UPDATE 2-BP to fund Martek research on biodiesel

* BP to fund $10 million for initial phase

* Deal latest tie-up of an energy giant, biofuel maker

* Martek yet to find microbe for sugar conversion (Updates with stock move, industry background, additional deal details, analyst comment, byline)

By Ernest Scheyder

NEW YORK, Aug 11 (Reuters) - Oil giant BP Plc (BP.L) and Martek Biosciences Corp (MATK.O) are forming a partnership to study the use of algae to convert sugar into biodiesel, the companies said on Tuesday.

The deal is the latest in a series of research agreements between multinational energy companies and start-up alternative fuel makers as the industry looks for ways to diversify its supply base.

If successfully commercialized, the BP-Martek tie-up will let both companies use algae to turn biomass refuse, such as sugar cane and wood chips, into biodiesel that can be used to power vehicles or further refined into cosmetic or pharmaceutical applications.

The challenge for Martek is to find algae or related microbes that will convert biomass into fuel. The company does not currently have a microbe strain that performs that function.

"It's going to take a lot of work to get the right organism," Steve Dubin, Martek's chief executive, told Reuters.

Converting biomass to fuel is an expensive venture, and finding the right microbe could potentially help lower costs.

London-based BP will initially contribute $10 million to the project, and Columbia, Maryland-based Martek will conduct the research and development.

"As an alternative to conventional vegetable oils, we believe sugar-to-diesel technology has the potential to deliver economic, sustainable and scalable biodiesel supplies," Philip New, the chief executive of BP Biofuels, said in a statement.

Each company will retain intellectual property rights owned before the partnership. BP will own the rights to any research conducted during the partnership, though Martek will have an exclusive license to commercialize the research.

While the deal is promising, DA Davidson & Co analyst Timothy Ramey said it resembles a "man on Mars" proposition simply because Martek does not yet have the technology to convert biomass to biofuel.

"Is this a new business? The answer is no," said Ramey, who rates Martek's stock "underperform."

Patents and supply contracts for many of Martek's products expire in 2011, so the company need to find new sources of revenue, he said.