* Investment picks up in expansion of big sugarcane mills
* Growing crops to exceed current crushing capacity by 2015
* Government steps help ethanol producers, make biofuel competitive
By Reese Ewing
SAO PAULO, Feb 11 (Reuters) - Brazil's big sugarcane mills have begun to invest in ethanol production again, after licking their wounds from years of slim margins, as an expanding crop and favorable government policies brighten the horizon for the biofuel.
The world's largest sugarcane industry is still fragile, but a record cane crop is swelling in the fields nearly ready for harvest, which will improve mills' profit margins by spreading costs over a bigger stream of revenue.
"Just a little more cane, and the industry's cup will be entirely full," Carlos Eduardo Cavalcante, director of the bioenergy department at the BNDES development bank that funds much of the sector, told Reuters. Cane will surpass crushing capacity by 2015, he said.
Brazil will without a doubt produce more sugar and ethanol with its next crop, analysts say, but weak prices and limited capacity for producing the sugar will force mills to devote a greater share of the crop to ethanol.
That could provide some relief to Petrobras, Brazil's state controlled oil company, which has faced heavy losses on spiraling demand for imported gasoline as consumers avoid high cost ethanol.
Brazil's ethanol sector started aggressive expansion almost a decade ago amid euphoric prospects for the biofuel with the launch of the flex-fuel car that could burn ethanol, gasoline or any mix of both.
But the heavy debts mills took on in the race to grab a share of this growing market left them financially vulnerable and the advent of the 2008-09 credit crunch left many mill owners insolvent, forcing them to sell out to larger, more cash-flush multinational commodities and oil companies.
Mills cut investment in renewing cane plants as they tried to get back on their feet financially, hitting output as yields from ageing cane dipped. But a wave of replanting backed by government-subsidized credit is boosting output. And aggressive replanting campaigns are now putting the sector back on its growth trajectory.
In addition, the government's decision to raise fuel prices last month and increase the mandatory blend of ethanol in gasoline will help increase demand for the biofuel at home.
Ethanol and gasoline compete for the same market of light vehicles using the flex engine whose owners opt for one fuel or the other depending on the price differential. Ethanol once held half of this market but poor cane crops and higher ethanol prices reduced that share to about 30 percent at present.
Currently, ethanol is a more economical buy for motorists in only Sao Paulo, Parana, Mato Grosso and Goias of Brazil's 26 states.
The growing U.S. market for advanced biofuels should also soak up some of the expected rise in output in Brazil, the second largest ethanol producer after the United States.
But the local sugar and ethanol industry, which will soon exhaust its crushing capacity, is behind in a race against the rapidly expanding cane crop. The crop is due to rise by 8-to-10 percent to a record roughly 650 million tonnes this harvest.
Too little cane, as the industry saw in the past couple of harvests, is far more damaging to profits than too much. Market fundamentals drive down the price of cane when it is in oversupply, which helps lower mills' raw materials costs.
CONSOLIDATION AND EXPANSION
Liquidity problems, stemming largely from the global financial crisis that caught the industry over-leveraged from its expansion, forced more than 40 mills to shut down over the past few years. This took more than 30 million tonnes off Brazil's 690 million tonne crushing capacity.
But big milling groups with access to financing have improved their vantage for growth by expanding existing plants or acquiring other facilities over the past year.
For now, most of the 15-odd recently announced investments are aimed at adopting state-of-the-art cellulose ethanol technology in large-scale commercial mills, the BNDES said.
Cellulose ethanol remains still only a laboratory success and is not yet commercially proven, but the second generation technology could lead to a 30-40 percent rise in ethanol output from the same volume of cane and help mills win higher prices for the biofuel produced from cellulose of the left over cane known as bagasse.
Currently, RINs - credits issued to U.S. importers and fuel blenders - for cellulose ethanol are being quoted at just under 80 cents a gallon, nearly twice the value of regular Brazilian cane ethanol which occupies almost all of the U.S. advanced ethanol market.
Brazil exported nearly 2.5 billion liters of ethanol to the United States in 2012, almost 50 percent more than in 2011 thanks to the EPA's renewable fuels mandate.
The expansion coming down the pipe in Brazil's $50 billion sugar and ethanol sector should lend some support to the weak investment and industrial activity that has plagued Latin America's largest economy of late. The overall economy has been languishing at just over 1 percent growth for over a year now.
Brazil's largest sugar and ethanol producer Cosan announced it would invest in next generation ethanol technology at eight of its plants through 2024.
The company posted a 265 percent jump in its net quarterly profit on Wednesday night due to the bigger cane crop that finished crushing in December.
The Cane Technology Center (CTC), GraalBio, CMAA and ETH Bioenergia all announced bigger investments in new ethanol technologies, cane area expansion and plants in the past weeks.
Brazil's BNDES opened up its annual 4 billion reais ($2 billion) in financing for the cane sector to foreign groups, which now make up more than 40 percent of crushing.
George Soros' Adecoagro was one of the first foreign capital firms to tap the credit line for 488.6 million reais ($245 million) when it announced in January it would build a new greenfield mill in Mato Grosso do Sul.
Dow Chemical and Mitsui are also moving ahead with their cane mill - the only other greenfield project in the works. New greenfield projects are still very rare. Most investments are in expansion, or so-called brownfields.
GOVERNMENT TO THE RESCUE
The turnaround in investment in new crushing capacity is not a result of strong sugar and ethanol prices, mills' principal breadwinners, president of local sugar and ethanol analysts Datagro, Plinio Nastari, said.
At just over 18 cents a lb, sugar futures prices are below the average production costs in Brazil, he said.
The gasoline price increase by Petrobras at its refineries has meant a modest 4 percent hike at the pump, not enough to justify investments in ethanol. Brazilian gasoline prices are still estimated to be at least 10 percent below international prices, which makes it hard for ethanol to compete.
But the government decision to raise the mandatory blend of ethanol in gasoline back to its maximum 25 percent, the first time in over a year, will create additional demand for 1.9 billion liters of the fuel.
State governments such as Rio de Janeiro and Minas Gerais also created tax incentives for investment in ethanol.
And Mines and Energy Minister Edison Lobao said the government is studying a cut in the PIS/Cofins tax on ethanol to help improve the fuel's competitiveness.
The government has also reversed a 6 percent IOF tax on medium-term trade financing introduced in March 2012 that had choked off a vital source of capital that mills used for investment and working cash.
"The positive effects of this reversal are already apparent," said Andre Passos, a partner at Passos and Sticca Attorneys, which represents some of Brazil's biggest agricultural and commodities groups.
"Multinationals have better easy access to cash." (Additional reporting by Fabiola Gomes; Editing by Anthony Boadle and Phil Berlowitz)