Coming down from a Sugar High

Last weekend the US men’s national team managed to tie England in their opening game at the World Cup–an impressive feat. In the nation’s capitol many Washingtonians opted to watch the match on two massive screens stationed in Dupont Circle, though I preferred the air-conditioned comfort of a friend’s house over the oppressive crowds, heat and humidity.

Although local commentators have focused on the increasing popularity of soccer in the US, the event’s sponsor, UNICA–the Brazilian Sugarcane Industry Association–was a far more interesting story. The move was part of an effort to raise awareness about the advantages of sugar ethanol–one of Brazil’s other key exports besides coffee, sugar, soybeans, beef, poultry and jogo bonito (the beautiful game).

The trade organization continues to tout the environmental benefits of sugar-based ethanol relative to the corn ethanol that prevails in the US market; according to an oft-cited report from the Woodrow Wilson Center, the Brazilian variety produces 8.2 times the energy that it takes to produce, whereas corn ethanol generates only 1.5 times the initial energy input.

A month and a half ago the Brazilian Chamber of Foreign Trade announced that it would eliminate the 20 percent tariff on ethanol imports through 2011. Brazilian producers, eager for a new export market, hope that the US will allow existing duties on imported ethanol to expire this year.

Readers of The Energy Letter and Elliott’s paid advisory The Energy Strategist are undoubtedly aware of Petrobras’ (NYSE: PBR) massive oil and gas finds in Tupi and other deepwater fields offshore Brazil.

But you might be surprised to learn that Petrobras Biocombustivel, a subsidiary of Brazil’s national oil company, purchased a 45 percent stake in Acucar Guarani–the country’s third-largest sugar producer after the May acquisition of Usina Mandu–for USD921 million in April.  

And this marked only one of several major deals that have occurred in the Brazilian sugar and ethanol space so far this year. Agribusiness giant Bunge (NYSE: BG) continued to boost its exposure to the sugar and ethanol business while divesting fertilizer assets, purchasing five sugarcane mills from the Moema Group. The mills have a total crushing capacity of 13.7 million metric tons.

Meanwhile, ethanol and sugar company ETH took over Brenco, a debt-laden rival. The combined company, ETH Bioenergia will have the capacity to produce 3 billion liters of ethanol annually by 2012 and generate 4 billion reals of revenue.

However, the proposed joint venture between Cosan Industria e Comercio (Brazil: CSAN3), one of the world’s largest sugar producers, and Shell International Petroleum, a subsidiary of Royal Dutch Shell (NYSE: RDS.A) is perhaps the most intriguing deal. This USD12 billion deal would leverage Cosan’s processing and production capacity with Shell’s downstream assets to produce a behemoth of the sugar ethanol industry.

This flurry of consolidation and foreign investment in Brazil’s sugar business is far from a new trend. In mid-2007, foreign capital held the majority share in 7 percent of Brazil’s sugarcane industry; by the end of last year, foreign capital controlled 44 of 430 mills, accounting for 14 percent of crushed sugarcane.

But should individual investors be sweet on Brazil’s sugar industry?

Going forward, fragmentation in the space offers plenty of opportunities for the biggest operators to grow market share by acquiring smaller players.

And adoption of sugar ethanol has occurred at a rapid pace since flex-fuel cars entered the Brazilian market in 2003; last year roughly 90 percent of new cars sold in Brazil could run on either ethanol or a blend of gasoline and ethanol. At present, it’s estimated that flex-fuel cars account for 37 percent of passenger vehicles in Brazil. Ethanol is readily available at gas stations throughout the country, though price still appears to be the biggest driver of consumption.

As ethanol consumption picks up both domestically and in the EU, that puts pressure on the amount of sugar available for food applications. Meanwhile, improved standards of living and higher household incomes in emerging markets will continue to increase global demand.

Last year demonstrated just how easily conditions can tighten in the global sugar market. After inclement weather in both Brazil and India–the world’s top two sugar producers–constrained supplies, sugar prices shot through the roof.

In January the price of raw sugar touched USD0.29 per pound, the highest level in 29 years. In recent months prices have retreated substantially in anticipation of a strong growing season for Brazil, India and other key producers.

But international sugar stocks remain at historically low levels; for example, analysts expect China to import more than 1 million tons of sugar in 2010 after the government auctioned off 800,000 tons of strategic inventories in an effort to combat inflation.

Still, the sugar story can be a bitter pill to swallow, especially for “green” investors that buy into the environmental advantages of sugar ethanol and overlook the inherent volatility of international sugar markets. Remember, the sugar industry’s fortunes are subject to Mother Nature’s whims; investors should be prepared to stomach price volatility. Allocating money to the sector when the supply situation tightens also makes sense.

Agricultural outputs account for a quarter of Brazil’s gross domestic product and roughly 40 percent of its exports. China became a net importer of corn for the first time last year, and a shortage of land, water and agricultural labor in the country’s rural areas suggest that it will increasingly rely on imports to feed its population. This trend, coupled with robust domestic demand and an extended growing season, bodes well for Brazil’s agriculture industry.

To profit from this story, as well as emerging opportunities in Russia, investors might consider suppliers of agricultural machinery such as AGCO Corp (NYSE: AGCO) or CNH Global (NYSE: CNH). Both companies stand to benefit from increased sales to Brazil and in Russia, and the stocks are easy for US investors to buy.

Those looking for local exposure should take a look at All America Latina Logistica (Brazil: ALL11); its rail network serves an area that accounts for 68 percent of the Mercosur (a trading bloc whose full members include Argentina, Brazil, Paraguay and Uruguay) and includes seven of the eight most active ports in Brazil and Argentina. All America Latina Logistica transports a great deal of the region’s agricultural exports on its rails.  

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