I recently wrote about Valero (NYSE:VLO) and their "green energy" ventures, and how I thought they may have a model that will make biofuels a reality. Reading VLO's conference call transcript, it is evident that VLO is extremely focused and investors are highly interested in this segment of its business. A large portion of the prepared comments and a disproportionate number of questions are directed towards VLO's gas-to-liquids (GTL), Ethanol and RINs. Don't know what a RIN is? This link provides some details, but investors shouldn't invest in the energy sector without understanding at least the basics. This article will review the "green" aspects of the VLO conference call.
The first point is the margin per barrel of refined oil. For a 42 gallon barrel, that works out to $9.26/42 = $0.22/gal actual, or $10.63/42 = $0.25/gal in 2012. I highlight that to identify a margin benchmark, and I'm almost certain to reference it in future articles about biofuels. Last quarter, Renewable Energy Group ((NASDAQ:REGI)) reported that their margins were over $0.70/gal and this quarter the margins should be substantially higher.
Our second quarter 2013 refining throughput margin of $9.26 per barrel was over $1 per barrel lower versus the second quarter 2012 margin of $10.63 per barrel. The decrease was partly due to significantly lower discounts per heavy sour crude oil.
It didn't take them long to get to the RINs. This was one of the first topics covered in the conference call.
In addition, the refining throughout margin was negatively impacted by the higher costs of Renewable Identification Numbers or RINs needed to comply with the U.S. Federal Renewable Fuel Standard.
To say RINs have increased in value/cost is an understatement. When I wrote an article about ethanol RINs recently they were up over 2,700% year-to-date and that isn't a typo, I intended to type 2,700%. VLO reports that the RIN costs to have more than doubled since last year, and for the full year, RIN costs are expected to be $600 to $800 million. Those kinds of costs are going to open some people's eyes, and I would expect to see a lot more lobbying going on in Washington over this program, in fact they are currently meeting on it right now. This may, and I stress may, help explain why Syntroleum (NASDAQ:SYNM) hasn't restarted their plant, and chose mid- to late-July as the restart window. They may have wanted to see the outcome of the hearings before restarting. Once again, I stress the word may in my previous comments, so please keep the negative comments to a minimum. I am just speculating.
For the second quarter of 2013, the reported cost to comply were a $125 million versus $58 million for the second quarter of 2012. Given the recent escalation in RINs prices, we now estimate our cost to comply with the renewable fuel standard to be in the range of $600 million to $800 million for the full year of 2013.
As I pointed out in another article, $600 to $800 million can buy up a large amount of the existing biodiesel/renewable diesel industry and have plenty left over to expand capacity. Operating expenses for VLO were $3.82/brl, or $0.09/gal. That is substantially lower than the $0.55/gal estimated by SYNM for their "Synfining" process and much lower from what I could decipher from the KiOR (NASDAQ:KIOR) conference call. Because of the variety of plants REGI has, I don't have an OPEX estimate for it, but I assume they are marginally less than SYNM's $0.55 due to biodiesel being a much more simplified process.
Refining cash operating expenses in the second quarter of 2013 were $3.82 per barrel, which was higher than second quarter of 2012 due mainly to higher energy costs.
This following comment confirms the message I tried to convey in a recent article about the economics being very strong for gas-to-liquids GTL because of the relatively low natural gas prices and high oil prices. Ironically, I got a few negative comments about that article, so it is nice to see VLO confirming my analysis.
As a reminder, both of these hydrocrackers were designed to take advantage of the current environment of relatively high crude oil prices, strong diesel margins, and inexpensive natural gas. This is also consistent with our strategy to increase production of high quality diesel.
VLO is in a joint venture with Darling International Inc. (NYSE:DAR) called Diamond Green Diesel, which appears to be a situation relatively similar to SYNM's joint venture with Tyson (NYSE:TSN) called Dynamic Fuels. Diamond Green Diesel and Dynamic Fuels produce a "renewable diesel" through "hydro processing." I recently wrote an article about the SYNM lawsuit with Neste (NES1V.HE) in which I challenged its validity. The fact that Diamond Green Diesel also uses vegetable oil and animal fat to produce their renewable diesel and has not been sued by NES1V.HE strengthens my case. If not, NES1V.HE is oddly only selectively defending their patent. If NES1V.HE is successful with their SYNM lawsuit, I would imagine a lawsuit against Diamond Green Diesel would be an almost certainty, but that is pure speculation. It is the logical outcome of a successful patent dispute. One other speculative note is that the Diamond Green Diesel plant is just starting production, and it is a sizable 140 million gallon per year plant, twice the size of the Dynamic Fuels plant. That kind of size may, and I stress may, be able to impact the cost of feedstock. SYNM may be cautiously waiting to see if the additional demand for yellow grease makes renewable diesel unprofitable. A $0.01/lb change in feedstock reduces the margin by $0.076/gal.
Also at the St. Charles refinery, the Diamond Green Diesel joint venture biofuels plant started up at the end of June. Throughout July we have been ramping up rates, this plant is designed to produce approximately 9,300 barrels per day of renewable diesel from low quality recycled cooking oils and fats using refinery hydro processing technology...The project is a 50-50 joint venture between Valero and Darling International, a leading gatherer of used cooking oils and animal fats.
VLO is also in the ethanol business, and their comments may bode well for the ethanol industry as a whole. As noted above, and demonstrated by the VLO profits, the ethanol RINs have totally changed the economic outlook for ethanol. I would note that "economic incentives of higher gross margins" was used to justify the higher production. That is a theme I've written about many times, and the numbers are now confirming that analysis.
Our ethanol segment reported operating income of $95 million in the second quarter of 2013, an increase of $90 million from the second quarter of 2012 mainly due to higher gross margins per gallon and higher production volumes.
Production averaged 3.5 million gallons per day in the second quarter of 2013 for an increase of 156,000 gallons per day compared to the second quarter of 2012. The increase in production volumes was mainly due to the economic incentive of higher gross margins per gallon.
VLO again confirms my analysis of the favorable GTL economics, and is actually making investments in this area (to be covered later in the article). While I have some critical comments on my original article, VLO actually has some skin in the game and they seem to agree with my analysis.
Our premise is to capture the competitive advantages provided by the growing supply of cost advantage crude oil and natural gas in the U.S. and Canada. Along these lines we are also evaluating potential petrochemical investments that will leverage our existing assets to upgrade the value of abundant and growing supplies of natural gas and natural gas liquids.
I've written numerous articles on understanding RINs, in fact, one of my very first articles touched on them, but this quote from the conference call verifies that because RINs are so new to the market that there is still a learning curve that even the most experienced people on the ground floor struggle with.
Jeff Dietert - Simmons & Co.
Sure, they'll probably be a long list of these, but I wanted to start with RINs and one of the struggles I am going through is, our blenders passing through the cost of rents into the retail prices, does it vary by region, what are the major considerations with regard to whether or not these RINs cost are getting passed through to the retail well?
Joe Gorder President and Chief Operating Officer
Well Jeff, this is Joe. I mean, it's a great question. We're trying to figure the same thing out ourselves. And I would tell you that we look at it on a regular basis and it's very difficult to quantify whether or not we are seeing the effect of the RINs in the cracks. We think we might be able, but we're not 100% sure.
This quote from the conference call highlights two themes that I often hit on while discussing biofuels, 1) the huge role Washington plays in this industry and the associated political risks and 2) how changing RIN prices can dramatically alter the economics of this industry. Biodiesel can be profitable one day, and the next day Washington can grant a RIN waiver and everything is a loss, or a tax credit battle can emerge or a drought can lead to a suspension of the program. There is just huge uncertainty related to this program, and this following quote highlights that fact. I find comfort seeing that other analysts worry about the same things I do because from many of the comments I get, my concern isn't appreciated by some vocal critics that support these regulations. My goal isn't to support or defend these regulations, simply to provide analysis. The politics of which are part of any comprehensive analysis.
Evan Calio - Morgan Stanley
First question just to follow up to kind of keep the RIN conversation moving. I know Bill, you've been front center in the RIN conversation and I read portions of your testimony in Washington last week. My question is, as you run your system do you make operating decisions based upon a fully loaded kind of RIN economic analysis of each asset. So the question is, would Valero or the industry potentially see economically induced RIN cuts based upon RIN cost and margins et cetera, particularly as you move into the seasonally weaker fourth quarter?
This following quote is a question from the conference call highlights why I've been such a vocal critic of this RFS2 and RIN program, it is simply very poorly thought out. KIOR by the way is one firm that is actually producing cellulosic renewable diesel and the associated RINs. The quote does, however, highlight the frustration people are feeling, and why I always stress the political risk. Things in this industry are only as secure as control of the political process, which is only as secure until the next election at best.
Bill Klesse Chairman and Chief Executive Officer
Well, I think everyone on the call understands the RINs issue, and your assumptions when the 2005 and then the 2007 law were passed are very different today than before. The issue boils down to just a few things cellulosic is not available. That is not on the EPA's website, everyone says there is going to be a little cellulosic production this year, but it's totally uneconomic as well. I think it was clearly, let's pass the law and they will come, and it hasn't happened.
This following quote highlights the kinds of comments that are making their way back to Washington, and I can't imagine they are helping the RFS2 and RIN case. Claims of saving the earth only go so far in maintaining support. People are now getting hit hard in their pocket books during a difficult economic time, and that is a recipe for political upheaval, especially give the "green" track record.
Then the other part of it is, it encourages you or you have to buy Brazilian sugarcane ethanol or somebody sugarcane ethanol. We have a law that encourages you to import over producing domestically...And then on top of all of this, gasoline demand has not continued to grow. It's actually down and now flat. So the whole thing is screwed up...But the EPA solution of going to E-15 is not practical. There are no facilities. Even the service station people are saying they don't know about their tanks and lines. That is no, hardly any certified pumps and you have the car warranties...The whole thing is basically with RINs is now, as I got quoted everywhere, it is out of control. RINs were in the preamble of the EPA's regulations that they were not going to be significant...Well, the EPA doesn't seem to be able to do anything, and so it's a White House or Congress conversation, and the only way the White House will move is they get enough political pressure frankly from consumers.
This may anger some of my critics, but this following quote might highlight why SYNM hasn't restarted their plant, they may be petrified by what might come out of Congress. Sure the economics are extremely strong right now, but that can change overnight. They may, and I stress may, just be sitting back and awaiting the outcome of the current hearings. The underlined part of the quote sends fear shooting through anyone relying on these laws to justify their production and economics.
And they get enough pressure from consumers or the option that you see happening, and there will be some bills introduced here is over in Congress and the House and in the Senate, where people are at least understanding that this, the basis of the law are not appropriate anymore, yet there will be some compromise, so I am optimistic.
While the conference call is a bit sketchy on the details, VLO is considering a GTL plant, but this GTL plant will create methanol, which is different from most GTL plants that use the Fischer-Tropsch process to make alkane type fuels like gasoline and diesel. They are doing this because of the synergies associated with ethanol and renewable diesel production.
On methanol, because we have our own hydrogen plants at St. Charles, we are able to strip the sun gas before we finish and make hydrogen. We can take this sun gas, so we really don't have to build the front-end of methanol plant...But methanol is a way to move methane in a liquid from, if you think about it. And so, we just think it's a nice little bolt-on and we'll develop it little further. But we felt it's important to get it added into our marketplace, and Valero was looking at this.
This following quote also highlights how VLO uses their scale and scope to capitalize on synergies within their business. Something I highlighted in a past article.
Roger D. Read - Wells Fargo Securities LLC
What are the various ways you analyze what makes the most sense for Valero to do at a given moment in terms of investing in the methanol plant versus, say, a more aggressive share repo program or accelerated, maybe I should say rather than aggressive?
Well, so many of these plants are bolt-ons or extensions of our business. Because you're capitalizing on the whole refinery that's already there, these returns all are north of 25%, on all of them. These are IRRs.
The following are more comments about methanol. I highlighted how GTL is viewed as a "huge" opportunity, something I've tried to highlight in a past article.
Well, if you look at the logistics capital, it's kind of being intact, so in place and I'll just try to add clarity here the place where I'm sure some of you guys are wrestling with is in this whole petrochemical methanol area, and our view is that the marketplace is giving companies like us a huge opportunity that add a lot of value for our shareholder. We expect low cost natural gas, that's why the hydrocrackers looks so good.
It looks like I'm not the only one that gets criticism for my GTL analysis, apparently so did CEO Bill Klesse.
Methanol has, actually it's gotten some feedback from some of you that are questioning that. Well, Valero is very uniquely positioned at our St. Charles refinery. We have a lot of hydrogen production capability. We can pull this syngas of these plants. We can build on ethanol plant for half of what the grassroots methanol plant can be built (inaudible) and with all the hydrogen capability of our own plants and third parties, we think we have an opportunity here to add significant shareholder value.
So I feel strongly that this is our job and whether this or alkylation or adding some crude capacities around light sweet crudes, which we don't have at some of our plants. We certainly don't want to be buying feedstocks when I am absolutely certain.
Anyone that reads my analysis knows that I don't shy away from the controversial topics, and this article is no different. The entire RFS2 and RIN system is founded upon man made global warming and/or climate change, or when I was a child the coming ice age. In my opinion the science is very suspect and self serving. Just yesterday there was this article that highlights just how questionable the climate "science" has become. Most people aren't aware that the earth stopped warming over a decade ago, yet CO2 has continued its unaltered trend higher. You have to have warming to claim global warming, and we aren't warming. If you don't have warming, you can't have "climate change" that is being caused by the greenhouse gas effect. If you can't tie climate change, which by the way is the natural state of the earth, to CO2, you can't blame CO2 for it, at least if you follow the scientific method.
The global average surface temperature has not increased substantially over the last 10 to 15 years," Professor Sutton said...The problem for the Met Office is to explain why the rate of increase in global temperatures has declined in recent years while concentrations of carbon dioxide in the atmosphere have continued to accelerate. Sceptics claim that this shows there is not a strong link between the two, whereas climate scientists insist that rising carbon dioxide concentrations are largely responsible for the rise in global temperatures.
To explain this, the climate "scientists" claim that the energy that was being trapped in the atmosphere is now being transferred to the deep oceans, as if there is a giant on/off switch in the oceans that for some reason didn't absorb heat before, but is now. It also doesn't explain why the atmosphere isn't continuing to warm, considering the radiation must first pass through the atmosphere to get to the oceans. I simply don't find this "ocean heat vacuum" theory very plausible, and I doubt a congressional inquiry would either.
The most likely explanation for the current pause is that excess heat trapped by carbon dioxide in the atmosphere is being transferred from the atmosphere to the oceans where it is being transported down to deeper layers that cannot be monitored by satellites, Professor Belcher said.
"It looks like the Earth is continuing to accumulate energy but it looks like it is being re-arranged and hidden from view," he said.
Also, sea levels have been increasing since the end of the last ice age, but the rate of change has not been increasing, as would be required if we were in fact warming at an abnormal rate.
In conclusion, the VLO conference call appears to have validated the analysis I covered in many of the articles I've recently written. After reading the conference call, I'm even more confident that VLO may have a model that will actually make biofuels a reality. This is the first conference call I've read from VLO, and I was pleasantly surprised by the openness, honesty, frankness and boldness of the CIO. More importantly, he highlights the anger many are feeling about these energy regulations. Angry voters are by far the greatest threat to the "green energy" industries, and if Washington is hearing comments like the CEO made in the conference call, it may force changes in the RIN and RFS2 program. Unfortunately, I'm writing this before I have details to outcome of the meetings in Washington over the last two day, but I'll be sure to write a follow-up article once I have the details. The key being, any change/relaxation to the RIN program will likely harm biodiesel, ethanol and renewable diesel firms, and benefit "big oil."
Disclosure: I am long SYNM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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.