.  Interestingly enough, the largest community of ethnic Japanese outside of Japan is also in Brazil.

The major Japanese project finance banks have also been highly active with some recent big ticket ethanol deals.  Mitsui, ranked among the world’s top five banks by assets, spearheaded a deal last July with Brazil’s state-owned oil giant Petrobras and local ethanol producer Italuma by signing the oil giant’s first ethanol plant deal.  The project has an estimated value of US$250mn, with plant capacity likely be about 200mn litres/year (1.26mn barrels/year).

Mitsui’s latest ethanol deal comes after the two companies formed a joint venture in March to produce and export sugarcane-based ethanol from Brazil.  Petrobras and Mitsui also separately agreed in February last year to conduct a feasibility study on a pipeline to carry ethanol from the south-central interior states of Minas Gerais and Goias through Sao Paulo to a coastal export terminal at Sao Sebastiao.

On July 1, Petrobras also partnered with Japanese government-owned export credit institution Nippon Export and Investment Insurance (Nexi) to sign another MOU to jointly study the possibility of providing export credit opportunities to oil, gas and biofuel projects that would benefit both countries.  The agreement was signed in Brasilia after bilateral talks between Japan’s Akira Amari and Brazil’s energy minister Edison Lobao.  Under the terms of the deal, Nexi and Petrobras would jointly assess oil, gas and biofuels projects in regions such as South America and Africa.

By dollar-size alone, these deals may be a drop in the bucket for Mitsui’s project finance desk as well as Petrobras, ranked by market cap as the third largest company in the western hemisphere after Exxon Mobil and General Electric, making it larger than Microsoft, AT&T, and Wal-Mart, and within the world’s top 10.  However, since its founding in 1953, Petrobras, at its heart, is a traditional petroleum company.  Their foray into the ethanol market, a business which only a few years ago was scoffed at by US oil executives, points to the conviction that the industry will eventually grow into a major global export market.

At the same time, Tokyo-based Japan Biofuels Supply, a joint venture set up by 10 Japanese refiners, and Brazil’s ethanol producer Copersucar, have also recently concluded a memorandum of understanding to consider ethanol business opportunities.

In short, investor interest in the Brazilian sector is broad and deep.  “Most of the investments in Latin America are highly diversified and being made by oil and energy companies such as Petrobras and BP; or by integrated biofuel and agricultural companies in conjunction with other financing entities. Another trend that stood out was towards joint ventures,” adds Kumar from The Smart Cube.  “While most new entities have relied on debt for meeting their financing requirements, the established players such as Cosan have gone the IPO route.”
Multilateral Latin ethanol appetite strong as ever
Even beyond Japan, perhaps the biggest investor in Latin American biofuels may be the multilaterals.  The multilateral agencies, particularly the IADB, have been as active as ever in filling in for now risk-averse US commercial investors in this sector.

The Inter-American Development Bank (IADB) announced in July a US$269mn loan to Brazilian ethanol maker Cia Nacional de Açúcar & Álcool (CNAA), one of the largest development loans ever raised for biofuels.  “With all this debate of food versus fuel, we are trying to demonstrate that there is no competition with food,” said Sylvia Larrea, the IADB officer in charge of the deal.

The IADB investment will finance construction of three ethanol refineries in Brazil’s interior by CNAA, a joint venture between Santelisa Vale, Brazil’s second-largest sugar-cane miller, and a group of US funds led by Carlyle/Riverstone and the Goldman Sachs Group.  The US-based funds have put US$350mn into the company so far, and plan to borrow about US$400mn more in addition to the IADB loan.

With new funding, CNAA will also acquire mechanical harvesters to eliminate most manual labour. Additionally, by burning leftover plant waste, the company intends to produce enough electricity to supply 400,000 homes.

Such second generation of electricity, that is using a plant’s waste output as well as sugar cane for input stock, increases overall productivity and cost efficiency to the extent that lending agencies now demand that new projects should include such features.  The World Bank’s IFC says it has lent about US$164mn for similar sugar cane ethanol projects.

The IADB was clearly highly adroit in carefully negotiating the hot debate among emerging market policy makers that the threat of over-investment in ethanol production will continue to push food prices beyond already historic highs.  Already, rising animal feed prices have put the US ethanol industry on the defensive.  According to the World Bank, about 75% of new corn production globally over the past three years has gone to make ethanol.

For now at least, local investor enthusiasm appears as strong as ever and has hardly been dented by the blow out within the industry in the US.  New ethanol plants cost about US$300mn each to build and can come on line and start to generate cash flow within one to three years after groundbreaking – a mere drop in the bucket compared to the timeframe and Capex requirements for a gasoline refiner.

Even beyond Brazil, ethanol projects – as well as a host of related alternative energy deals – have been popping up throughout Latin America.  “The entire Latin market is now very dynamic with investors looking at a lot of different energy projects – including first generation bio, second generation bio, wind generators, and hydroelectric plants.

To help all this along, both Brazil and Peru within the last six months were upgraded to investment grade by the rating agencies,” explains José Ramón Gómez, an analyst at the infrastructure and environment sector of the IADB.  “Today, most of Latin American is in the midst of a continued boom of investing in alternative energy.”
Latin ethanol based on science – not politics
Without doubt, the largest driver to the continued success of financing Latin biofuel projects is not one of idiosyncratic investor interest – whether JBIC, IADB, IFC or otherwise – but pure and simple science.  By contrast, the ethanol bubble in the US was not based in science, but may have been inflated in large part by the hot air of politics.  According to Tim Sklar, principal of Sklar & Associates, a South Carolina-based consulting firm specialising in project finance: “The main reason that the US ethanol industry has even developed to the point that it is at today is the simple US political policy to eventually reach a degree of energy independence”.

In a hysterical feeding frenzy fuelled by ever rising oil prices, the draw of a hot new market, and the weakest debt underwriting standards in decades, investors were all too quick to look over the basic maths of the US ethanol industry and how it was fundamentally different from Brazil.

“For investors, right from the outset, investing in ethanol production from sugar cane in Brazil was the right strategy and investing in corn-based ethanol production in the US was the wrong strategy,” explains Jorge Cantonnet, chief executive officer of New York-based Global Capital Networks and founder of Brazil Ethanol, a Delaware company with production operations in Brazil.

Cantonnet outlines the key factors explaining why financing the Brazilian sector is still alive and kicking, while the US sector is now nearly facing a bust.

•  Ethanol, like gasoline, is a global commodity.  Since there is zero brand equity, success in commodity production is based on producing it at globally competitive costs.  Brazil, with its ideal sugar cane growing climate and abundance of land, enjoys the world’s lowest production costs.  Over the last 30 years, producers have increased their productivity and efficiency due in no small part to a highly developed domestic market where some 80% of new cars sold are Flex Fuel Vehicles (FVV), which can take any blend of ethanol mixed gasoline.  The US industry, by contrast, is now staggering under the world’s highest and arguably one of the least developed end markets for ethanol.
•  Feed stock: the “energy balance” from sugar cane is about eight times greater than that of corn.  This means that for every unit of energy used to produce sugar cane -based ethanol, the end energy production in ethanol provides eight units of energy.  For corn, the ratio is only 1.3.  In other words, sugar cane-based ethanol is far more economical and energy-efficient.
•  Long-term upside scalability: the potential long-term market worldwide for ethanol will demand vastly more arable land resources devoted to ethanol-related crop production than what is being used today.  In the US, most all arable land is already producing corn and other cash crops.  Thus, in the US, there is a near term absolute upside limit to how much the ethanol market can grow.  By contrast, in Brazil, as less than 1% of arable land is now used for sugar cane production, there still remains has huge amount of expansion and development of a vast number of new greenfield projects.  In fact, there is so much excess unused land available in Brazil, that the local markets have not seen an appreciable rise in sugar prices despite the steady growth in ethanol production.
•  Vertically integrated and robust supply chain: in Brazil, the entire ethanol production cycle, from sugar cane production out in the fields to wholesaling to gasoline refiners, is usually fully vertically integrated within one holding company.  What this means is that the producers own and control the agricultural land and entire production of sugar cane itself – thus insulating themselves from the volatility of agricultural market forces.
•  Apart from a few farmer-owned ethanol cooperatives, US producers are entirely dependent of fluctuating corn prices and supply shortfalls – which adds that much more risk and volatility to the entire business model.
•  According to Sklar of Sklar & Associates: “the US ethanol supply chain is very inefficient and does not at all compare to the vastly more developed gasoline industry.  With ethanol, there are a web of suppliers, brokers, producers and buyers.  You have to pre-market all of these deals to the end user.  In doing that, you must line up all the parties and interests involved and have them all jointly participate in the project – if all of this can ever be accomplished”.
Smooth sailing for ‘08?
With the US industry now plagued by the threat of a domino effect of bankruptcies among ethanol producers, Brazil no doubt still presents a very strong fundamental case to offer investors.

Even the current hot talking point of the day within the global industry – the fate of protectionist trade barriers in the US – may have only limited long-term effects.  Presently, the US imposes a 54 cent per gallon import tariff on imports of Brazilian ethanol which are partially intended to protect the heavily subsidised and politically sacred constituents of US corn farmers.  However, on the other side of the coin are politicians looking to bring down energy prices at all costs, even if it means flooding the market with cheap imports.

Even if protectionism in the US tightens, Brazil still has a hugely developed domestic market to supply.  This market is set to grow at double digit rates given the explosive increase in new car ownership.  As recently as six years ago as Latin markets were still reeling form the affects of the Argentine debt default, and most new car purchases were for cash with limited opportunities for financing.  Today, auto financing at tenors stretching out to five years and beyond is readily available making private automobile ownership accessible to a bulk of Brazil’s enormous middle class.  Given soaring car sales, few analysts expect any near-term glut in domestic ethanol production.

“For now, all local production can be easily and fully utilised in local markets.  But, the Brazilian government is betting far above and beyond the local market and hoping that foreign markets, notably Japan, can increase purchases from Brazil,” explains Mauro Cavalcanti di Albuquerque, head of trade, export and commodity finance at Banco Santander.

Over the longer term, Albuquerque is cautious about predicting any limitless growth to the global market.  “The biodiesel production capacity Brazil is building will eventually outstrip local domestic demand.  We have many questions as to what extent international markets will support consumption of Brazilian ethanol.  How will political pressure from environmentalists affect demand, particularly in Europe?  How much more protectionist will the huge US market become?”