Renewable fuels may be changing drastically in the next 12 to 24 months due to the threat of mandated supply outpacing sluggish renewable fuel usage. The Renewable Fuel Standard (RFS) Program was first developed as part of the Energy Policy Act of 2005 and later updated by the Environmental Protection Agency (EPA) in 2007. Achieving energy independence as a county is the goal of the RFS, although set mandates are already causing concern among agriculture and biofuel producers.
A part of the original RFS, 7.5 billion gallons of renewable fuel were to be blended into U.S. gasoline by 2012, when in fact the U.S. produced around 13 billion gallons and seemed well on its way to meeting current and future mandates. The extended mandate now requires 36 billion gallons of renewable fuels to be blended into transportation fuel in 2022. The key concern is not the ability to produce increased amounts of renewable fuels moving forward, but to consume renewable fuels at such an increased pace.
In the U.S., 97% of renewable fuel production is derived from corn based ethanol as of 2011. The RFS requires that by 2022, corn based ethanol only comprise of 41.7% of the total renewable fuel production. The balance will primarily develop from cellulosic ethanol production, which has yet to be commercially produced in the U.S.
By the end of November each year, the EPA assigns amounts of renewable fuels to be blended by all the renewable fuel refineries and blenders (obligatory parties) in the U.S. for the following year. The mandated amount is called a renewable volume obligation (RVO). For every single gallon of renewable fuel produced in the U.S., a Renewable Identification Number (RIN) is provided by the EPA that the producer can then tag to a gallon of biofuel so the obligatory party can redeem the RIN to meet their RVO.
Renewable fuels are produced from many different sources and RINs are source specific. D3 RINs for cellulosic biofuels, D4 RINs for biomass-based diesel, D5 RINs for other advanced biofuel sources, D6 RINs are derived from corn and other renewable fuel based sources, and D7 for cellulosic diesel.
RINs can be exchanged so that obligatory parties have the option of buying RINs on the open market to make up for their potential shortfall to their RVO. Refiners and blenders may also blend more renewable fuel than what they had been assigned and in turn sell off their surplus of RINs. Each year, only 20% of surplus RINs may be carried over to the following year. If a refiner fails to meet their RVO and fails to purchase additional RINs, the refiner has until the end of the following year to blend the shortfall in biofuel, or buy additional RINs before fines start accruing at $25,000 per gallon below their RVO.
RINs do have an expiration date. Once a gallon of renewable fuel is produced, the corresponding RIN must be redeemed to the EPA by the end of the following year after the RIN was created. For example, if a gallon of corn based ethanol was produced on May 6, 2012 generating a D6 RIN, the RIN will expire after December 31, 2013. The expiration date is embedded within the 38 digit RIN. Additionally, the RIN may be applied to a shortfall for one year prior.
The Blend Wall
The RFS requires a set amount of renewable fuels to be produced each year; steadily increasing. Biofuel refiners fear a potential blend wall may be on the horizon in 2014. The blend wall will occur when the RFS required amount of renewable fuel production is higher than current demand for renewable fuels. In 2011, 13.5 billion gallons of corn based ethanol were produced in the U.S.; well above the RFS requirement, although the outlook for ethanol usage does not appear to be able to increase as fast as RFS mandates call for.
In 2013, 2.6 billion D6 RINs were carried over to start the year. These D6 RINs can act as safety for ethanol refiners and blenders in 2013 if production costs rise or output prices decrease. Since 2007, U.S. consumer demand for gasoline has been decreasing from 142.35 billion gallons to 133.78 billion gallons in 2012, according to the EIA. The point at which ethanol refining and blending ceases due to meeting consumer demand and also when RINs are exhausted, the blend wall will be met. Many experts expect this to occur in mid 2014. As U.S. gasoline demand decreases and the amount of ethanol blended into each gallon of gasoline remains constant, the blend wall becomes more of a reality.
The U.S. goals of becoming energy independent and decreasing the country's carbon foot print are novel approaches indeed, but the required mandates to reach these goals can at times, clash. Although there are multiple ways to meet these broad goals, one of the primary issues is the conflict between the RFS and Corporate Average Fuel Economy (NYSEARCA:CAFE).
CAFE was first enacted in 1975 for the purpose of reducing energy consumption by increasing fuel economy in cars and light trucks. CAFE is regulated by the National Highway Traffic Safety Administration (NHTSA) and the EPA. Average fuel economy standards have been established through 2025. The standards consist of three categories: passenger cars, light trucks, and a combination of the two. The standard calls for an average combined fleet-wide fuel economy of 48.7 to 49.7 miles per gallon (NYSE:MPG) by the year 2025. The 2012 combined fleet-wide fuel economy was 25.2 MPG. It is estimated that between the years of 2017 and 2025, the U.S. will save approximately 4.0 billion barrels of oil and 1.8 billion metric tons of CO2 emissions.
So what is the problem with increasing fuel economy and reducing our carbon foot print? Nothing, unless you are an ethanol refinery trying to meet RFS production goals. The Energy Independence Act of 2007 made assumptions that gasoline demand would increase each year leading up to 2022. The opposite has occurred, and in fact, 2007 marked the peak of U.S. gasoline consumption. In 2012, 133.8 billion gallons of gasoline were used; far below the estimated 150.0 billion.
A portion of the decrease in gasoline consumption is due to increased fuel efficiency of passenger cars and light weight trucks. Fuel efficiency has been improving drastically over the past 10 years and is expected to double in the next 12 years according to the CAFE standards.
The EPA regulates both the CAFE standards and the RFS goals, yet both programs contradict each other. If the CAFE standards decrease fuel demand through improved fuel economy and the RFS mandate calls for increased production of fuel, one of these goals is doomed to fail.
Demand for RINs
RIN prices have recently been increasing to record levels and surpassed $1.00 in March of 2013; over 5,000% above price levels seen at the end of 2012. Why the spike in RIN prices? The potential blend wall has a large part to do with the recent uptick.
In order to comply with the RFS, biofuel refiners and blenders have to produce a certain amount of ethanol in a given year. Due to the blend wall, it would not make sense for refiners and blenders to produce more blended gasoline. In order to comply with the RFS, refiners and blenders purchase RINs instead. Each RIN is tied to a gallon of ethanol, thus RINs can run out. The production of D6 RINs dropped in 2012 to an equivalent of 12.97 billion gallons, compared to 13.59 billion gallons in 2011.
It is estimated that through 2013, there are enough RINs in the market to comply with the RFS, but from 2014 and on, RINs are expected to deplete and run out. Obligatory parties are aware of this scarcity and have been buying RINs at a rapid rate and subsequently driving RIN prices higher.
Lagging Cellulosic & Biodiesel Production
In 2013, 1.0 billion gallons of cellulosic ethanol is to be produced per RFS mandate. The Cellulosic ethanol mandate will triple by 2015 to 3.0 billion gallons and by 2022, 44% of the 36 billion gallons of renewable fuels are to derive from cellulosic ethanol. Unfortunately, the cellulosic ethanol industry has not been advancing as fast as the EPA had originally forecasted.
In 2011, no cellulosic ethanol was produced in the U.S. and finally in October of 2012, the first commercial cellulosic biofuel plant opened. Within the next two years, companies including DuPont, Poet, Mascoma, and Valero are all planning on opening commercial cellulosic biofuel plants with capacities of over 20 million gallons per year, according to Bloomberg.
The RFS mandate pertaining to cellulosic biofuel likely will not be reached in 2013, although the EPA has been waiving D3 RIN RVOs. We forecast D3 RINs to be mandated if commercial cellulosic biofuel plants continue to open in 2013 and 2014. Large government loans are available for new cellulosic biofuel production facilities to help speed along the lagging industry.
Biodiesel is considered the utility fuel within the RFS. It can be used as any type of RIN within a given year and is also given a preferential 1.5 gallon RIN towards the mandate for every one gallon produced.
Why can't the RFS be met with increased production of biodiesel? Again, we go back to the supply and demand of biofuels. It is estimated that 7.5 pounds of feedstock is required to make one gallon of biodiesel. The 2013 mandate for producing biodiesel is 1.28 billion gallons, thus it would take 9.66 billion pounds of feedstock to meet the mandate and of that 9.66 billion, 6.66 billion would come from vegetable oils.
If we fast forward to 2015 and ask biodiesel to pick up the entire volume for other advanced biofuels including biodiesel and undifferentiated biofuel, it would take the total 2012 consumption of vegetable oil in the U.S. to produce that much biodiesel.
Similar to cellulosic ethanol, biodiesel has limits on capacity. It is estimated by the EPA that biodiesel capacity in the U.S. is 2.5 billion gallons. If biodiesel were to be used to fill the advanced mandates in 2014, it would reach the 2.5 billion gallon maximum capacity. Moving forward, biodiesel RINs may have the most value in the marketplace due to their multiuse functionality.
As it stands, RFS cannot be changed unless legislature passes alterations. One scenario to solve the failure to meet the RFS mandate would be to temporarily lock 2013 mandates in place for 2014 and 2015. The current amount of RINs would be able to carry producers through 2015 and delay the potential blend wall.
If RFS is held constant, cellulosic, biodiesel, and other advanced biofuels would be held at levels below 1.28 billion gallons. Corn based ethanol production would be capped at 13.80 billion gallons. The lack of expansion in cellulosic ethanol production and biodiesel production would be temporarily stalled, but after 2015, production would need to continue to progress.
The U.S. Government would need to take action and agree upon a temporary freeze of the RFS mandates in time for biofuel producers to plan for future production. The short-term history of major decisions being finalized quickly by the government has not been good.
In order to break down the blend wall, more action is needed than simply approving ethanol blends above E10. Consumer adoption and private support will be the key drivers for knocking down the blend wall. Consumer concerns with ethanol stems from the automakers disdain for ethanol and the fact that fuel is being produced at the expense of food. The later would be hard to disprove, but working with automakers should be a top priority for the ethanol industry.
At the beginning of 2012, the EPA approved E15 gasoline for any car or light truck 2001 or newer. Major automakers have not accepted this approval and argue that the use of E15 will void most warranties including cars and light trucks that are 2001 and newer.
Misfueling is another risk that auto companies are warning consumers about. AAA has been the leading authority warning consumers that mistakenly filling up with E15 could cause problems with cars, trucks, and small engines.
The RFS has been implemented since 2007 and so far refiners and producers have been able to meet the mandates, but there is much concern over the coming years for meeting these lofty goals. Reality has been starting to set in as RIN prices have surged from pennies to over $1.00 already in 2013 over the fear of the blend wall.
Speculators have started to invest in RINs as a way to capitalize on the potential failure of RFS in the upcoming years. Investing in RINs is high risk as RIN prices are very volatile. There have also been reports of fraudulent RINs being traded. We will monitor RIN prices moving forward and production data on biofuels to see if/when the blend wall will arrive.
At some point, there needs to be a change for either biofuel production to be accepted at growing below expected pace in regards to RFS, or for Americans to start consuming all renewable fuels at an increased pace. E85 has been in existence since 1995, but less than 4,000 gas stations offer it. If E15 usage increases fast enough, there is still hope RFS mandates can indeed be met. Government support, commercial support, and consumer support will all be needed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.