The deal, announced on Monday, significantly expands Shell's ethanol operations in Brazil and follows moves by British oil major BP, which in 2008 took a stake in a Brazilian biofuel project and unveiled $1 billion in investments.
Shares of Cosan jumped more than 6 percent in Sao Paulo, while Shell rose nearly 1 percent in London.
It's a vote of confidence from an oil major for the Brazilian ethanol industry -- one of the most ecological and sustainable alternative fuels, said Jonathan Kingsman, managing director of the Lausanne-based Kingsman SA ethanol and sugar consultancy.
I expect more interest from the oil companies in Brazilian ethanol, both in production and distribution, Kingsman said.
The deal will extend Cosan's fuel distribution business in Brazil after the company took over U.S.-based Exxon Mobil's Esso unit in 2008 for nearly $1 billion. Cosan last month also agreed to buy a local chain of filling stations called Petrosul for an undisclosed sum.
Oil companies and major global investors have been searching for partnerships in Brazil's ethanol sector, which is still largely dominated by family firms with complex ownership structures.
Shell has been looking for opportunities in Brazil's ethanol industry for years. U.S. agribusiness giant Bunge Ltd struck a deal in December to buy sugar and ethanol producer Moema for $452 million, while French commodities company Louis Dreyfus said in October that it would take over Santelisa Vale for an undisclosed sum.
Cosan said the Shell deal would help it gain greater access to Brazil's thriving ethanol retail market as the combined company would be the country's third-largest fuel distributor, with 4,500 filling stations around the country.
The combined entity will have about 40 billion reais in annual sales, Cosan Chief Financial Officer Marcelo Martins said on a conference call with analysts and investors.
Cosan said it had 180 days to discuss the nonbinding memorandum of understanding exclusively with Shell International Petroleum Company Ltd.
As part of the transaction, Cosan will transfer its sugar, ethanol, fuel distribution and energy generation business to the merged entity, with assets valued at $4.93 billion and debt of $2.52 billion.
Cosan said Shell would contribute its retail fuel and aviation distribution business and inject about $1.63 billion into the merged company in up to two years. Cosan will contribute another $300 million in cash over five years.
Cosan and Shell will have the option of buying each other's stake in the venture after 10 years, with the price to be determined at the time of purchase.
(Additional reporting by Reese Ewing in Sao Paulo, and David Brough and Tom Bergin in London)