Seeking Alpha
Research analyst
Profile| Send Message|
( followers)  

I wrote an article back on February 14, titled "Early Signs Mixed for Biodiesel," highlighting how Q4 2012 was an extremely difficult economy for the biofuels industry. Here is the introduction of the article that explains the conditions:

2012 and especially 4th Quarter of 2012 was challenging time for the biodiesel industry. Fraud relating to the Renewable Identification Numbers (RINS), early fulfillment of the EPA quota and uncertainty about the reinstatement of the "blenders tax credit" all worked against the industry. All these factors combined to drive the average margin on a gallon of biodiesel into the negative category.

Recently Renewable Energy Group (REGI) reported earnings that appeared positive, $13.64 million EBITDA, but the stock still sold off closing down over 20% the day after the announcement. Back when I wrote the original article Biox Corporation (OTC:BXIOF) reported a loss, reduced production and released what appeared to be a bad earnings report and the stock gapped up. It appeared at the time that the market had already discounted the bad news into the stock, and possibly the biofuels industry as a whole. What then could have triggered a sell off of over 20% in REGI? The stock has since recovered all of its loss, and is trading at $7.94, $0.34 above the $7.60 pre-announcement level. It appears that this quote from the original article actually turned out to be accurate, but with a time delay.

The positive response of Biox to what appeared to be bad news may bode well for other biodiesel and alternative fuels companies. Renewable Energy Group is slated to report earnings on March 4, 2013

The signs were so mixed it seems it even took the markets awhile to figure out what is happening in the industry. This is the REGI chart highlighting the steep drop on what appeared to be good news. The stock has since regained all of its losses and is now trading at a level higher than pre-announcement.

(click to enlarge)REGI Price

What then is causing so much confusion in this industry? Why would a stock drop so sharply, only to reverse itself and go on to higher ground? To make matters worse, Syntroleum (SYNM) just released a 10-k stating that the Dynamic Fuels plant, a joint venture with Tyson (TSN), wasn't producing in Q1 3013 because the partners can't agree on whether or not the economics justify resuming operations. They don't produce biodiesel, they produce a drop-in diesel fuel, but the economics are very similar to biodiesel.

The plant was placed in stand-by mode after completion of a maintenance turnaround in December, 2012, primarily because of economic conditions. Although economic conditions have improved in 2013, the plant remains in stand-by mode as the Company and Tyson have not yet agreed upon the economic conditions required for plant start-up.

This article attempts to put some clarity into the chaos that existed in the bio-fuels industry during Q4 2012, and appears to have some lingering effects even into Q1 2013.

Let's first examine why a stock would drop over 20% on what appeared to be good news, especially when it turned a profit when the market conditions of Q4 2012 were so awful.

The REGI conference call and other sources may provide some clues.

My first thought was that the REGI stock price may have appreciated after the release of the BXIOF.PK earnings, and this was simply profit taking, "buy the rumor sell the news." From the stock chart and price history, that does not seem to be the case. REGI was essentially trading unchanged from mid-February. That implies that the markets found something in the conference call that they did not like.

One concern may be the hedging activity. During the Q3 2012 conference call it was announced that:

We incurred $18 million of losses in our risk management positions.

That is old news, and should not impact the stock price, but as the conference call continued, the hedging strategy was explained. I listened to the conference call back in Q3 2012 and from the explanation, I walked away with the expectation that Q4 2012 was going to see an unexpected boost in profits due to the unwinding of the profitable side of the hedge. This quote from the conference call at least gave me the impression that this hedging issue was simply a timing and a "mark-to-market" issue, and that everything would work its way out in the wash.

According to generally accepted accounting principles, we are required to measure contracts at fair value and recognize corresponding gains or losses in current earnings. This is what you saw in Q3.

So, while a short position in heating oil is showing the loss, the other half of the trade you do not see reported is the long exposure via the biodiesel sales, whose price is indexed to heating oil. That "gain" is not recognized until the sale is fulfilled.

As you can see, we are essentially protecting future margins.

(click to enlarge)REGI Q# 2012 Hedge

From the discussion of the hedging strategy, it was reasonable for the market to expect a nice pop in the earnings when the profitable side of the hedge was recognized in Q4 2012. That however didn't happen. Hedging activities were essentially flat. This may have been an unwelcome surprise to the market, I know it was to me.

we had a very minimal risk management loss for the quarter. It's actually a slight positive gain. Chad Stone CFO

(click to enlarge)REGI Q4 Hedging

The other possible unwelcome surprise was that REGI liquidated its Renewable Identification Number (RIN) inventory in Q4 2012.

The 19% decrease in gallons sold, and a 17% year-over-year decrease in average selling price per gallon was partially offset by an increase in RIN revenues, as we essentially liquidated our inventory of 2012 RINs.

As this 8-k from Syntroleum highlights, RIN prices were at historic lows in Q4 2012.

The economics of the U.S. biomass based diesel industry are currently challenged by significantly lower RIN (renewable identification number) prices. D4 RIN prices averaged $1.39 for the first six months of 2012. As of December 10, 2012, the D4 RIN price was $0.56. RIN prices at these levels have not been seen since the implementation of the RFS2 program by EPA in July of 2010.

While I was unable to get an answer as to the number of inventory RINs that were liquidated in Q4 2012, the most recent REGI 10-Q (pdf) used the term "significant" when describing the size of the inventory entering Q4 2012.

along with a significant increase in the number of RINs we held in inventory at the end of the most recent quarter

Assuming it had 0 RINs to start Q4 and only liquidated the RIN produced during Q4 2012, we can at least form a conservative rough estimate for a the lower end impact. Using the mid-point of the RIN range stated would give us an average RIN price of ($0.70 + $0.42)/2 = $0.56, REGI produced 36.4 million gallon in Q4, and it received 1.5x RIN per gallon produced. That would mean that it made about 36.4 x 1.5 x $0.56 = $30.5 million from the RINs from normal operations. Any liquidation of inventory RINs would increase this value. In the conference call it was reported that:

Revenues from RIN, co-products, feedstock sales, demurrage, and storage amounted to $65.8 million during the quarter, and this includes again, liquidating our 2012 RIN position, as we finished out the compliance year.

That implies that $65.8 - $30.5 = $35.3 million in excess of the Q4 2012 RINs were generated from non-biofuel sales related activities and RIN liquidation. That helped boost the earnings this quarter, but leaves no excess inventory of RINs to be liquidated in the future. To make matters worse, as stated, RINs are now trading about $0.80. The most recent D4 RIN bid quote (March 15, at the time of this writing) from Progressive Energy Limited (pdf) is $0.82, and were recently over $1.00. Using $0.82, RINS are $0.26 above average calculated for Q4 2012. On the Q4 2012 production of 36.4 million gallons, that represents a loss of 36.4 x 1.5 x $0.26 = $14.2 million dollars compared to if it had waited until today to liquidate the RINs, and that doesn't include any excess inventory of RINs that were liquidated. The liquidation of the RINs may have helped boost earnings in Q4 2012, but it came at a steep cost in lost future revenues, and they most likely were sold at very unfavorable prices.

Another source of concern may be from the information provided about the tax credit that passed at the turn of the year. It was stated in the conference call that part of the tax credit was accounted for in Q4 2012.

For the fourth quarter, adjusted EBITDA was $13.6 million, which was a 54% increase from fourth quarter of 2011. This does include an allocation of $11.7 million of the $58 million related to the retroactive 2012 portion of the blenders tax credit.

Recognizing the prorated tax credit in Q4 2012 once again helped boost the Q4 2012 numbers, but reduces the benefit to future quarters. The $11.7 million is almost all of the $13.6 million EBITDA reported, and remember that $13.6 includes liquidated RINs and other non-fuels sales related income. One thing to keep in mind however is that REGI had the insight to anticipate the possible passage of the tax credit and was proactive. I would imagine many of the smaller independent producers weren't so lucky.

It may worth noting that BIOX Corporation (BX.TO) mentioned, but did not account for any of its tax credit in the recent earnings release, and will be recognizing all of the gain in future earnings reports. (Note: its most recent earnings report (pdf) is Q1 2013 released in February 2013 for the period ended December 31, 2012. REGI reports that time period as Q4 2012)

Subsequent to the end of the period, the retroactive reinstatement of the U.S. federal tax incentive which had ended on December 31, 2011 , allows BIOX to collect approximately US$7.7 million related to sales to customers during calendar 2012

Another bit of insight gathered from the tax credit discussion is that REGI will be receiving $58 million in a tax credit for 2012 production of 188 million gallons sold. Assuming that each gallon of the 188 gallons sold was eligible for the tax credit, that means that REGI only keeps an estimated 55/188 = $0.29 of the tax credit and passes on $0.71 to others. To put things in perspective, if my math is correct, BX.TO produced 44.91 LITERS in calendar year 2012. That translates to 11.86 million gallons of fuel. If all those gallons are eligible for the tax credit, that would mean BX.TO keeps an estimated 7.7/11.86 = $0.65 of the tax credit and passes along $0.35. Syntroleum through its 50/50 joint venture with Tyson called "Dynamic Fuels" has the benefit of acting as the blender and produces a "drop-in" "Neat" qualified ultra low sulfur diesel (ULSD) advanced biofuel instead of biodiesel, claimed:

"Dynamic Fuels or its owners will receive a combined total of approximately $23 million for 2012 production from the $1 tax credit."

I show Dynamic Fuels producing approximately 30.3 million gallons for 2012. Dynamic fuels has a production mix of approximately 83% ULSD 12% Naphtha and 5% Liquid Petroleum gas (LPG). Based only on the ULSD production 0.83 x 30.3 = 25.15 million gallons of $1.00 tax credit eligible fuel were produced. That means that SYNM's Dynamic Fuels is keeping an estimated 23/25.15 = $0.91 of the tax credit per gallon. From those estimates, it appears that REGI is at the low end of the scale for capturing the tax credit."

Note: SYNM also captures an additional tax credit for the naphtha, but that is a different issue not relevant to this analysis:

"will receive the alternative fuels mixture credit of $0.50 per gallon for a portion of the renewable naphtha also produced during 2012"

Another source of concern may be the product mix that REGI is producing. REGI has the benefit of owning multiple-feedstock plants, which allows it to use soy oil, yellow grease, tallow, inedible corn oil and other. This allows it to use the lower cost feedstocks in production, but that flexibility comes at a cost. According to the conference call:

we have typically done at least 80% high cloud or non-virgin vegetable oil based feedstocks. So when you look at '11, I recall it being approximately 15% virgin veg oil, 85% not. Then out of that 85%, while we produce from a really wide array of feedstocks that are all EPA compliant, the principal components would be choice white grease, beef tallow, used cooking oil and inedible corn oil.

"High cloud" is the lower priced biodiesel. This clip from the Progressive Fuels Limited market report shows the price difference between low cloud SME vs high cloud FAME.

Biodiesel Prices

Currently (3/15/2013) the difference between SME Chicago and FAME Chicago is $4.84 - $4.65 = $0.19/gallon and varies with the seasons. That lower fuel price of course has to be weighted against the benefit of the lower feedstock costs and the net impact on the overall margin. I will save that analysis for another article. This is what REGI said about this issue in the recent 10-Q.

Those are some of the possible reasons REGI sold off on what appeared to be good news. REGI did report a profit during an incredibly difficult time for biodiesel production, but it came at the expense of future earnings. It essentially shifted earnings from 2013 into Q4 2012.

Why then did the stock price of REGI turn around and erase all the loss from the earnings release? As Bill Clinton would say, "it's the economy stupid." The economics in the industry have taken a dramatic turn for the better. Margins are very solid (a topic I will be addressing in future articles), the tax credit passed, RINs have recently traded above $1.00 and currently trade over $0.80. More information on this issue can be found in this instablog post written back in early February. (Note: some of that information is now dated. SYNM has since released that it is also getting a tax credit for their naphtha)

In addition to the economics driving the REGI stock price higher, the firm itself has many positive aspects. REGI has the size and scale that allows it many competitive advantages over the smaller independent biodiesel producers. It has the capital that allows them to buy up firms and expand production during tough economic times, upgrade those plants to multi-feedstock plants, negotiate better contracts up and down the supply chain and has the capability to hedge the operations and appears to have a solid grasp of the markets and economics of the industry. Most importantly however is that the U.S. Government seems intent upon making alternative energy a reality in America. To meet the targets set by the EPA and others, high cost soy oil will almost certainly have to be part of the mix. If that is the case, the economics will have to make soy oil biodiesel profitable, and if the high cost producers are profitable and can survive, the low cost producers should thrive. But as the tax credit battle demonstrated, the road isn't guaranteed to be smooth and without its risks.

In conclusion, with the Q4 2012 chaos of the biodiesel industry behind us, Q1 2013 appears to be shaping up nicely for firms like REGI and others in the biodiesel industry. The economics have dramatically improved, and the recent price movement of REGI appears to signal that the markets are no longer looking back, they are looking forward. I am planning a series of article and a weekly margin report so that interested investors can keep better track of how the economics, profits and margins of this industry are progressing, so check back often.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Signs Still Mixed For Biodiesel But Economics Improving For Q1 2013