For most of its existence the revised Renewable Fuel Standard [RFS2] has been the policy equivalent of a tempest in a teapot. The program incentivizes biofuel production via the carrot and the stick: the carrot subsidizes production by means of tradable compliance commodities called Renewable Identification Numbers [RIN] while the stick requires petroleum refiners to purchase the produced biofuel (or the corresponding RINs) in proportion to their U.S. share of the refining market. The refiners bear the costs of the RINs, which are nominally equal to the difference between a biofuel's market price and its production cost. RINs can therefore be considered a subsidy to biofuel producers paid by a tax on refiners, albeit a flexible one set by market fundamentals rather than Congressional pencil-pushers. The refining industry has never been happy with this arrangement, protesting since its inception that the RIN program merely amounts to another tax on "Big Oil" imposed by idealistic politicians. These claims rang hollow for several years, however, due to the fact that RINs have largely been all but worthless for most of their existence, ranging between [pdf] $0.01 and $0.04/gal. As recently as 2012, when the RFS2 mandated the usage of 13.2 billion gallons of corn ethanol, the annual cost imposed on the entire refining industry by RINs amounted to roughly $330 million (out of revenues of $700 billion).
The end of cheap RINs
The era of inexpensive RFS2 compliance came to an end at the beginning of 2013 as corn ethanol1 RIN values rapidly increased from $0.04 in January to nearly $1 by the end of February (at the time of writing they are $1.02). The corn ethanol mandate for 2013 is 13.8 billion gallons, imposing an annual compliance cost of $14.1 billion on the U.S. refining industry at current values. While still just a fraction of industry revenues, the numbers look much worse from an income perspective. Valero, for example, operates 10.4% of U.S. refining capacity (see table), making it responsible for roughly the same share of the RFS2 volumetric mandate if we use refining capacity as a proxy for calculating the company's Renewable Volume Obligation [RVO]. At current values, Valero would need to spend $1.5 billion out of an annual operating income of $4 billion to purchase sufficient RINs to satisfy its portion of the 2013 mandate. (In reality Valero operates 10 corn ethanol facilities with a combined annual capacity of 1080 million gallons, allowing the company to meet the majority of its portion of the mandate via biofuel production rather than RIN purchases). Furthermore, this doesn't account for the biodiesel (1.28 billion gallons) category of the 2013 mandate, which further increases the total cost of compliance by more than $1 billion at current RIN values.
Top 10 U.S. Publicly-Traded Refiners by Capacity
|Refiner||Million bbl/day||% of U.S. total||2012 operating income (billion)|
|Phillips 66 (NYSE:PSX)||$6.6|
|Marathon Petroleum (NYSE:MPC)||$5.3|
|PBF Energy (NYSE:PBF)||$0.9|
|Royal Dutch Shell (NYSE:RDS.A)||$46.4|
Sources: EIA, Google Finance
The sharp increase in RIN values was not unexpected given both the fall in corn prices relative to gasoline prices at the end of 2012 and a 11% decline in monthly ethanol production since the beginning of the year (see charts). The primary cause of such low RIN values until this year was U.S. ethanol production overcapacity. While RIN values operate as a function of biofuel production costs and market prices to prevent biofuel producers from running losses, this only holds true so long as annual production falls short of the volumetric mandate for a given year. In other words, RINs have sufficient value to ensure that the mandate is met, but no more. One consequence of the now-defunct Volumetric Ethanol Excise Tax Credit [VEETC] was ethanol production overcapacity since the credit didn't operate as a function of the mandate. Annualized ethanol production didn't fall below the respective annual volumetric mandate until the summer of 2012, when the combination of drought-induced high corn prices and almost-worthless RINs resulted in the nationwide shuttering of corn ethanol facilities. When annualized production fell below the mandated volume for 2012 and gasoline prices fell relative to corn prices, however, the recipe for higher RIN values was in place.
CORN data by YCharts
US Fuel Ethanol Production data by YCharts
Hitting the blend wall
While the dynamic between ethanol production and corn and gasoline prices explains why RIN values finally began increasing at the beginning of the year, it doesn't explain why RIN values have remained at all-time highs in 2013 even as ethanol production has remained flat and gasoline prices have risen relative to corn prices (see chart). This can be explained by the blend wall, a unique hurdle facing all ethanol pathways (both starch and cellulosic) that the U.S. industry has yet to overcome. Fuel ethanol is a gasoline substitute rather than replacement, and it can only be used in conventional internal combustion engines when blended with a large proportion of gasoline. At present in the U.S. it is limited by the Environmental Protection Agency [EPA] to a 15% blend by volume [E15], although practically the former 10 vol% blend limit is far more common at pumps offering ethanol blends. This blend limit has the effect of limiting ethanol's domestic consumption to 10 vol% of gasoline, meaning that the size of the U.S. fuel ethanol market can only expand when U.S. gasoline consumption also does so. Unfortunately for ethanol producers, U.S. gasoline consumption peaked in 2007 and fell to 134 billion gallons in 2012, with further declines projected in the coming years by the U.S. Energy Information Administration. With the U.S. transportation fuel infrastructure only able to handle 13.4 billion gallons of ethanol and the RFS2 calling for 13.8 billion gallons of ethanol consumption in 2013, refiners ushered in the year by scrambling to purchase sufficient RINs to meet their RVOs for the year before the blend wall was hit. RIN demand has remained high with monthly ethanol production still 12% below its 2012 peak.
US Fuel Ethanol Production data by YCharts
A permanent RIN plateau?
Given the substantial compliance costs that RIN values in excess of $1 impose on refiners, it is worth considering whether RINs will remain high as well as the necessary conditions for values to fall. Falling gasoline consumption does not bode well for refiners, since corn ethanol production is still below the 15 billion gallon per year [BGY] usage cap imposed on it by the RFS2. Furthermore, cellulosic ethanol is about to achieve commercial-scale production with 155 MGY in capacity expected to be completed by the end of 2014 (based on current construction). While tiny relative to corn ethanol capacity, any increases in cellulosic ethanol production will displace corn ethanol production so long as the blend wall remains in place. Successful adoption of E15 pumps and/or E85 flex-fuel vehicles would push the blend wall back, although rates of adoption for both have fallen woefully short of energy economists' expectations.
An additional release valve for the ethanol industry is available in the form of fuel ethanol exports, as RINs are also available for trade when ethanol is exported. As an agricultural product, however, corn ethanol is exempt from the tariff restrictions imposed on World Trade Organization members and faces stiff trade barriers in a number of foreign countries. It's possible that excess U.S. fuel ethanol could be exported to Brazil, which doesn't have the same blend wall issue due to high flex-fuel infrastructure and vehicle adoption rates in the country, although this would need to overcome both uncompetitive production costs relative to cane ethanol as well as Brazilian political opposition (the U.S. only recently removed a long-standing import tariff on Brazilian ethanol).
RIN values could still fall in the future despite these challenges, although a number of certain conditions would be required. First, a sustained fall in corn prices and rise in gasoline prices would improve ethanol producer profits and reduce the RIN value necessary for production to increase. Furthermore, were such price movements to occur, drivers could be incentivized to purchase flex-fuel vehicles and/or increase demand for higher blends of ethanol with gasoline. While a RIN premium would be required to cover the costs of infrastructure upgrades and vehicle conversion, most of the costs would be borne up front (i.e., a smaller premium would be necessary after the infrastructure upgrades were made).
Second, a breakthrough in the production of high-energy biofuels from corn starch, such as Gevo's (NASDAQ:GEVO) biobutanol, would postpone the blend wall while effectively reducing the annual volumetric requirement. The RFS2 mandates are based on ethanol-equivalent gallons and ethanol has only 67% of the energy content of gasoline. Higher-energy fuels generate additional RINs, up to 1.5 RINs per gallon of renewable gasoline (so-called "drop-in biofuels"). Their presence would increase the supply of RINs and thus cause their value to fall, assuming that they could be produced cost-competitively with corn ethanol.
Finally, any substantial reductions in the costs of producing drop-in cellulosic biofuels would ultimately cause RIN values to fall, especially if these reductions were to occur in conjunction with high corn prices. In addition to the energy content advantage of drop-in biofuels described above, lignocellulosic biomass is a much cheaper feedstock than corn. More importantly, drop-in cellulosic biofuels are most likely to be produced in part via routes such as hydroprocessing that are frequently used by refiners to produce gasoline and diesel fuel. (In fact, back in 2011 I spoke with a grizzled petroleum engineer working for the National Academy of Sciences who stated that he didn't expect biofuel hydroprocessing costs to fall in the future since the petroleum industry has already perfected the process.) KiOR (NASDAQ:KIOR), which began continuous production of drop-in cellulosic biofuels earlier this year, employs petroleum refining technology in the form of hydroprocessing to do so. Refiners could directly reduce their costs of compliance with the RFS2 by employing their own technology to produce drop-in cellulosic biofuels, much as Valero has done with corn ethanol. Drop-in cellulosic biofuels also provide an implicit price advantage to refiners under the RFS2 since they can be used in compliance with three of the four mandate categories, thus offering more flexibility than corn ethanol.
U.S. refiners have experienced a drastic increase in the costs of compliance associated with the RFS2 thus far in 2013 due to surging RIN values. Once a mere nuisance, these costs now represent a substantial cost to refiners, particularly dedicated refiners. It is unlikely in the short-term that RIN values will fall substantially, although a simultaneous decrease in corn prices and increase in gasoline prices would put pressure on them. In the mid- to long-term RIN values will largely be driven by the ability of the U.S. to overcome the ethanol blend wall. A number of options are available for doing so, including consumer acceptance of higher fuel ethanol blends such as E15, making the fuel infrastructure flex-fuel capable, and replacing ethanol at least in part with high-energy biofuels. These longer-term options are more uncertain, although refiners have more influence over them than they do over the relationship between corn and gasoline prices. U.S. refiners will need to take action to mitigate their costs of compliance with the RFS2 in the future since RIN values are unlikely to return to their previous low levels without such action.
1 The technical term for the corn ethanol RIN category is "total renewable fuel" because biofuels qualifying for any of the other biofuel categories can qualify for it as well, although at present only corn ethanol is produced under it.