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(Editors' Note: This article covers micro-cap stocks. Please be aware of the risks associated with these stocks.)

Every once is awhile, an article triggers a real "ah-ha" moment, when a certain comment provides a missing piece of a mental puzzle. That recently happened to me while reading fellow Seeking Alpha contributor Tristan R. Brown's article titled "Refiners Should Get Used To The High RIN Tax". Tristan is a lawyer as well as a Ph.D student in the biorenewable field. He does an outstanding job staying abreast of the changing regulatory environment and reporting on it in an impartial manner. On the other hand, I am a free market economist/financial analyst, and his articles, while much appreciated, make my blood boil with the inefficient and nonsensical manner in which many of these regulations are designed and implemented. Case in point is how Tristan semi-objectively reports that:

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

As a lover of the free market, I would have elaborated that forcing "Big Oil" with a "stick" to give "carrots" to biofuels firms is analogous to forcing an innocent man sentenced to death to buy the rope that will be used to hang him. Of course "Big Oil" is upset -- they are being forced to fund the industry that is being intended to make them obsolete. This centralized "Big Government" command and control approach is like having the government in the early 1900s taxing the horse ranchers and buggy makers to fund the emerging auto industry, or taxing the whale oil industry to fund John D Rockefeller's oil refineries. They are simply highly market distorting, inefficient, extremely expensive and awful economics. They reflect the goals and objective of a certain political party and ideology, with no consideration to what the consumer is demanding. That assumes, of course, that the consumers demand cheap and abundant energy. Worst yet, these policies often ignore real free market solutions.

That being said, these regulations may have accidentally stumbled upon a way to make biofuels a reality and be funded by "Big Oil" in a relatively non-punitive and less-divisive and confrontational manner. Right now, as the regulations stand, "Big Oil" is forced to fund the development of their competition. A commercially viable solution, however, is for "Big Oil" to be the ones that benefit from these regulations. Nothing is stopping "Big Oil" from simply buying up these biofuels plants and paying themselves the cost of the RINs. Valero (NYSE:VLO) seems to have figured that concept out. I doubt that the environmentalists had helping "Big Oil" in mind when they thought up these regulations, but leave it to the free-market to figure out a way to make "Big Oil" the beneficiary of these anti-Big Oil regulations. Ah, you just gotta love the law of unintended consequences. The irony is just too... well, ironic.

Valero, for example, operates 10.4% of U.S. refining capacity ... 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).

With RINs currently trading at around $1.40, we can then analyze the economics of this theory.

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 $1.42).

Right now the RFS2 mandate if for 13.8 billion gallons of ethanol in 2013.

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

That means that "Big Oil" is going to be hit with a $19.6 billion dollar "stick" to provide its competition free "carrots." That may sound like an "idealistic" utopia sitting in some ivory tower spending someone else's money, but I assure you, a whack on the head with a $19.6 billion stick is going to wake a lot of bean counters up out of their hibernation. Right now, I'm pretty sure most "Big Oil" firms are looking for ways to reduce the pain inflicted by that "stick," and the most cost effective way most likely will to copy the Valero model.

Biodiesel company Renewable Energy Group (NASDAQ:REGI) would be an ideal candidate. It has already been on a shopping spree buying up failing biodiesel plants and has been rapidly expanding capacity. It has a market cap of under $500 million, and produces over 225 million gallons annually. Its biodiesel gets 1.5 RINs per gallon, so at the current market cap, the investment would pay off in less than 2 years assuming that its production process at least breaks even. Other candidates for this kind of analysis would be Pacific Ethanol (NASDAQ:PEIX), KiOR (NASDAQ:KIOR), BIOX (OTC:BXIOF) and Syntroleum (NASDAQ:SYNM). The important metric is $19.6 billion annually. One single year's "stick" could buy up all the above companies and still have over $18 billion left for more acquisitions and expansion. Trust me, with those kinds of economics, "Big Oil" will be paying attention.

The economics, however, aren't that simple. Because "Big Oil" has to buy the RINs in order to meet the regulatory requirement, they don't necessarily care if the biofuels plant they buy turns a profit or not. What is important to "Big Oil" is that the plant they buy doesn't lose more money per gallon than the RINs that they get. For example, right now, without owning a biofuels plant, "Big Oil" would incur the entire $1.42 cost for the RINs. The "tax" on "Big Oil" would be $19.6 billion for 2013. Now assume "Big Oil" was able to purchase 13.8 billion ethanol gallon equivalent capacity that had a break even production cost without the RIN. "Big Oil" would then lose $0.00 on producing the biofuel, and be able to pay the entire $19.6 billion "tax" to itself. If the production process turned a profit, "Big Oil" would not only effectively pay no RIN "tax," they would make a profit for avoiding the "tax." To me, being an "idealistic" capitalist, that would be the best outcome. Markets, however, don't work that way. "Big Oil" would be concerned with minimizing their $19.6 billion tax liability, not turning a profit. Anything they could do to reduce that liability would make economic sense. What that means is that they would likely increase production of these biofuels until the loss they were taking on production matched the "tax" savings they were making on the fuel, or in economic terminology, they would produce up to the point where marginal revenues matched marginal costs.

The result of this would likely be that RIN prices would collapse for various reasons:

1) The production quota would almost certainly be met.

2) RIN prices would no longer be priced in a manner to ensure profitability of production, they would be priced to reduce a "tax" liability.

3) "Big Oil" embracing biofuels would signal to the market that plenty of capital would be invested in the industry resulting is increased capacity.

The other impact would be that feedstock prices would be bid up to a level that would make production unprofitable for independent biofuels firms. "Big Oil" wouldn't care about turning a profit -- they care about reducing a liability. This totally alters the financial dynamics on which the RINs are based. "Big Oil" would likely increase production to the point where the entire industry was producing at a loss, but at a "tax" loss savings. Ironically, this regulatory scheme has the potential to destroy the independent biofuels producers and benefit "Big Oil." I seriously doubt the ivory tower central planner considered that outcome when these regulations were being written, but that is the likely outcome if you understand how markets work. Existing biofuels plants will likely be purchased and benefit from this trend, but future firms will likely face an industry designed to generate annual losses, resulting in "Big Oil" being the only ones producing, and producing at a loss. Smaller independent firms simply won't be able to survive in that kind of economic environment.

In conclusion; while I am no fan of what the government is doing in the alternative energy sector, like inspector Clouseau or a broken clock, it may have accidentally stumbled upon a solution. With RIN prices over $1.40, the bean counters working for "Big Oil" have most likely been awaken by the sudden and sharp pain of being beaten with a $19.6 billion "stick." I assure you, "Big Oil" is now paying attention, and if they have any common sense they will choose the path of least resistance to ending the pain of the beating. That path would simply be to buy up and expand the capacity of the existing ethanol, biodiesel and renewable fuels firms. If that were to happen, America will get the alternative energy industry she wants, and it will be paid for by "Big Oil" paying itself a "tax." The most ironic twist to this solution is that these "green" regulations will likely eventually destroy the independent biofuels firms and effectively be a tax-payer/oil-consumer subsidy to "Big Oil." You simply can't make this stuff up.

Lastly, I put quotes around tax in the above article. I do that because the EPA doesn't have the power to tax, only Congress does. "Big Oil" may be able to argue against these regulations if they are deemed to be a "tax" on the basis that the EPA has no power to tax. We do after-all live in the United States which was founded upon the belief of "no taxation without representation." As I've always maintained, the greatest risk to these "green" energy firms is the political risk that they face. A single landslide election can legislate away the entire foundation on which they are based. I can't think of a better and faster way to erode support for these regulations than for "Big Oil" to become the beneficiary of them. That alone is a huge incentive for "Big Oil" to embrace biofuels.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please 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: Why Big Oil Should Embrace RFS2 And Biofuels