Shares of biobased diesel (i.e., biodiesel and renewable diesel) producers handily outperformed the market yesterday (see figure) on news that the fiscal cliff fix revived the biodiesel tax credit, which had previously been allowed to expire at the end of 2011. Investors in biodiesel producer Renewable Energy Group (REGI) saw their shares rise 9%, while shares of Syntroleum (SYNM), which operates renewable diesel producer Dynamic Fuels as a joint venture with Tyson Foods (TSN), bounced more than 30% before settling for a 19% gain on the day. Even renewable diesel producer Amyris (AMRS), which has experienced a share price decline of nearly 90% over the last two years, managed to beat the S&P 500.
AMRS data by YCharts
The biobased diesel credit, officially named the "Biodiesel Mixture Excise Tax Credit," is a refundable credit equal to $1 for every gallon of biodiesel or renewable diesel that is blended with conventional diesel. It is valuable to producers: as a refundable credit, it is first offset against the blender's fuel tax obligation and then taken as a direct monetary transfer from the IRS to the blender. In practice it is very similar to the old "Volumetric Ethanol Excise Tax Credit" (VEETC), or "blender's credit,", that prompted much controversy prior to its expiration in 2011. While the payments are made directly to blenders (i.e., refiners) from the IRS, most of the credit's value is passed on to the biobased diesel producers to incentivize production.
While very attractive to biobased diesel producers when taken at face value, the market appears to be responding as if the biobased diesel credit operates within a vacuum. This isn't the case, of course: biobased diesel producers and blenders also operate within the larger framework of the revised Renewable Fuel Standard (RFS2). (For more information on the underlying mechanism of the RFS2, see my previous article on the subject.) As a reminder, the RFS2 serves as a carrot for biofuel producers and a stick for refiners. Refiners (i.e., "obligated blenders") are required to meet the volumetric blending mandates of biofuels established by the Environmental Protection Agency (EPA) and purchase Renewable Identification Numbers (RIN) to demonstrate compliance with the mandate. Biofuel producers receive the value of the RINs on each gallon of biofuel sold to the refiners, in addition to the fuel's market value. These RINs can be very valuable to producers, with those for the biomass-based diesel category nearly reaching $2/RIN [pdf] in 2011, with each gallon qualifying for at least 1.5 RINs.
Most notable about RINs is that they operate as a flexible (or variable) subsidy payment from refiners to biofuel producers. Unlike the ethanol and biobased diesel blending credits, which are fixed by statutory language, RIN values operate primarily as a function of biofuel production cost, conventional diesel market price, and existing biobased diesel production relative to the mandated volume. In other words, RIN values increase as feedstock costs increase and decrease as conventional fuel prices increase; producers receive the value necessary to incentivize sufficient production for the industry to meet the RFS2 mandate but no more, so as to prevent windfall profits. RIN values fall to zero (or very close to it) when the mandate is exceeded for a given year, as happened with corn ethanol in 2012.
Biobased diesel production surpassed its 2012 mandated volume under the RFS2 of 1 billion gallons sometime in November. Due to this success, the EPA increased the mandated volume of biobased diesel for 2013 to 1.3 billion gallons. RIN values never fell to zero as the 2012 mandate was met as a result, since producers would need to receive sufficient value to expand production by 300 million gallons to meet the 2013 mandate. Now that the biobased diesel credit (which should not be confused with the RFS2) has been revived, however, biobased diesel producers no longer need to be further incentivized to increase production. One study estimates an additional 300 million gallons of production to occur because of the biobased diesel credit - the exact amount that the EPA recently increased the mandate by. In other words, between 2012 production and the revived blending credit, 2013 production can easily be expected to exceed the 1.3 billion gallons required by the mandate and RIN values will collapse as a result. Sure enough, RIN values for the biobased diesel category fell by 16% yesterday, from $0.50/RIN to $0.42/RIN. If the past experience of corn ethanol RINs when production exceeded the mandate is any indication, biobased diesel RINs will fall until they only reflect their transaction costs - i.e., about $0.02/RIN.
That's not to say that producers will gain no value from the biobased diesel credit; the $1/gal credit will only be partially offset by the fall in RIN value. Assuming biobased diesel RINs fall to $0.02/RIN and each gallon of the biofuel qualifies for 1.5 RINs, then each gallon produced will lose $0.72 due to the fall in RIN values (this is a conservative estimate, as some types of biobased diesel qualify for up to 1.7 RINs/gal). Furthermore, the $1/gal credit will serve as a "floor" for producers, ensuring that they receive close to that value for every gallon of biobased diesel produced, regardless of market and RFS2 conditions. Still, it is a mistake to assume that the reintroduction of the biobased diesel credit automatically increases producer profits by $1/gal, as most of this value will be offset by lower RIN values.
The real winners
One other important difference between the biobased diesel credit and RINs is the identity of the parties responsible for paying the cost of each subsidy. U.S. taxpayers shoulder the burden of paying the biobased diesel credit, as the $1/gal credit is a direct transfer from the IRS to refiners (and taxpayers pay the IRS). RINs, on the other hand, are purchased by refiners (i.e., obligated blenders) from producers in proportion to their share of the market to demonstrate compliance with the RFS2 mandate. A fall in RIN values due to the reintroduction of the biobased diesel credit is effectively a transfer of the burden from refiners to taxpayers. The biggest winners due to its reintroduction, therefore, are the largest U.S. refiners, which in 2010 were: Valero (VLO), Phillips 66 (PSX), ExxonMobil (XOM), BP (BP), and Royal Dutch Shell (RDS.A) (see table). We can estimate the total value of the biobased diesel credit to the refining industry based on the expected fall in RIN values per gallon ($0.74) and the number of RINs required to meet the 1.3 billion gallon 2013 mandate, assuming each gallon qualifies for 1.5 RINs: $1.44 billion.
Major refiners by capacity
|Refiner name||Refiner capacity (bbl per day)|
Source: Congressional Research Service (2010)
Interestingly enough, most of those refiners are underperforming both the S&P500 and major biobased diesel producers such as Renewable Energy Group today (see figure). I'm not enough of a market prognosticator to predict which way this price discrepancy will resolve itself (refiners outperforming or biobased diesel producers underperforming), but it is worth taking note of.
PSX data by YCharts
Also in the category of "odd price movements" is the Teucrium Soybean Fund (SOYB), which has managed to fall nearly 2% since the end of the year on the news that biobased diesel production has been further incentivized for 2013. Soybeans are a farm commodity so a number of very different factors could be at play here, but I wouldn't have expected the price of the main U.S. biobased diesel feedstock crop to fall on this news.
Shares of biobased diesel producers have performed quite well following the news that the January 2 fiscal cliff legislation contains a provision reviving the biobased diesel credit of $1/gal through 2013. Investors should be aware that the resulting increase to producer value will be mostly offset by a reduction in RIN values for the biobased diesel category of the RFS2 due to the way in which RIN values are established. The primary beneficiaries of the credit's revival will be U.S. refiners (i.e., obligated blenders under the RFS2) as the fall in RIN values due to the revived biobased diesel credit will represent a shifting of the subsidy cost burden from refiners to taxpayers. The value of this shift in 2013 could reach $1.44 billion, assuming that biobased RIN values fall to $0.02/RIN.