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ALTERNATIVE ENERGY
Ethanol Tariff Loophole
Sparks a Boom in Caribbean

PORT OF SPAIN, Trinidad -- Surrounded by ramshackle watermelon stands and burning sugar-cane fields, Texas oil man Ron White shows off the site for his next big investment: a planned $20 million ethanol processing plant. His company, EthylChem Ltd., is just one of a rush of new Caribbean enterprises trying to serve the suddenly booming U.S. ethanol market.

These biofuel entrepreneurs won't actually make ethanol from Caribbean sugar cane, even though sugar makes the best base for the fuel. Instead they'll just import it from ethanol powerhouse Brazil, and process it here. Then they'll try to cash in on the islands' sweet tariff status: an exemption from a 54-cents-a-gallon U.S. tariff on ethanol processed anywhere else. "Avoiding the tariff -- that's the economics of our business," says Mr. White.

As President Bush meets Brazil's president, Luiz Inácio Lula da Silva, today in São Paulo to promote a loose alliance to encourage more production of ethanol and other biofuels, the Caribbean ethanol industry illustrates how U.S. energy policy and trade policy can stand at odds.

A top energy priority of Mr. Bush is to end a U.S. "addiction" to foreign oil partly by encouraging alternative sources such as ethanol, which can be made from sugar, corn or other agricultural products. (See related article on page C5). But the U.S. tariff, which Mr. da Silva has been lobbying unsuccessfully for Washington to remove, damps the supply in order to protect prices for U.S. corn growers in Farm Belt states.

A tortured route around the tariff goes through the Caribbean Basin. There, two dozen small countries are exempted as part of a 24-year-old trade agreement from near the end of the Cold War, designed to combat communism by feeding the U.S. dollar into their poor economies. Even that tariff exception -- which requires entrepreneurs like Mr. White to jump through legal hoops while risking losses from volatility of supply and demand in Brazil and the U.S. -- is under attack.

Jamaica is home to more and more ethanol installations. Above, storage tanks and, inset, cooling towers at an ethanol plant in Kingston harbor run by ED&F Man of London.

U.S. farm-state lawmakers want to close the loophole. Sen. Charles Grassley of Iowa, the ranking Republican on the Senate Finance Committee, last year accused a Trinidad ethanol business of unfairly harming U.S. farmers. Last week he asked the president in a letter to refrain from using taxpayer dollars to encourage foreign ethanol production, as intended by the planned agreement with Brazil, the second-largest ethanol producer after the U.S.

Caribbean ethanol businesses also are in some danger from the opposite camp, which wants to drop ethanol tariffs generally. That would wipe out the Caribbean advantage. Mr. Bush's brother, former Florida governor Jeb Bush, has forged a coalition of American and Brazilian ethanol interests called the Inter-American Ethanol Commission to lobby to drop the tariff. At times Mr. Bush and his cabinet members have indicated interest, though given the farm-state objections it's unlikely to be removed any time soon.

In a world without trade barriers -- and trade politics -- Brazil would be ethanol king, and the U.S. would be importing Brazilian fuel far more heavily, stoking production further in turn. With efficient sugar-cane production and chemical processing, Brazil can produce ethanol for as little as 80 cents a gallon, less than half the price of U.S. ethanol producers, who mainly convert corn to make the fuel. Sugar cane is a better raw material for ethanol because it ferments more quickly into alcohol. But the 54-cent tariff, on top of the cost of shipping to the U.S., wipes out much of the price advantage. There are exceptions: In the summer of 2006, the U.S. price spiked enough that Brazilian producers that reacted quickly made money exporting large quantities to the U.S., despite the tariff.

Encouraging more imports of foreign ethanol would drive down prices and likely boost the American market further. While the 54-cent tariff early on encouraged the U.S. domestic industry, now it has become counterproductive, contends Robert Howse, a trade expert at the International Food & Agriculture Trade Policy Council, an advocacy group sponsored largely by agricultural companies. "If we wanted to achieve the energy goals in the U.S. we would disassemble a lot of the protectionist policies," he says.

The Caribbean sugar industry is so antiquated that it can't produce the fuel competitively from its own cane fields. Instead, Caribbean companies take on a middle step in the production process: They dehydrate the ethanol from its original state, then ship it to U.S. refiners, which add gasoline to make the fuel useable in American cars.

The dehydrating meets the U.S. requirement that products be "substantially transformed" in Caribbean Basin countries, if they don't originate there, to escape tariffs. Such techniques to satisfy trade rules often are controversial: In the 1980s and 1990s, Caribbean Basin countries ran afoul of U.S. apparel makers when they started finishing low-cost apparel from Asia and sending it on to the U.S., skirting trade barriers aimed at the Asian products.

U.S. farm-state lawmakers like Sen. Grassley say that merely siphoning water from ethanol shouldn't qualify Caribbean firms for tariff breaks. "It's subterfuge," he says.

The Caribbean tariff exception originates in a Reagan Administration agreement called the Caribbean Basin Initiative in 1983, between the U.S. and most countries with Caribbean coastline, plus El Salvador, not geographically in the Caribbean Basin but seen then as vulnerable to communism.

Nations in the group were awarded incentives to increase local production of ethanol and given duty-free access to the U.S. equal to 7% of the U.S. ethanol market. That trade preference is currently worth $600 million. A U.S. International Trade Commission study says that ethanol was Jamaica's leading export to the U.S. under the initiative in 2004, the most recent year for which those data are available.

As the U.S. appetite for ethanol grows, and total consumption swells, so will the volume of Caribbean exports that can enter the U.S. duty-free. This year, the 7% rule means the nations in the agreement can export about 350 million gallons of dehydrated ethanol duty-free. Next year that's estimated to grow to 420 million gallons. If the U.S. manages to meet President Bush's goal of using 35 billion gallons of alternative fuels, up from six billion gallons last year, the Caribbean Basin nations' 7% slice would probably top two billion gallons.

So investors are lining up at Caribbean Basin ports. In Trinidad, Angostura Ltd., better known for its bitters and rum products, started processing ethanol in 2005. In El Salvador, U.S. agricultural giant Cargill Inc. is producing the fuel as part of a joint venture. In Jamaica, two ethanol processors are up and running, with two more ready to start production this year. Another is trying to line up backing from U.S. venture capitalists. In Haiti, an idled ethanol dehydration plant has attracted renewed attention. Projects also are in the works in Guyana, the Dominican Republic and Aruba.

So many players are entering the Caribbean market that the ethanol exporters may produce more than the duty-free allotment -- meaning some shipments would have to pay tariffs after all. "The Caribbean is heading to 397 million gallons" capacity this year, or almost 50 million gallons above the estimated cap for 2007, warns Jeffrey Tuite, managing director of London-based ED&F Man Holdings Ltd., which operates an ethanol dehydrator outside Kingston, Jamaica. "We're looking at a quota race. Then it will be first come, first served." In 2006 about three-quarters of the fast-rising quota was produced, up from less than half in recent years.

Smart operators can do extremely well, especially if they time market swings properly. But that's no simple task. Despite the bravura of the dehydration crowd, fat profits are hardly guaranteed, given price fluctuations in energy markets. "We've always referred to [Caribbean] plants as 'fireflies,' for the way they turn on and off whenever the price window fails to open in their favor," says Manfred Wefers of Coimex Trading Co., one of Brazil's largest ethanol traders. Demand for ethanol is so strong in Brazil that no more than 20% of the fuel production is exported, and sometimes at prices that are too high for Caribbean dehydrators to make any profit. On the other end, sometimes the U.S. price rises so high Brazilian producers can make a profit bypassing the Caribbean step.

Along a seafront highway east of Kingston, a relic known as Jamaica Ethanol Processing Ltd., which is ED&F Man's subsidiary on the island, has made money despite relying on ancient equipment. Some of the storage tanks, originally built to hold petroleum for Royal Dutch Shell, are still clad in brick masonry, a defense rushed into place against Axis submarine missions in the 1940s. The boilers were built in the 1980s, but look a lot older as they sputter and squirt steamed ethanol through creaking pipes. The little plant employs 30 people to run round-the-clock shifts dehydrating "wet" ethanol, mostly from Brazil.

The business works, managing director Erwin Jones says, because the company has learned to lock in prices for "wet" ethanol when it's cheap, and pounce on opportunities to ship far from Jamaica when the price of dehydrated ethanol spikes.

On the southern tip of Trinidad, Angostura's ethanol subsidiary, Trinidad Bulk Traders Ltd., wasn't profitable last year -- because its 50-million-gallon-a-year dehydration plant couldn't get enough fuel from Brazil. But Curtis Mohammed, an Angostura general manager, says he's confident of profits this year, and is doubling annual capacity. He says the revenue generated from the ethanol business will be funneled back into Angostura's rum business, which has taken a hit in recent years from increased prices for raw materials like molasses.

EthylChem's Mr. White says the years he spent calculating risk as a sales representative for Exxon Mobil and other refiners should help in the ethanol business -- although sometimes his calculations worked out poorly. In 1999, he became president of Global Octanes Corp., a small Texas company that manufactured methyl tertiary-butyl ether, called MTBE, which oil refiners were using at the time to reduce air pollution and comply with environmental regulations. It looked like a growing business -- until MTBE was discovered to contaminate ground water. Global Octanes folded in 2003, after California banned MTBE, and in 2005 Congress failed to give liability protection to its refiners, effectively ending the business. Mr. White took a course to become an insurance salesman.

Before he started going door-to-door, however, the 62-year-old entrepreneur met Patrick Johnson, a Texas businessman familiar with the Caribbean ethanol business, which was getting a boost from the failure of MTBE. He joined Mr. Johnson's EthylChem on Trinidad, whose economy is built on petroleum, natural gas and petrochemicals. Trained labor was abundant, as was the energy to run an ethanol dehydration plant.

The pair cobbled together a small number of investors from Trinidad and the U.S. and hired a Houston investment banker to scour for more funds. They found a Trinidad bank willing to kick in construction financing and are working on a deal with a second bank overseas. Mr. White is telling investors they can expect returns on investment of between 30% and 50% when the initial debt is paid down. He figures he can reduce the risk of not getting enough Brazilian supply, if necessary, by reversing the business model and charging Brazilian producers to dehydrate their ethanol and avoid the tariffs, without EthylChem buying the fuel.

In 2004, Petrojam Ltd., Jamaica's state-owned oil company, put together a joint venture with Brazil's Coimex Trading to process ethanol for the U.S. market. At the time, Petrojam executive Winston Watson recalls, ethanol was selling for about $1 a gallon in Brazil and U.S. buyers were paying between $2 and $2.20 a gallon for dehydrated fuel. "Our break-even number was about $1.50 or $1.60," says Mr. Watson.

But last year, Brazilian ethanol export prices soared to $1.60 a gallon as Brazilian ethanol makers fed their growing domestic market for flex-fuel cars, which can run on either gasoline or ethanol. At the same time, the U.S. purchase price for dehydrated ethanol dropped below $2 a gallon, as American ethanol makers improved productivity. "We didn't lose money," Mr. Watson insists, but acknowledges that the plant still isn't running at full capacity.

Ultimately, says Karl James, chairman of Jamaica's Petrojam Ethanol Ltd., and leader of that country's Sugar Industries Association, Caribbean producers must learn to produce ethanol from the abundant sugar cane on the islands, either for the U.S. or other energy-thirsty markets. But few Caribbean players are in any position to convert sugar production to capitalize on ethanol.

In many parts of the Caribbean, the sugar-cane industry is rotting. The governments of Trinidad, St. Kitts and Barbados have already decided the sugar sectors of their islands are not worth further investment. They'd rather use their islands' limited land for tourism and retirement real estate, figuring that even with the booming ethanol demand, there isn't enough growing space to make modernizing worthwhile. Rum distillers like Trinidad's Angostura and Jamaica's Appleton Ltd. now reach all the way to Fiji for molasses to import for their spirits.

But Angostura's Mr. Mohammed wants to encourage sugar-cane production in the Caribbean Basin in Guyana. And Jamaica hopes the sale this year of five government-owned sugar-cane estates will lead to a renewal of the sugar business there for ethanol production. Authorities are encouraged that among the prospective bidders at this summer's auction are Brazil's Coimex Trading and India's Dhampur Sugar Mills Ltd., both big ethanol traders.

Write to Lauren Etter at lauren.etter@wsj.com¹ and Joel Millman at joel.millman@wsj.com²