Reference no: EM133416246

Greenergy

A biodiesel arbitrage opportunity

This case was written by Jorge Romero-Day, and it is based on a true story. For confidentiality reasons the actual names, and some geography data, have been disguised.

The biodiesel markets have been flourishing over the years due to the search for a renewable and more sustainable liquid transportation fuel. Most countries with strong agricultural and oilseed industries have developed parallel industries that produce biodiesel from refined oilseeds, recycled cooking oil, and other materials. These are then mostly blended into refined petroleum diesel. Depending on the country this mix can go from 10 up to 50%. In certain cases, it can also be the sole energy source of the final product

Some agriculturally based developing countries are net biodiesel exporters to where major demand occurs. For biodiesel, the main markets are the European Community (EC) and North America. These regions tend to have their own industries, but they need additional imports to meet renewable goals, as well as legally mandated renewable standards. Argentina as the major oilseed exporter in the world, has a robust biodiesel industry oriented towards exports. On average 70-80% of production is exported, and the EC in 2009 was its main market.

In 2010 the EC decided to ban Argentina biodiesel imports enforcing its antidumping regulations. This was based on the fact that government tax incentives in Argentina in effect subsidized biodiesel production. The EC measures were implemented to protect its domestic biodiesel manufacturers from unfair competition. Argentina has appealed this decision, but it is known that a resolution, even if favorable, will take several years, and no less than 3.

Clark has been an executive for multinationals developing and managing overseas businesses, mainly in Latin America. Adonis was an owner and managing partner of one of his main customers. Through several commercial interactions they developed a friendship that transcended the business relationship. As their professional paths separated they lost contact in 2001.

In 2009 Clark and Adonis crossed paths again in Ecuador where they both have professional interests. Ecuador happens to be one of Clarks new frontier markets for the German multinational business he was developing at the time. Clark and Adonis did not have a possibility of a commercial relationship since there are not any product offerings in Clark´s portfolio that could be offered to any of Adonis current entrepreneurial ventures. Most of these enterprises deal with supplying services and products to the public sector´s social programs, and other government institutions. His newest venture is a biodiesel plant in the suburbs of Quito, the capital, in final phase of completion.

Ecuador does not have a substantial oilseed industry, but in 2008 it had implemented legislation that promoted the production of biodiesel. The government will put out tenders every quarter for their biodiesel needs. These closed envelope bids are to be submitted one week before the contracts are awarded. Those bids that come from domestic production will receive preferential treatment. Since local production due to scale, raw material availability, and cost of production is not competitive with imports, a complicated handicap formula exists to favor domestic manufacture. In this, a foreign bid would need to be at least 7% cheaper while attending to all technical specifications to be a winner. To be considered domestic manufactured the cost components must be at least 50% of the final product. This would be obtained through domestic sourced components, and the blending of imported product with a local produced one. This last rule promotes Ecuadorian production, and allows manufacturers to utilize some percentage of imported biodiesel.

In 2010 Adonis and Clark realized that there was a significant arbitrage opportunity between the excess biodiesel capacity in Argentina, the surging demand in Ecuador, and Adonis biodiesel plant capacities in Quito. These would allow them to take advantage of the different market prices and distortions. Therefore, they created two companies. One, Greenergy Argentina, would procure in the Argentina market the volumes of biodiesel and export these to Greenergy Ecuador. The latter would import, and process the biodiesel to attend the tender specifications. The imported biodiesel would be processed through Adonis´ plant in order to participate in the Ecuadorian tenders. Biodiesel being a commodity oriented product is characterized by low margins and high volumes. Greenergy Argentina per unit operational costs are extremely low. Due to very favorable Argentine sourcing costs the Ecuadorian operation would limit itself to simply providing minimal domestic components to allow it to compete favorably in the government tenders. Adonis and Clark were 50/50 partners in the Argentine company, and the Ecuador operation was solely owned by Adonis and his partners.

The procurement from Argentina was very competitive, and volumes were secured with discounted prices, given the excess capacity. Also, Clark was able to secure 90 days payment terms, allowing for negligible working capital. The government in Ecuador paid for the tender awards 30 days post delivery. These conditions set the stage for a very profitable operation.

Greenergy Ecuador right away was securing most of the tenders in Ecuador. There was no tender in which there was at least 50% of the volume awarded to Greenergy. This albeit that less than 5% of the product sold had a domestic cost component. The Ecuadorian operation received the imported product, and the only transformation it made was to change the containers to ones that were locally produced.

After a few months of hefty profits, Clark started wondering how was it that Greenergy Ecuador was being so successful. On the next planning trip to Ecuador, Adonis mentioned that they were able to secure the majority of the tender business due to friendships that they had developed in the government. These provided some inside information as to prices of competitive bids, and some leniency regarding the specifications.

On the flight back to Buenos Aires Clark was wondering about the future of the business. Although he did not feel comfortable with the way the business was being handled in Ecuador, he realized that Greenergy Argentina did not infringe any local laws by selling product to Greenergy Ecuador. Also, the Ecuador business was over 80% of the Argentina business revenues. The viability of the operation without these would be highly questionable.

With all these considerations, Clark wondered about the future of the business, and what his role should be within the operation."

1. What are the main issues around this case?

2. Is arbitrage a correct way of doing business?

3. What is the dilemma Clark is facing, and what should he do about it?