Vertical Integration

Vertical integration is a time-honored strategy in the oil and gas industry, though for the last couple of decades it has operated in more of a virtual, rather than physical mode. Oil producers sell mainly into the open market, and the refineries of integrated companies buy as much or more from third-party suppliers as from their own affiliates, and then ship their products in fungible pipelines, with brand identity deriving from the additives with which the fuel is dosed at the distribution terminal, rather than any notion of continuous custody of molecules from well to pump. Various factors have prevented alternative fuels such as ethanol from attaining this highly-evolved state, and that makes the acquisition of Exxon Mobil's Esso marketing network in Brazil by Cosan Ltd., a large Brazilian ethanol producer, all the more interesting. Call it convergence or an example of parallel evolution; this is a notable signpost of the growth of biofuels and the diversification of the global liquid fuel system.

There are many reasons why a producer might want to integrate into the distribution and marketing of its products, and they vary with the conditions of the market in which it operates. The relatively recent integration of the leading US refiner Valero into branded marketing probably had more to do with gaining access to a less cyclical and non-correlated source of profit margins than with any concern that it would be unable to sell its output into the market. From the account of the Cosan/Esso Brasileira transaction in this morning's Wall St. Journal, however, the impetus for this deal seems to be one that would have been well understood by the founders of today's major oil companies, who operated in a similar period of rapid market growth, product oversupply, and cut-throat competition in this country.

Despite frequent and sometimes breathless comparisons to the success of ethanol in Brazil, the US produces more ethanol from corn than Brazil does from cane: 6.5 billion gallons last year, compared to around 5 billion. But the critical difference is that, while ethanol in Brazil enjoys a much higher share of the domestic motor fuels market, there is also a surplus, leading to substantial exports to the US and other countries. Producing ethanol from sugar cane in the tropics is so efficient that Brazilian ethanol can, without any government subsidy, overcome the $0.54/gal US ethanol import tariff--a necessary element of our domestic ethanol subsidy structure. That means that ethanol producers in Brazil must compete aggressively to supply the domestic retail fuel market controlled by Petrobras, Ipiranga, Shell, Chevron's Texaco brand, and Esso.

Buying Esso's marketing and distribution network should provide Cosan with a dedicated outlet for its entire 330 million gallon per year ethanol output. However, the world has changed since the days when energy companies regarded their marketing arms as a mechanism for locking in upstream profits--a means of "disposal". Cosan is effectively buying an option that it will choose how to exercise every day, pushing its product into its own stations or buying from other producers and continuing to export to other markets. Whether local marketing margins are low or high, it will be able to optimize around its new value chain and enhance the profitability of its core sugar cane business.

Some will wonder whether this deal foreshadows a future move by a US ethanol producer to build or buy its own retail network, to push E85 into this market. It's possible, but while corn and cane are similar in each having other uses besides fuel production, cane ethanol's much larger energy surplus makes it a valuable energy source, like crude oil, rather than just an energy extender. Corn ethanol is a margin business that hinges on the "crush spread" between a lively commodity market for corn and the mandated, subsidized use of ethanol by gasoline blenders. Efficiency and scale are its key drivers, and that's reflected in the merger of VeraSun and US Biofuels. For now, at least, horizontal integration and consolidation, rather than vertical integration, looks like the trend to watch here.

Note: I have a financial interest in one of the companies mentioned today, Chevron, and none of my comments should be construed as investment advice.