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SAO PAULO/LONDON (Reuters) - Brazilian sugar cane mills are vulnerable to a wave of takeovers in which deep-pocketed groups devour fragile neighbors, while soft sugar and ethanol prices weaken small mills and make building new ones too costly, industry analysts said.
Although efficient smaller mills will survive, more of the world's sugar production is likely to fall into the hands of large traders such as Bunge (BG.N), Cargill CARG.UL and Louis Dreyfus LOUDR.UL. Oil companies including Brazil's Petrobras (PETR4.SA) and traditional sugar giants such as Cosan (CSAN3.SA) and France's Tereos TERI3.SA will also expand by way of mergers and acquisitions of smaller rivals.
Newcomers may also enter the Brazilian cane business, albeit late, as the industry positions itself for Asian-driven growth in sugar demand.
"I anticipate consolidation," Leonardo Bichara Rocha, a senior economist with the London-based International Sugar Organization (ISO), said. "The least efficient mills are not crushing enough to pay off their debt."
In stark contrast to the boom years leading up to 2008, roughly 41 of the center-south's 380 mills have been closed -- 30 in the past year and a half, the leading labor union Forca Sindical said. Roughly 45,000 jobs have been lost, and some mills may never reopen, since opening would only dig them deeper into the financial hole they are in.
The closed mills are selling their cane to bigger neighbors to generate cash without incurring operating costs, which larger mills are better able to dilute. At least a dozen mills are looking for buyers or partners, leaders in the sector said.
After the 2008 credit crisis, many cash-strapped mills cut back on costly replanting, which has returned to haunt the industry with eroding yields. Drought over the past two years has exasperated the problem, saddling mills with a record idle crushing capacity of 20 percent. Brazil's main center-south cane region harvested roughly 495 million metric tons (545.64 million tons) in 2012/13, but has sufficient capacity to crush around 620 million metric tons, a situation that has inflated mills' operating costs.
The sector's fragility has induced the big groups such as Louis Dreyfus's Biosev, Brazil's second-largest milling group, to raise capital for expansion.
Arnaldo Luiz Corrêa, head of local commodities consultant Archer, said the cane sector carries debts of roughly $21 billion (42 billion reais) with half of all mills facing some financial or cash-flow problem.
The sector is already highly concentrated. The ISO estimates the top 25 milling groups now crush more than 53 percent of Brazilian cane.
Mills will have to be more competitive. The emergence of bigger groups has already altered how the sector secures financing, which used to come from multinational trading firms.
Now big mills get direct credit lines from banks, which has also changed the game plan for commodities traders. Cargill, Bunge, Louis Dreyfus, Olam and others have started to buy up mills to maintain their share of the sugar business.
"Consolidation will be driven by the super farms, or very large groups, which will enjoy special negotiating power due to their scale and strong cash generation," lead commodities analyst Giovana Araujo at local investment bank Itau BBA said.
But Araujo said consolidation would have limits. Takeovers will tend to occur in the vicinity of a large group's existing operations, in what are called clusters, to keep costs down.
"Many small mills will continue to exist," she added.
The fragility in the sector has opened the door for late-comers to the Brazilian sugar cane business. During the peak of investment prior to 2008, companies were paying as much as $135 per tonne of crushing capacity for mills. Recently built mills crush between 3 million and 6 million metric tons.
Prices have come so far off their highs that potential buyers have remained largely on hold to get a better sense of the current market value of potential target mills.
Asian commodities trader Olam made one of the only acquisitions this year when it bought the 1.75-million-metric tons Usina Açucareira Passos sugar mill in Minas Gerais, a source close to the deal said, adding that the company paid just less than $130 million, or close to $75 a metric ton.
"It's clearly a buyers market," said Wilson Lucas, president of real estate classifieds MFRural, which lists a dozen mid-sized cane properties for sale.
For now, mills are focused on replanting fields to boost cane output and to return yields to optimal levels.
The ISO's Bichara Rocha said growing Asian demand for sugar is a strong incentive to invest in crush capacity.
China surprised markets by becoming one of Brazil's leading buyers of sugar over the past year, and increasing middle-class demand from other emerging markets will likely drive investments in sugar capacity going forward.
This is an about-face from the industry's preference for ethanol capacity only a few years ago. Sugar cane is the feedstock for both Brazil's sugar and ethanol industry.
Sugar production offers the best returns for mills, even though demand remains weak due to a global sugar glut of nearly 5 million metric tons. Prices are expected to fall further after slipping 40 percent from a 30-year high posted in February 2011.
The increased cost of sugar production due to poor yields as well as surging labor and equipment costs in recent years created opportunities for origins such as Thailand, Australia and Russia to increase output.
The 21 percent gain of the dollar against the real since March, which has boosted mills' export revenues in local currency terms, has been one of the few bright spots for mills.
Analysts estimate average local sugar production costs for existing mills at 19 to 20 cents a lb, but with the closing of the idle capacity gap this should fall to 17 to 18 cents and restore Brazil as the world's lowest-cost producer. ICE benchmark raw sugar futures are trading at around 22 cents a lb.
The government continues to cap gasoline prices at the pump, which has squeezed nearly all profit from cane mills' ethanol operations, and it shows little sign of change.
Analysts estimate building a new mill from scratch, which is known as a greenfield project, would require sugar prices at 25 cents a lb for an extended period. But expanding existing mills still makes financial sense.
One of Brazil's biggest ethanol producers, ETH, which has only modest sugar production capacity, posted a 790 million real ($350 mln) loss in the most recent quarter.
"The mills that bet all their chips on ethanol are going to have to come back to the table and put up more money to build sugar capacity if they want to survive," an executive at a multinational sugar trader with mills in Brazil said.
Writing by Reese Ewing; Editing by Jim Marshall and Maureen Bavdek