by Tony DAltorio Friday, February 5, 2010 Natural Riches

by Tony Daltorio, Investment U Research

Friday, February 5, 2010

With its newly announced partnership with Cosan ADR (NYSE: CZZ ), the world’s third largest sugar producer, Royal Dutch Shell (NYSE: RDS.A ) has taken a bigger step into biofuels than any oil major has ever attempted.

The $12 billion joint venture into ethanol includes about 75% of Cosan’s assets, including its sugarcane processing mills, co-generation power plants, ethanol trading company and 2 billion liters of annual ethanol production capacity, which just happens to be the second largest amount in the world.

In return, Shell will pay $1.62 billion for a half-stake in Cosan’s core asset base, contributing an additional 2,740 gas stations and other fuel distribution assets in Brazil. Those measures guarantee control of 4,500 stations in the Latin-American country and makes Shell-Cosan its third largest fuel distributor.

So even though other formidable oil companies like BP PLC (NYSE: BP ) and Petrobras, and commodities trading companies like Bunge (NYSE: BG ) have already ventured into the Brazilian ethanol industry, Shell and Cosan still have plenty of room to thrive and profit.

A Well Made Match

Cosan is the fifth largest ethanol producer and one of the world’s leading ethanol exporters, in addition to the nearly 60 million tons of sugar it processes per year. And as I mentioned back in July. it really made out in the wake of India’s dreadful sugar crop and rising global demand.

The company picked a good time to monetize its assets, clearing part of its $2.5 billion net debt as it did. And while the deal with Shell won’t immediately add to its existing sugar cane capacity, it does give it an immediate, deep-pocketed partner right when many of its rivals are vulnerable to takeovers.

Shell profits just as much from the partnership. It already has contributing stakes in Iogen and Codexis, two companies actively involved in producing fuel from non-food crops. But with second-generation biofuels still years away from practical production, sugar cane ethanol continues to stand out as the greenest alternative, emitting 90% less greenhouse gases than gasoline.

It’s also one of the most profitable and could bring in even more revenue in the future if western governments impose even tighter emission standards. So while ethanol only accounts for 7% of total, global gasoline demand right now, it should rise rapidly in the years ahead.

And Shell now has easy access to the business.

Shell and Cosan’s Vision

The venture combines Shell’s vast global distribution network with Cosan’s production capacity, a combination they hope will more than double ethanol output from 2 billion liters per year to 5 billion through organic growth and takeovers.

Of course, as with any other business idea, there are obstacles in the way, including U.S. and European trade barriers that get in the way of Shell and Cosan’s goal of global exportation.

So they plan to focus on Brazil for now instead, where their retail fuel network demands 3 billion liters of ethanol annually, a full billion more than Cosan can produce alone. It’s a huge market for biofuels, since 90% of all new vehicles have flex fuel engines that run on gasoline, ethanol or any mixture of the two. Naturally then, demand for ethanol has increased 15% — 20% annually since 2003.

The two companies should succeed in their global schemes too, eventually fueling more than just automobiles. For example, Brazil just opened the world’s first ethanol-fueled power plant with the help of Petrobras ADR (NYSE: PBR ) and General Electric (NYSE: GE ). And it’s in talks with Japan to develop biofuels power generation over there as well. Those markers of the changing times indicate increased demand for Shell and Cosan down the road.

In fact, as long as the world depends on first generation biofuels, Brazilian ethanol should remain the most sustainable and the most commercially viable. And Shell’s commitment to that field could eventually pave the way for second-generation fuels. When that happens, Brazil will doubtlessly continue as the world’s lowest-cost producer of biomass and an extremely relevant player in the game.

Shell and Cosan have situated themselves perfectly in a country that shares their goal of becoming a major ethanol exporter. That placement, along with their individual and combined skills, puts them in an ideal situation going down the road into a green future.