I recently wrote about how ethanol RINs were up over 2,700% year to date. I did so anticipating that ethanol would soon to be making the headlines. Well, I didn't have to wait long. In this video, David Lutz, head of ETF trading at Stifel Nicolaus, does a great job reviewing the economics that are driving ethanol RINs into bubble territory, and why they are likely to stay there for an extended period of time.
First, the basics. If you didn't read the above linked article, a RIN is a regulatory tool similar to a tax that ensure a certain amount of ethanol is produced each year. So far this year they have gone from about $0.05 to well over $1.00. This article provides a few more details.
While the mechanics of the RIN market can be dizzyingly complex...Each RIN is a unique 38-character code that is assigned by an ethanol producer to each gallon or batch of fuel. When the fuel is sold to an oil company that blends the ethanol with gasoline, the RIN can then be "retired" to regulators, or sold on the market.
Second, the details. The video does a great job covering the economics and is worth watching. In this article I'll expand upon the concepts explained in the video, and provide some investment ideas.
Point #1: Each year the amount of ethanol required to be produced increases each year, with the current quota being 13.8 billion gallons for 2013. The problem is, blenders can only realistically blend in 10% ethanol to their gasoline. Most cars simply are not made to run of high ethanol blend gasoline. When U.S. demand for gasoline is growing, the ethanol mandate usually isn't a problem because the quota represents less than 10% of the fuel they sell. The problem is the EPA's quota has grown at a rate that has outpaced fuel sales. Now that 13.8 billion gallons is reaching 10% of all fuel sales, or what blenders call the "blend wall."
Point #2: Once the "blend wall" is reached, the blenders don't want to buy more ethanol, but they are legally required to. This is an almost classic "pour milk in the streets" government manufactured surplus. The ethanol will be produced however because the RINs will guarantee it is profitable to do so, but the refiners and blenders won't use it, they will simply dump it on the market if they take delivery, or simply buy RINs on the exchange. Either way, it should send ethanol prices lower, but the ethanol producers won't care, the RINs will make up for the loss. A classic recipe for waste that would make Stalin look like an amateur.
Point #3: Year to date it is estimated that 50% of the increase in fuel prices is due to ethanol policy. This is due to a two pronged effect 1) refiners are passing these RIN "tax" on to the consumer and 2) refiners are exporting more of the gasoline to avoid these regulations. This is a classic government boondoggle that could only have been baked, or half-baked up in a ivory tower or in a smoke filled room. This would be funny if it wasn't real.
Point #4: I've always maintained that the #1 threat to the biofuels industry is political risk. I've had countless articles rejected by Seeking Alpha because I firmly express my opinion on these issues. Fortunately others in the financial community are speaking out, and I can now quote them. Here are a few quotes from the video.
I'm hearing about ethanol plants being bulldozed because there is no demand for ethanol...its a screwed up policy. Unfortunately its a broken policy, it was right on paper.
Another quote discusses the political risk that I'm always trying to highlight. These entire industries can be eliminated with a stroke of a pen. That kind of risk unique to these industries. They are government manufactured industries.
They're going to be a lot of hearing going on on Capital Hill, I believe there is another couple of days talking about another renewable fuel standard next week and ethanol policy is going to be a big focus for them just because they need to back away from the implications of these policies
Point #5: Most cars won't run well on E15 and most filling stations aren't equipped to sell it, so the additional ethanol will not been needed. The result should be lower ethanol prices (unless we export it), and higher RIN prices.
Point #6: One implication not covered in the video is that this ethanol boondoggle is a windfall for the biodiesel and renewable diesel industry. Ethanol generate what are called D6 RINs, and biodiesel and renewable diesel produce what are called D4 and D5 RINs. D4 and D5 RINs can be used as a substitute for D6 RINs, but not vice versa. What that means is that the D6 will put a price floor in the market for D4 and D5 RINs, so as D6 RINs increase, they will also push D4 and D5 prices higher. Another implication is that blenders and refiners will be more likely to substitute biodiesel, renewable diesel and renewable gasoline/naphtha for their ethanol. Those fuels provide 1.5 to 1.7x the RINs that ethanol does..and some are "drop-in fuels that don't require any modifications to the cars or filling stating infrastructure. This should benefit companies like Renewable Energy Group (NASDAQ:REGI), Biox (NYSE:BX), KiOR (NASDAQ:KIOR) and Syntroleum (NASDAQ:SYNM).
In conclusion, the spike in ethanol RINs is sure to catch the attention of Washington, and is finally making the financial press. As things stand now, the dynamics point to lower ethanol prices, higher RIN prices and greater demand for ethanol substitutes like biodiesel and renewable diesel and gasoline/naphtha. This however is subject to change depending on how Washington reacts, which is unpredictable, and why investing in these industries has an added level of risk not found in many other industries. If you do choose to invest in these ethanol related industries, be sure to understand how RINs work, and the political risks involved.
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.