Renewable Energy Group And Syntroleum: Alpha Generation And Intelligent Way To Hedge RIN Risk Of Independent Refiners

| About: Renewable Energy (REGI)

The overall Renewable Identification Numbers (RINs) market is undergoing significant disruption for the first time in history. Surging RIN prices are especially bullish for biofuel producers such as Renewable Energy Group (NASDAQ:REGI) and Syntroleum (NASDAQ:SYNM). Key points highlighted in this report:

  1. Gasoline refiners are facing unprecedented biofuel-related mandates, which creates secular tailwinds for RINs generated by biomass-based diesel producers
  2. D4 RINs, generated by biodiesel and renewable diesel producers, are uniquely positioned (see Figure 1) to satisfy the looming shortfalls in key biofuel mandates (see Figure 2 and Figure 3)
  3. High RIN prices across all fuel categories for the foreseeable future will ensure strong demand for biomass-based diesel producers (see Figure 4)
  4. Buying D4 RIN producers such as REGI and SYNM are potentially a savvy way to hedge RIN consumers such as VLO, TSO and HFC
  5. REGI and SYNM, priced at similar trading multiple to other biofuel producers such as GPRE, ADM and ANDE, should trade at $22 and $1.10 share respectively

Investment Overview

The US refining industry is operating in an interesting period under the Renewable Fuels Standard (RFS) which requires the industry to blend increasing amounts of advanced biofuel and ethanol with refined fuels over the next several years. If refiners fail to do so, they must purchase Renewable Identification Numbers (RINs) to offset shortfalls and comply with the requirements or mandate. The price of RINs has risen dramatically this year and continues to be volatile, which may impact the earnings of refiners and related companies. There is a large imbalance between the government RFS mandate, in both advanced biofuel and renewable fuel, and market's natural demand of refined fuel. This article investigates ways to hedge RIN consumers and profit from RIN producers, by understanding the intricacies of the various RIN categories. The investment thesis rests on how the flexible D4 RIN will benefit biomass-based diesel producers, such as Renewable Energy Group and Syntroleum.

RINs are 38 digit serial numbers assigned to every gallon of renewable fuel produced in the US. When the Renewable Fuels Standard was included in the Energy Policy Act of 2005, RINs were created as a market mechanism to ensure compliance with the Renewable Volume Obligation (RVO) set by the US Environmental Protection Agency (EPA). Every year obligated parties such as refiners and importers must demonstrate that renewable fuels comprise a predetermined percentage of their refined fuel volume. Under the RFS, obligated parties are companies who produce or import petroleum gasoline or diesel fuel. They do not have to blend a physical gallon of renewable fuel in order to satisfy the mandate, but can satisfy RFS compliance obligations using RINs. RINs can be acquired through the purchase of physical fuel attached with RINs or purchased on the market through RIN-only transactions. Many investors have a difficult time understanding the purpose of RINs, but the concept is similar to a carbon credit. For simplicity, this article discusses biodiesel/renewable diesel (D4 RINs and in the biomass-based diesel category), sugar cane ethanol (D5 RINs and in the advanced biofuel category), and corn ethanol (D6 RINs and in the renewable fuel category).

D6 RINs, most commonly traded, are created from the production of corn ethanol. There is no good way to hedge out D6 RIN volatility for the average equity investor. Investors have rightly begun to acquire and invest in ethanol and D6 RIN producers such as Green Plains Renewable (GPRE, +47% YTD), Archer Daniels Midland (ADM, +20% YTD), and The Andersons (ANDE, +22% YTD). Although ethanol market fundamentals have improved dramatically, investors may also look at ethanol producers as potential hedges to their refiner investments. Not widely known to the investment community, D4 RINs are another hedge against refiners, and have significant alpha generating potential. D4 RINs are generated by biomass-based diesel producers. Not only are biomass-based diesel producers such as REGI and SYNM witnessing improving economics, we believe the current RFS mandate provides them a structural advantage in the advanced biofuel and renewable fuel super-cycle.

D4 RINs, generated by biomass-based diesel (includes biodiesel and renewable diesel) producers such as REGI and SYNM, can be used to satisfy both advanced biofuel and renewable fuel mandates (see Figure 1) - corn ethanol resides in the general renewable fuel category. In fact, outside of cellulosic biofuels, only D4 RINs can be used in the biomass-based diesel (D4), advanced biofuel (D5) and renewable fuel (D6) categories, making it the most versatile of all RINs. D5 RINs are typically created from the production of sugar cane ethanol, which is predominantly imported from Brazil, and can only be used in the advanced biofuel and renewable fuel categories.

Refiners can blend in additional biodiesel or renewable diesel, over the biomass-based diesel RVO and use the attached D4 RINs towards the advanced biofuel and renewable fuel mandate. As refiners update their operating plans and strategies for this new period, refiners may blend more biomass-based diesel (increase from B1, 1% biodiesel blend to B5, 5% biodiesel blend), remove the D4 RIN attached to the physical gallon of biodiesel, and use it towards the advanced biofuel and/or corn ethanol mandate. In addition, obligated parties can also purchase D4 RINs on the open market. Because of the increasing RVO mandates for both the advanced biofuel and renewable fuel (i.e. corn ethanol), there will be strong demand tailwinds for biomass-based diesel and its D4 RINs.

Figure 1: Visualization of RIN acceptability in RFS designated categories

Note: Area is not proportional to actual renewable volume obligations. Each shared area depicts RVOs for each of the major categories: Cellulosic biofuel, Biomass-based diesel, Advanced biofuel, and Renewable Fuel

The massive RIN deficits will provide a strong secular demand for biomass-based diesel. We will examine the driver for the deficits in the next two sections.

Given the industry dynamics and improving unit economics, REGI and SYNM are undervalued. Applying industry comparable multiples to conservative production volumes and margins, REGI should be trading at $22/share, approximately 250% premium to today's share price of $8.87. Using a similar valuation method, SYNM should be trading at $1.10/share, approximately 280% premium to today's share price at $0.40/share. A detailed valuation is provided at the end of the report.

For a detailed description on the dynamics of RINs, please see Appendix A.

Corn ethanol and the increasing D6 RIN deficit

Renewable Identification Numbers or RINs have gained a lot exposure in the past several weeks. The value of corn ethanol RINs, also known as D6 RINs, has skyrocketed from 7c at the beginning of 2013 to highs of over $1, recently settling at approximately 80c. The once sleepy D6 RIN market has jumped into the spotlight, as investors and consumers fret about its implications on gasoline refining margins and the indirect impact on gasoline prices at the pump. US Senator David Vitter (R-La.), top Republican on the Environment and Public Works Committee, and Senator Lisa Murkowski (R-Alaska), Ranking Member of the Energy and Natural Resource Committee have gone as far as to demand the Environmental Protection Agency, or EPA, to provide a plan to protect American citizens from the potential escalation of gasoline prices. It is unclear what governmental policies, if any, will be enacted to resolve this issue. If history is any indicator, it is highly unlikely there will be a comprehensive change to the RFS mandates in the near-term (i.e. 2013 and 2014). In the near-term, it is fair to expect increased D6 RIN price volatility, most likely to the upside.

D6 RINs are a complex issue. At the heart of the matter is US gasoline demand, the E10 ethanol blend wall and the EPA's predetermined RVO for ethanol. The EPA requires obligated parties such as Valero Energy (NYSE:VLO), Tesoro Corporation (NYSE:TSO) and HollyFrontier Corporation (NYSE:HFC) to blend 13.8 billion, 14.4 billion and 15 billion gallons of ethanol in 2013, 2014 and 2015 onwards respectively. These figures were determined as part of the Renewable Fuel Standard - a legislation originated with the Energy Policy Act of 2005 and expanded and extended by the Energy and Independence and Security Act of 2007 (EISA).

A D6 RIN is produced with every gallon of corn ethanol produced in the US, and retired out of circulation when the gallon of ethanol is blended with motor gasoline. These are unique numbers that were designed to track production, but also to act as a renewable fuel credit that ensures obligated parties blend to the predetermined quota. The RIN market was designed to bridge economic gaps between renewable fuels and refined fuels. D6 RINs will hold limited value (or close to no value) when the mandate is met; however, when the mandate is not met, the value of D6 RINs will increase. Investors could view the D6 RIN as a potential supply-demand proxy for corn ethanol.

Ethanol, acting as an oxygenate to help reduce carbon monoxide created during the burning of fuel, is used as a blend stock with gasoline. E10 is a blend of 10% ethanol and 90% gasoline sold in many parts of the country. All auto manufacturers approve the use of blends of 10% ethanol or less in US gasoline vehicles. The current gasoline demand forecast is between 132 and 135 billion gallons in the next two years. Per E10 blend wall, the corresponding ethanol demand would be 13.2 to 13.5 billion gallons (i.e. 10% of gasoline demand). Because of the ethanol mandate of 13.8 billion gallons in 2013, obligated parties such as refiners and blenders may be forced to acquire additional D6 RINs to show compliance. Figure 2 forecasts the approximate gasoline demand from the EIA and the resulting deficit of D6 RINs.

Figure 2: Basic issue with the ethanol blend wall, future D6 RIN deficit, and the mandate

Source: EPA, EIA motor gasoline forecast based applying E10 blend wall. E10 ethanol demand curve is drawn for illustrative purposes. Note: For simplicity, analysis does not take into account previous year carry over.

The blend wall is defined as the maximum amount of ethanol that can be blended in with gasoline. Prior to 2013, the ethanol RVO was easily met. In addition, ethanol prices were high enough to allow the corn ethanol producers to break even or better without RIN value. As a result, the value of D6 RINs hovered close to zero.

As refiners began to hit the blend wall early 2013 and concerns for 2014 mandate surfaced, the value of D6 RINs increased significantly as market participants bid up its value in order to meet the current and future ethanol RVO (blue line in Figure 1). We believe that the value of D6 RINs will continue to increase going forward due to increasing ethanol mandate to 2015 and the sluggish gasoline demand. The D6 RIN deficit, if not solved via political means, could be filled by other categories in the renewable fuel standard such as biomass-based diesel (D4 RIN). For detailed RIN deficit estimates, please see the Appendix.

Obligated parties such as refiners and blenders have threatened to pass the cost of buying additional D6 RINs to consumers. In a widely followed industry newsletter, dated March 18, 2013, OPIS, speculated that at the current D6 RIN price, VLO's implied liability for 2013 is $341M or 5% of EBITDA, while TSO and HFC's implied liabilities are approximately 4% of EBITDA. Deutsche Bank analyst, Paul Sankey, in recent research report titled "RINfuriating," [3] estimates that VLO costs alone will be between $500M to $750M, costing about -54c to -85c EPS.

The RIN liabilities could potentially increase further as the ethanol mandate is increased to 14.4 billion and 15 billion gallons in 2014 and 2015. Of course if D6 RIN prices increase, the implied liabilities will increase as well.

Missing commercial cellulosic fuel and potential lack of cane ethanol, will create more demand for biomass-based diesel

A less followed and discussed market is the advanced biofuel market. This segment includes cellulosic biofuels and biomass-based diesel (basically all fuels excluding those derived from corn ethanol). The advanced biofuel market is facing a similar, but more severe issue than its sibling, the ethanol market. We believe that this could be an even stronger demand driver for D4 RINs and biodiesel as compared to the corn ethanol situation.

Historically, the advanced biofuel mandate has been fulfilled by biomass diesel (D4) and cane sugar ethanol (D5 and imported to the US from Brazil). Going forward, the EPA envisions cellulosic biofuel to comprise the lion's share of this segment, forecasting 16 billion gallons of cellulosic biofuel by 2022. However, there is no commercial production of cellulosic ethanol to date. This resulted in the courts vacating the 2012 cellulosic mandate. Using conservative estimates, we believe that commercial volumes won't actually be available until 2017. Because cellulosic biofuels are in nascent stages, much of the advanced biofuel category will be filled with biomass-based diesel (D4 RIN) and cane-sugar ethanol (D5 RIN) in the foreseeable future.

When a gallon of cane ethanol is imported in the US from Brazil (US has hardly any cane ethanol production), it receives a D5 RIN. When the cane ethanol is blended with gasoline, the D5 RIN is retired from circulation. Similarly, when a gallon of biomass diesel is produced in the US, attached with the physical gallon is 1.5 unique D4 RINs. In the case of the biodiesel market, biodiesel is blended with refined diesel at rates of 1% to 5% (also known as B1 and B5), and the corresponding D4 RINs are retired to the EPA.

Figure 3 highlights the expected year-over-year increase in advanced biofuel mandate. The current RVO for biomass diesel is 1.28 billion gallons or 1.92 billion in ethanol RIN equivalent. Industry experts believe the biomass-based diesel RVO will increase to approximately 1.4 billion to 1.5 billion gallons in 2014, or 2.1 billion to 2.25 billion gallons of ethanol equivalent. To be conservative, the model assumes 1.28 billion gallons going forward. Excess biomass-based diesel production, can be used to fulfill the advanced biofuel category. The figure also assumes zero contribution of commercial cellulosic biofuels prior to 2017. The Appendix provides a more detailed figure.

Figure 3: Advanced biofuel RIN deficit, severe demand and supply mismatch

Source: EPA and EIA. Note: For simplicity, does not take into account previous year carry over. Also assumes biomass-based diesel RVO is held at 1.28 billion gallons from 2013 going forward. The EPA can increase/set the biomass-based diesel RVO annually

The D5 RIN deficit will most likely be filled by biodiesel and renewable diesel (D4 RINs) in the near-term. Because the advanced biofuel mandate is expected to increase going forward, biomass-based diesel will be one of the few commercially viable fuels available to fill the demand. Because Brazil plans to increase its own blend wall from 20% to 25% by June 2013 (here), we expect limited cane ethanol exports to the US. Historically, Brazilian ethanol exports to the US were also primarily driven by RIN arbitrage (D5 RIN higher value than D6, so blenders were incentivized to blend cane ethanol), which does not exist today. More importantly, is the US ethanol blend wall (mentioned in previous section) is fast approaching to being met; hence, there is no desire for additional physical ethanol gallons. In latter sections, we will discuss in detail the issues with the advanced biofuel category and the opportunity.

Investors should focus on biomass-based diesel (D4 RIN) and advanced biofuel mandate

Biomass-based diesel typically comprises of mono-alkyl esters of long chain fatty acids created from inedible corn oil, other vegetable oils or animal tallow. To be qualified as a biomass-based diesel, the renewable fuel will meet the requirements of ASTM D6571. Products and blending percentages are typically designated Bzz, where zz represents the volume percentage of biodiesel in the fuel blend.

The savvy investor or industry insider may have noticed the correlated increase in biomass-based diesel and advanced biofuel, D4 and D5 RINs respectively. However, many market participants may not understand the reason behind it. Reading through the fine print of the EPA proposal for the 2013 renewable fuel standards (here), it is clear that advanced biofuel category can be considered a swing category for excess production in biomass-based diesel and cellulosic biofuels:

The volumes in Table 1 are the minimum that would need to be consumed in the U.S. Insofar as excess volumes of cellulosic biofuel or biomass-based diesel were to be consumed, they would count towards the advanced biofuel and total renewable fuel volume requirements

In more basic language, Ron Stinebaugh, Senior Vice President of Finance, Syntroleum in its recent annual 2012 earning call said:

D5 RINs are for advanced biofuels, which typically includes biomass-based diesel, naphtha and carbon intensity sugarcane ethanol and D6 RINs are for other renewable fuels, which is typically corn ethanol. What can D4 RINs be used for? The answer is that D4 RINs can not only be used for D4 compliance, but also D5 and D6 compliance. However, D5 and D6 RINs cannot be used for D4 compliance. This makes D4 RINs the most flexible RINs.

Ron's insight shown in the below figure highlights the market dynamics of the D4, D5 and D6. It is imperative to notice the convergence. The D4 is the most flexible RIN. The D4 RIN price is set by the minimum RIN price needed to motivate enough biomass-based diesel production to meet the biomass-based diesel mandate, which is dictated by the marginal cost of the merchant producer's economics. As for D5, the current prices are similar to the D4, so the expected D5 shortfall could also be driving D4 prices. What is also clear from the data is that D4 RINs trade at a premium compared to D5 RINs, and D5 RINs trade at a premium to D6 RINs. One argument for the premiums is due to the optionality value of D4 RINs over D5 and D6 RINs, and D5 RINs over D6 RINs. We believe in the current and future tight environments, D4 RINs will continue to command a premium and this spread to D6 RIN could increase significantly (using historical trends). Biomass-based diesel producers will do well in this environment.

Figure 4: OPIS data showing the convergence of D4 and D5 to D6 RIN prices

Source: OPIS

Historically, the D5 advanced biofuel category was met with excess renewable diesel, biodiesel produced in the US, or imported cane ethanol from Brazil. In the future the EPA envisions this category to be met with cellulosic biofuels, biomass-based diesel and cane-sugar ethanol.

In 2012, Brazil exported to the US approximately 403 million gallons of cane ethanol (here). Historically, Brazil produces about 5 billion gallons of cane ethanol. However, Brazil is set to increase its ethanol blend wall from 20% to 25%. Currently, it blends about 20% of anhydrous ethanol with 80% of refined gasoline. The increase in blend to 25% of ethanol will increase domestic anhydrous ethanol demand by 25%, thus immediately reducing exports to the US. In addition, Brazil's anhydrous ethanol pricing at $2.76/gal (FOB SANTOS), compares with Chicago ethanol pricing at $2.54/gal). Because pricing is higher in the domestic markets, cane ethanol gallons will most likely keep at home as it would be uneconomical to export to the US (estimates for shipping ethanol to US is about 5c to 7c/gal).

Figure 5: Likely scenario: Brazil ceases to export cane ethanol to the US in 2013

Source: EPA. Note: All figures in ethanol equivalent. The additional 830 million gallon biomass diesel, corn ethanol equivalent, equals to ~550 million gallons of physical biomass diesel (830Mgals/1.5, due to energy density conversion).

To fill the big gap left by Brazilian ethanol imports to the US, other allowable fuels such as biomass-based diesel will be required. Because cellulosic fuels are not commercially available, there is a high probability that the 2013 and 2014 advanced biofuel RVO mandate could only be met by biomass-based diesel. The above chart shows the potential upside for biomass-based diesel in 2013. Should industry dynamics stay on current trends, the upside will grow in subsequent years.

In addition, we believe refiners will blend even more biodiesel and use its D4 RINs towards compliance for the ethanol business and the overall renewable fuel mandate. The next section discusses Renewable Energy Group and Syntroleum, who will most likely benefit the most from this environment and likely scenario.

Renewable Energy Group and valuation

Renewable Energy Group is the leading North American biodiesel producer with a name plate of approximately 225 million gallons of owned and operated annual production capacity. It produces a B100 and B99 biodiesel from a variety of feedstock such as soybean oil, inedible corn oil, choice white grease, yellow grease and inedible tallow. Many of REGI's plants are multi-feedstock capable allowing it to use the most economic feedstock to generate the maximum EBITDA/gal. On the most recent earnings call, CEO Daniel Oh quoted:

We enter 2013 as one of the stronger players in the biodiesel industry. Both the 2013 RVO and the extension of the blenders tax credit lead us to anticipate industry growth of nearly 30% this year. We intend to protect our market share and capture a portion of this growth.

Conducting our due diligence, we found that blenders (REGI's customers) are benefiting from both the reintroduced $1 tax credit (part of the fiscal cliff agreement) and the high D4 RIN prices. Below is the approximate blenders' margin.

Figure 6: Typical contribution margin for biodiesel blenders

Source: Bloomberg and OPIS

Blenders and obligated parties that blend in B100 biodiesel receive both a $1 tax credit and RIN credit (biodiesel blenders receives 1.5 x D4 RIN, current market value for D4 RIN = 80c). Blenders are receiving margins approximately 35c/gal to 50c/gal, depending on commodity prices. This is a significant boost compared to last year when blenders were receiving negative blend margins to 9c/gal margins. To quote an industry veteran: "at 35c/gal to 50c/gal, this is one of the best blender margin environments in a long time." These blender margins are expected to continue at these levels due to the increasing D4 RIN and the reinstated blenders' tax credit of $1/gal.

With favorable blender margins, REGI should continue to benefit as their biodiesel will be in high demand. In 2011 and 2012, REGI saw EBIT/gal of approximately $0.72/gal and $0.51/gal, respectively. In 2012, the blenders' tax credit was allowed to expire and thus the drop in EBIT margin. Using conservative assumptions on feedstock costs, REGI can expect to see EBIT/gal between $0.70/gal to $0.90/gal. Depreciation and amortization is approximately $0.05/gal, hence EBITDA/gal will range between $0.75/gal and $0.95/gal. Using these assumptions, the valuation is shown in Figure 7.

Figure 7: REGI valuation and implied share price

Source: Capital structure from Bloomberg, EBITDA computer from company figures

To be conservative, the model assumes an industry low 2013 EV/EBITDA = 5.0x. Comparable firms are GPRE, ADM and ANDE, who have 2013 EV/EBITDA multiples of 7.5x, 8.4x and 7.2x, respectively. The model also assumes that firm will produce at 86% of REGI's nameplate capacity. Applying the current capital structure, the model computes an implied share price of $22/share or an approximate upside of 250% to the current share price of $8.87. Per Bloomberg, REGI is trading at 2013 EV/EBITDA = 3x, which is far below its peers. This significant discount is due to market's misunderstanding of REGI's true economics and the economics of D4 RINs.

Syntroleum and valuation

SYNM is a producer of renewable diesel, which is a different than biodiesel. SYNM, through a 50/50 joint venture partnership with Tyson Foods (NYSE:TSN), owns Dynamic Fuels, LLC. SYNM and Dynamic Fuels can produce a name plate capacity of 5,000 barrels per day or 210,000 gallons per day of renewable diesel, meeting the requirements of ASTM D975.

Renewable diesel receives 1.7 x D4 RINs as compared with biodiesel that receives 1.5 x D4 RINs, because renewable diesel has higher energy density than biodiesel. Because the renewable diesel that SYNM produces is drop-in replicable (molecularly similar to refined diesel), it can produce renewable diesel, generate the subsequent D4 RIN, but separate it at production. This is different compared to biodiesel producers, who cannot separate the RIN from the physical gallon until the gallon is blended with refined diesel. Finally, SYNM can also act as a blender, so it can receive the $1 blenders' tax credit, providing it superior economics.

On January 3, 2013, President Obama signed the legislation that made the blenders' tax credit retroactive in 2012 and 2013. Remember the blenders' tax credit was allowed to expire in 2012. This new legislation allows SYNM and other biomass-based producers to collect tax credits on production in 2012, which should provide significant amount of additional working capital.

However, Dynamic Fuels has been shut down since October 25 to December 10, 2012 due to plant turnaround (swapping out compressors, heat exchanges etc). However, due to unfavorable economics (negative margins in 4Q12) the plant has remained idle. The resulting share price has underperformed due to the idled plant. However, in the most recent earnings call, CEO Gary Roth indicated many of the past technical problems had been resolved in the scheduled turnaround.

Well, the plant operation has improved fairly dramatically from the start of the operations till we work through our feedstock related issues, till we made the modifications to the plant; we have talked about the compressor, we've resolved those issues. We have the new solvent recycling purchase.

Given the length of the turnaround, new parts and encouraging commentary from the CEO, we are increasingly confident as well. Although no clear timetable has been given to start up the plant, we believe that the current biomass-based diesel economics should provide more than enough incentive to start the plant within the next several months. A timely plant start-up would provide a significant catalyst to the share price. Continuous error-free operation of the plant would provide investors confidence that past operational issues have been resolved.

The below figure provides a valuation model for SYNM in operation. Because Dynamics Fuels is a 50/50 JV, SYNM only receives 50% of the economics. Given past operating problems, to be conservative, if we assume that Dynamic Fuels produces at 75% of its name plate capacity, SYNM should be able produce and claim approximately 29 million gallons of renewable fuel in a given year. Given the current RIN economics (1.7x D4 RIN), $1 blenders' tax credit and conservative operating estimates, SYNM should be able to generate approximately EBITDA/gal = $1.00/gal.

Figure 8: Valuation assuming conservative start-up phase

Source: Capital structure from Bloomberg, EBITDA computer from company figures

Applying the current capital structure, the model suggests an implied share price of $1.10/share or an approximate upside of 280% to the current share price of $0.39/share. SYNM's share price has underperformed given operating challenges they faced. Given the extended downtime, we believe they were able to swap-in the necessary equipment and fine-tune operations. Upon start-up, SYNM should be able to get Dynamic Fuels operational to capture the favorable economics in the biomass-based diesel sector.

Appendix A: Background on Renewable Identification Numbers

Most of the recent focus has been on the price of RINs. It is fairly easy to see how supply, demand and the mandate can impact RIN prices with basic supply and demand curves. When the quantity of ethanol demand is equal to the mandate (i.e. the red lines shift to Q*), then the price of the RIN diminishes to zero. In 2012 and early 2013, the ethanol production was meeting the ethanol mandate and the value for the RIN traded very low prices. Corn ethanol production has exceeded regulator's expectations faster than anticipated. For the first time, the mandate is higher than the actual demand of ethanol as determined by E10 gasoline. Going forward, as the mandate requires more volume quantities of ethanol than the actual demand schedule (0 < RIN QM, 2012 < RIN QM, 2013), the value of RINs is expected to increase. An improving economy and demand for gasoline will shift the demand curve to right, and the price of ethanol will rise, but the RIN value will decrease. In a balanced market, the mandate, QM should equal Q*. However, with the increasing mandates and sluggish gasoline demand, expect RIN values to stay at elevated levels.

Figure 9: Supply and demand curve for renewable fuels, determination of RIN prices

Source: Bruce Babcock [1]. Note: Figures not drawn to scale - just for illustrative purposes

Below figure shows the various categories of renewable fuels, RIN classification and RVO mandates for 2013 and 2014. Although the 2014 RVO mandate for biomass diesel has not been set, industry consensus is that EPA will set the 2014 requirement between 1.4 billion to 1.5 billion gallons. Each gallon of biomass-based diesel can generate up to 1.5x D4 RINs. A gallon of renewable diesel (different than biodiesel since it considered drop-in replaceable) can command up to 1.7x D4 RINs. The number of RINs generated is determined by the energy density of the fuel - higher energy density fuels will produce more RINs. For simplicity, industry insiders often quote RIN values in ethanol equivalent. The Actual RVO is the number of physical gallons required by the EPA.

Figure 10: EPA Renewable Fuel Standard for 2013 and 2014

Source: Environmental Protection Agency, Renewable Fuel Standard. Note: (1) Volume in ethanol equivalent. Actual RVO means the actual amount of physical gallons. For example, the actual amount of biomass-based diesel required for 2013 is 1.28Bgals

Appendix B: Ethanol and D6 RINs

According to Paulson and Meyer [2], from 2007 to 2011, domestic ethanol production exceeded the mandate by approximately 3.6 billion gallons. They estimated that approximately 1.9 billion gallons of excess D4 corn ethanol RINs are banked and can be used to help future mandates. We expect the EPA to release the number of banked or carried over RINs from 2012 within the next few weeks. The remaining excess production over the 1.9 billion gallons of carry over RINs was mostly likely exported and their respective RINs retired from circulation. The EPA has mandated that 13.8 and 14.4 billion gallons, 2013 and 2014 respectively, of corn ethanol to be blended by obligated parties. To be compliant and to achieve the mandate, obligated parties may be forced to acquire additional D6 RINs. Once a sleepy market, where the value of D6 RINs hovered around 7c/RIN, recently touched highs over $1/RIN and settled around 70c/RIN.

Since the 1970s, the Clean Air Act imposed regulatory cap on the volume of ethanol permitted in a gallon of gasoline to 10% (here). Up to a 10% blend of ethanol is covered under warranty by every auto manufacturer that sells vehicles in the US for every make and every model of vehicle. Consensus estimates for gasoline usage in 2013 and 2014 ranges from 132 billion gallons to 135 billion gallons of finished motor gasoline. Given that forecasted demand, a maximum of 13.2 to 13.5 billion gallons of ethanol will be required. Many also recommend its use because of its high octane and superior performance characteristics. E10 is also safe to use in small engines such as motorcycles, lawn mowers, personal watercrafts and many others. The trade-off between gasoline and ethanol is energy density. For example, crude oil, gasoline (petrol) and E10 gasoline have energy densities of approximately 37, 34.2 and 33.18 MJ/liter (here).

A potential upside to the ethanol industry is E15 (15% ethanol and 85% gasoline), which will increase demand by 50% from current levels. In January 2011, the EPA granted a waiver to allow up to 15% of ethanol blended with gasoline to be sold only for cars and light pickup trucks with a model year 2011 or later. The EPA waiver authorizes, but does not require stations to offer E15. However, we don't believe E15 will be widely adopted in the near term.

The 2013 ethanol RVO requires 13.8 billion gallons to blend into the domestic market. 13.8 billion gallons per year run rate requires ethanol blends at rates of approximately 900,000bbl/day (13.8Bgal / 42gal / bbl / 365 days). Per recent data from the EIA (here), obligated parties are blending ethanol at rates of 817,000bbl/day; far below the required mandate. As the US approaches the blend wall limits, there is a strong possibility of D6 RINs approaching higher levels. This phenomenon is not expected to end in the near term, as the ethanol mandated increases to 14.4 billion gallons in 2014 and 15 billion gallons in 2015 and beyond.

To achieve compliance, refiners will be forced to buy additional D6 RINs at the current levels if they can get their hands on it. These RINs may prove elusive as they are only created when a gallon of ethanol is produced. Given the drought in 2012, many ethanol producers were forced to exit the business or idle their plants as the industry had to rationalize higher corn prices. At one point, 36 of the 211 ethanol plants in the USA were idled or shut down. As a result the industry is currently producing at rates of 807,000bbls/day, which is far below the 3-year average (here).

Politics aside, the current situation has been a positive for ethanol producers such as GPRE, ADM, and ANDE. Although each company is quite different in terms of plant economics, they are producers of ethanol and D6 RINs. As the ethanol mandate continues to increase to 2015 and the potential for E15, the valuation of these stocks may continue to increase.

Appendix C

Figure 11: Detailed figures on potential RIN deficit for corn ethanol mandate

Source: EIA and EPA

The advanced biofuel category is a diversified class that can be met with cellulosic biofuel, cane-sugar ethanol, renewable diesel, biodiesel and isobutanol. Per Dr. Wisner at Iowa State University (here), the advanced biofuel mandate is met with cellulosic biofuels, cane ethanol, and additional biomass diesel over its 1.28 billion gallon mandate. There is no direct mandate for corn ethanol, but its mandate is computed by subtracting the gallons of advanced biofuels mandates from the total renewable fuels mandate.

Figure 12: Detailed figures on potential RIN deficit for advanced biofuel mandate

Source: EIA and EPA. Note: Assumes no commercial production of cellulosic biofuels until 2017. Cane ethanol imports to the US are assumed to stay steady from 2013 onwards at 200 million gallons. Finally assume biomass-based diesel RVO at 1.28 billion gallons (or 1.92 billion gallons of ethanol RIN equivalent, since it is 1.5 x D4 RIN).

Additional Disclosure

Please see the following for additional disclosure.


[1] Outlook for Ethanol and Conventional Biofuel RINs in 2013 and 2013, December 2012

[2] An Update of RIN Stocks and Implications for Meeting the RFS2 Mandates with Corn Ethanol." Nick Paulson and Seth Meyer, August 1, 2012

[3] RINfuriating, Deutsche Bank, Paul Sankey, March 19, 2013

Disclosure: I am long REGI, SYNM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.