California's low carbon fuel standard may provide a significant opportunity for biomass-based diesel producers such as Renewable Energy Group (NASDAQ:REGI), Syntroleum (NASDAQ:SYNM), and FutureFuel (NYSE:FF). In addition, low carbon ethanol producers such as Pacific Ethanol (NASDAQ:PEIX) and Aemetis (OTCQB:AMTX) could benefit as well. Key points highlighted in this report:
- Biodiesel blend rates to increase from 1% to 5%, in the near-term, and to 20% in the medium/long-term, substantially increasing the biodiesel demand in California, America's largest transportation fuel market.
- Carbon credit prices suggest that California's regulated parties (i.e. oil companies, refiners) will be required to blend more biomass-based diesel to meet state mandated carbon intensities, increasing demand for biodiesel producers.
- At current carbon credit prices of $62 per metric ton, biomass-based diesel producers could earn up to an additional $0.44/gal of EBITDA/gal net of transportation costs, selling into California. For a biodiesel producer, the historical industry average EBITDA/gal is between $0.55/gal and $0.85/gal. Thus, at current EBITDA/gal levels, per unit gallon sold in California, LCFS can provide an operating profit upside up to ~60%.
- Given LCFS declining carbon intensity, we expect a carbon credit deficit that will support continued high carbon credit prices. This will benefit biofuel producers' bottom line for the foreseeable future.
- LCFS can potentially drive share price appreciation of 120%, 30% and 160%, from current levels, for REGI, FF, and SYNM, respectively.
- Low-carbon ethanol producers such as PEIX and AMTX, with production in California, will also see EBITDA/gal increases from 7c/gal to 20c/gal, a 185% increase from current levels.
Additional Disclaimer here
Not well known to the investment community, California's low carbon fuel standard or LCFS has the potential to provide significant earnings power to biomass-based diesel producers such as Renewable Energy Group, Syntroleum and FutureFuel, and ethanol producers such as Pacific Ethanol and Aemetis (OTCQB:AMTX). Since the publication of "Renewable Energy Group and Syntroleum: Alpha Generation And Intelligent Way to Hedge RIN Risk of Independent Refiners," much of the investment community's attention has been rightly focused on Renewable Fuel Standard (RFS) and Renewable Identification Numbers (RINs). The federally mandated RFS continues to provide secular tailwinds and enhances the profitability of biofuel producers. However, investors should also pay attention to LCFS as it is expected to provide significant incremental upside for biofuel producers. Under LCFS, we believe regulated parties such as refiners in California will be forced to increase biodiesel blend rates up to 20%, increasing biodiesel demand in California, America's largest transportation fuel market.
LCFS is a regulation adopted in 2009 that requires regulated parties such as Chevron, Valero (NYSE:VLO), Tesoro (NYSE:TSO), etc., to reduce the carbon intensity or CI of their transportation fuel mix by at least 10% by 2020. It sets declining annual targets, starting with 0.25% reduction in 2011 and accelerating to 10% reduction by 2020 (the standard is back loaded and more stringent in later years). Since the policy's implementation, regulated parties have responded to the LCFS by lowering CI of California's transportation fuel pool by blending in low carbon fuels such as biodiesel, renewable diesel and low carbon ethanol. For example, in 2012, low carbon fuels displaced roughly 1.06 billion gallons of gasoline and 45 million gasoline equivalents of diesel (representing 6.2% of combined gasoline and diesel fuel) at average CI of 84.95 gCO2e/MJ (grams of carbon dioxide equivalent per megajoule) and 58.34 gCO2e/MJ respectively . Shown in Figure 1, LCFS decreasing CI requirements will increase demand for low carbon fuels such as biodiesel, renewable diesel and low carbon ethanol. In order to meet the reduced CI of transportation fuels, regulated parties must blend increasingly more biodiesel and renewable diesel, and more low carbon intensity ethanol.
Figure 1: LCFS requires declining carbon intensities for transportation fuel
Source: California Air Resource Board or CARB. Note: The average carbon intensity requirements for years 2011 and 2012 reflect reductions from base year (2010) CI values for ULSD and CaRFG calculated using the CI for crude oil supplied to California refineries in 2006. The average carbon intensity requirements for years 2013 to 2020 reflect reductions from revised base year (2010) CI values for ULSD and CaRFG calculated using the CI for crude oil supplied to California refineries in 2010.
LCFS carbon credits are designed to provide financial incentives to promote innovation and deployment of low carbon fuels into California's transportation fuel pool. One carbon credit is equal to one metric ton of carbon dioxide equivalent. The objective is to allow market mechanisms to drive industrial and commercial processes to support low emissions or less carbon intensive fuels. If a regulated party is not compliant with LCFS, it could blend additional biofuels or purchase carbon credits to achieve compliance. Alternative fuel producers such as REGI, SYNM, FF, PEIX and AMTX, when selling biofuel into the California market, will be able to command a higher price for their product that includes the value of the generated carbon credits. When there is more demand than supply for carbon credits, credits rise in value. This will encourage more biofuels to be blended in California. The average daily credit value was approximately $12.50 in November 2012, and is most recently trading around $62 ($/MT gCO2e). Figure 2 provides a snap shot of the current trend with LCFS carbon credits. Since the beginning of 2013, the value of the LCFS carbon credit has increased by 131%.
Figure 2: Increasing carbon credit values is expected to continue
The rapid increase in value is primarily due to expected increase in demand for biofuels to meet future compliance needs. In fact, if regulated parties remain at current average fuel mixes and carbon intensities, as reported during the last four quarters, the use of banked credits (carried over from surplus credits of previous years), will only cover the LCFS requirements for 2013. Future compliance will require further CI reduction from the transportation fuel pool. Figure 3, provides a potential scenario from the Institute of Transportation Studies, University of California at Davis.
Figure 3: Expected deficit of LCFS carbon credits if remaining on current status quo, blend rates and fuel mixes
Source: Institute of Transportation Studies, University of California at Davis. Net credits generated are the number of credits or deficits generated in each period. Banked credits, after compliance, are the number of excess credits banked from the current or previous years.
Because gasoline/ethanol and diesel/biomass diesel are pooled under LCFS for compliance purposes, regulated parties can over-blend in one category to compensate for deficiencies in other categories. Given the 10% blend wall for ethanol and gasoline (10% ethanol 90% gasoline), and in order to meet decreasing CIs requirements, we believe that California will increase the amount of biodiesel blended into diesel from its current level of approximately 1% (B1) to 5% (B5) in the near term, and 20% (B20) over the medium/longer term. In the past, California has not been consuming biodiesel at 5% blend rates - last year the blend rate was closer to 1% of total distillate sales. Given the strong blending economics and strict LCFS requirements, we believe blend rates will increase to 5%, which will provide significant growth opportunities for biodiesel producers. Regulated parties such as VLO and TSO will likely blend more biodiesel to capture favorable economics and to meet compliance.
California Diesel Market to Undergo Significant Demand Expansion
As mentioned in this Seeking Alpha article, the biomass-based diesel industry is facing favorable margins driven by the $1/gal tax credit and high D4 RIN values. Strong blending economics resulting from the RFS mandate, blenders are now incentivized to blend up to 5%. However, not well known to the investment community, the California Air Resources Board is working on state regulations that will help the adoption of blend rates up to 20%. The increase in the blend rates is to accommodate future LCFS requirements. The finalized terms of the regulations are expected to be completed later in 2013 and could be a significant catalyst for the entire biodiesel sector. Assuming regulated parties blend up to the rate of 5%, approximately 175Mgals per year (5% * 3.5Bgals/year of diesel used in California) of biodiesel will be blended in California. This is a significant increase compared to the 30Mgals of biodiesel that was blended in 2012. At 20% blend rate, the amount of biodiesel that can be blended into the transportation fuel pool will be around 700Mgals per year (5% * 3.5Bgals/year). To illustrate the significance of the California opportunity, the federally mandated renewable volume obligation (RVO) for the entire US is 1.28B gals for 2013 as shown in Figure 4. The B20 opportunity, as a result of LCFS, will significantly increase the incremental demand for biodiesel production in the US.
Figure 4: B20 blend will increase the available market for biodiesel in California. Increase in demand due to LCFS could potentially benefit biomass-based diesel producers
Source: RFS, EIA
As shown in Figure 1, the year-over-year requirements to decrease carbon intensity will provide secular tailwinds for certain biofuel producers for many years. In order to meet increasing stringent requirements of LCFS, 20% biodiesel blends are expected to quadruple the available market for biodiesel producers who sell into the California market. Figure 5, illustrates the economics for biodiesel and renewable diesel producers at current LCFS carbon credit levels.
The carbon intensity of biofuels is highly dependent on its feedstock and use of land. Biodiesel producers such as REGI and FF, can use corn oil as a feedstock which has a very low carbon intensity of 4. Soybean oil based biodiesel has a relatively very high carbon intensity of 84.25. California Air Resources Board provides a carbon intensity lookup table for various feedstock here. To compute the value of the carbon credit per gallon of biomass-based diesel, one can use this formula: (Annual Baseline CI of ULSD - CI of the pathway depending on feedstock) * Energy Density * Carbon Credit Value.
Figure 5: Selling biodiesel into the California market can create significant earnings upside for biomass-based diesel producers
Source: California Air Resources Board. Assumption: REGI and FF have similar economics. They are both multi-feedstock capable.
Assuming today's LCFS carbon credit value of $63/MT, and transportation and transloading cost of 25c/gal and 5c/gal respectively, the model in Figure 5 provides the "Additional EBITDA" as a result of the LCFS program. Although transportation costs vary from one location to another, for simplicity, we assume similar transportation and transloading costs for REGI, FF and SYNM. From the model it is very clear that biodiesel producers such as REGI and FF can generate net EBITDA/gal equal 44c/gal if they sold corn oil based biodiesel in California. Per this SeekingAlpha article, current average EBITDA/gal for biodiesel producers is around 75c/gal. Selling biodiesel into California will increase this average EBITDA/gal to $1.19/gal (44c/gal + 75c/gal), which is 60% upside from current levels. Renewable diesel producers such as SYNM will receive 36c/gal of additional EBITDA if they sold their product into California. The LCFS program will provide an additional 36% upside to SYNM's projected EBITDA levels (SYNM is in the process of starting its plant and should be running by mid-July 2013). Even at lower carbon credit values, biomass-based diesel providers will continue to benefit from the LCFS program. Nevertheless, we believe the LCFS credits will continue to rise for the foreseeable future.
Although this article is primarily focused on biomass-based diesel producers, for low-carbon ethanol producers located in California, we also see potential upside for PEIX and AMTX as illustrated in Figure 6. To compute the value of the carbon credit per gallon of low carbon ethanol, one can use this formula: (Annual Baseline CI of Gasoline - CI of the pathway depending on feedstock) * Energy Density * Carbon Credit Value.
Figure 6: Local low-carbon ethanol producers such as PEIX and AMTX will also benefit from LCFS
Source: California Air Resources Board. Assumption: PEIX and AMTX have similar economics. Both have ethanol plants in California.
Selling low carbon ethanol into California will increase this average EBITDA/gal to $0.20/gal (13c/gal + 7c/gal), which is 185% upside from current levels. Not all ethanol producers will receive similar carbon intensity ratings. PEIX and AMTX produces low carbon intensity scores primarily due to the fact they generate wet distillers' grains, a byproduct of corn-ethanol production - versus dry distillers grains, which require an energy intensive drying process.
Valuation and Conclusion
This section, we model the potential upside for REGI, FF, SYNM. Using reasonable scenarios and some basic assumptions, Figure 7 provides a target price of $28.95, $20.13 and $18.51 for REGI, FF and SYNM respectively. Basic assumptions for the model are listed in the caption below the figure. We encourage readers to model out their own scenarios and apply their own assumptions.
Figure 7: Potential scenario, LCFS to improved EBITDA/gal for REGI, FF and SYNM, translating to higher valuations
Source: Bloomberg for the current capital structure and share count. Assumptions: REGI, 90% utilization, 30% of production from corn-oil and all sold into California market, production figures were raised given their recent acquisition of 30Mgpy plant; fully diluted shares would be 36.6M including the preferred that would covert to common; FF, 90% utilization, 100% of production from corn-oil and 50% sold into California market, $50M EBITDA contribution from other business lines; SYNM, 50% ownership of Dynamic Fuels and 77% utilization rate, all production from animal fat feedstock, 50% of total production sold into California market. As with the previous article, we use EV/EBITDA multiple of 5.0x for REGI and SYNM. However, for FF, the model employs FF's current EV/EBITDA multiple of 6.3x. Given the strong economics, biomass-based diesel producers will sell as much product into California as possible.
At the current valuation levels, we believe that the market has not priced in the potential upside due to the LCFS program. Applying the current capital structure (est. from Bloomberg), the model suggests an approximate upside of 120%, 30% and 160% from current share price levels for REGI, FF and SYNM, respectively. Savvy investors will quickly conclude that the LCFS program will cause a significant disruption in the biofuel space, which will ultimately benefit biofuel producers.
Appendix A: Background on LCFS
The California low carbon fuel standard or LCFS has been in effect since 2011. Most regulatory information on LCFS can be found on the CARB website.
California is steadfast leader in supporting for drastic improvements in carbon emissions. The purpose of this regulation is to implement a low carbon fuel standard, which will reduce greenhouse gas emissions by reducing the full fuel-cycle, carbon intensity of the transportation fuel pool used in California, pursuant to the California Global Warming Solutions Act of 2006. The carbon intensity, defined as grams of carbon dioxide equivalent released per megajoule of energy produced, is used to rank and compare biofuels and fossil fuels.
Transportation is one of the largest sources of global warming, which must be reduced to avoid further deterioration. With the creation of the Federal Renewable Fuel Standard and the California Low Carbon Fuel Standard, fuel suppliers and regulated parties are looking to include more renewable and low carbon replacements for conventional gasoline and diesel. Biodiesel, with its unique chemistry, has the potential to replace conventional petroleum diesel and can be considered an alternative diesel fuel . The LCFS was designed to encourage the use of all types of low carbon fuels. Rather than promoting particular technologies or specific fuels, fuel suppliers are free to choose how they meet their emissions targets. The most common low carbon fuels today are biomass-based diesel and low carbon ethanol. By allowing compliance flexibility, the LCFS supports innovation in transportation fuels while contributing to both energy and climate security .
Appendix B: Background on Biofuel Producers
Renewable Energy Group is a leading North American biodiesel producer with a nationwide distribution and logistics system. Utilizing an integrated value chain model, Renewable Energy Group is focused on converting natural fats, oils and greases into advanced biofuels. With more than 225 million gallons (excluding recent acquisitions) of owned/operated annual production capacity at biorefineries across the country, REG is a proven biodiesel partner in the distillate marketplace.
FutureFuel is engaged in the chemical and biofuels business. The Company operates in two segments: chemicals and biofuels. Through its wholly owned subsidiary, FutureFuel Chemical Company, the Company owns approximately 2,200 acres of land six miles southeast of Batesville in north central Arkansas fronting the White River. FutureFuel Chemical Company manufactures diversified chemical products, bio-based products comprised of biofuels, and bio-based specialty chemical products. Approximately 500 acres of the site are occupied with batch and continuous manufacturing facilities, laboratories, and associated infrastructure, including on-site liquid waste treatment.
Syntroleum, together with Tyson, operates a 75 million gallon per year plant renewable fuel plant. Building on over 20 years experience, Syntroleum has proven its ability to produce synthetic fuels from a wide variety of feedstock-from natural gas to fats, oils and greases. The Fischer-Tropsch process has already been utilized through the company's comprehensive labs and production facilities to produce significant amounts of synthetic diesel and jet fuel. These fuels have been successfully proven to perform better than conventional fuels across most operating parameters, including emissions, thermal stability, and cetane. With the growing demand for renewable fuels worldwide, Syntroleum is also utilizing its Bio-Synfining™ technology to produce renewable synthetic fuels with the same superior qualities.
Pacific Ethanol is a marketer and producer of low-carbon renewable fuels in the Western United States. Pacific Ethanol markets all the ethanol produced by four ethanol production facilities located in California, Idaho and Oregon, or the Pacific Ethanol Plants, all the ethanol produced by three other ethanol producers in the Western United States and ethanol purchased from other third-party suppliers throughout the United States. It also markets ethanol co-products, including wet distiller's grains and syrup (WDG), for the Pacific Ethanol Plants.
Aemetis is an international renewable fuels and biochemicals company focused on the acquisition, development and commercialization of innovative technologies that replace traditional petroleum-based products by the conversion of first generation ethanol and biodiesel plants into advanced biorefineries. The technology platform allows for the conversion of existing biorefineries, thereby substantially reducing capital expenditures, construction time and startup costs associated with building plants for processing biomass into renewable chemicals and fuels. This strategy enables Aemetis to quickly commercialize technologies by leveraging investments already made in existing biorefineries through joint ventures with existing biofuel plants.
 Status Review of California's Low Carbon Fuel Standard, Institute of Transportation Studies, University of California, Davis, S. Yeh, J. Witcover and J. Kessler, Spring 2013
 Carbon Intensity Lookup Table for Gasoline and Fuels that Substitute for Gasoline, California Air Resources Board, Low Carbon Fuel Standard Program
 Discussion of Conceptual Approach to Regulation of Alternative Diesel Fuels, California Environmental Protection Agency, Feb 15, 2013
 Benefits of a Low Carbon Fuel Standard: Performance Based, Technology-Neutral Policy to Reduce Emissions from Transportation Fuel, Union of Concerned Scientists