The biggest story of 2013 for the first-generation biofuels industry and its analysts has easily been the arrival of the so-called "blend wall," as the point at which the U.S. gasoline infrastructure can no longer absorb additional ethanol is known. The revised Renewable Fuel Standard (RFS2) mandates the consumption of increasing volumes of biofuel through at least 2022 (see figure below). Ethanol, which is a gasoline substitute rather than a gasoline replacement, is the primary biofuel used in the U.S. and is almost entirely derived from corn starch (although imported ethanol sourced from Brazilian sugarcane is accounting for an increasing fraction of the total). Most fuel ethanol is blended with gasoline prior to consumption to create "gasohol," and the chemical differences between gasoline and ethanol limit this blend to 10% ethanol by volume (E10). While the EPA permits blends of up to 15 vol%, opposition from refiners, automakers, and drivers has made E15 consumption in the U.S. virtually non-existent.
This E10 limit was not considered to be a serious hurdle when the RFS2 was designed in 2007 for two reasons. First, U.S. gasoline consumption was expected to steadily grow for the foreseeable future, ensuring that the volume at which the blend wall would be hit would do so as well. Second, most energy economists and policymakers assumed that the increasing numbers of flex-fuel vehicles (FFV) capable of running on ethanol blends of up to E85 on American roads would effectively eliminate the blend wall as a hurdle.
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*TBD by EPA, but no less than 1 billion gallons. Source: Schnepf (2012).
The first six years of the RFS2 have seen these earlier assumptions turn out to be woefully inaccurate. The combination of high petroleum prices, poor economic growth in the developed world, and increased CAFE standards have caused current and anticipated U.S. gasoline consumption to decline (see figure below). FFV adoption has been decent but E85 consumption has remained low due to a combination of ignorance (most FFV owners aren't aware that they can consume E85) and opposition (many consumers believe that ethanol causes ecological and humanitarian disasters).
Source: EIA 2012.
This misguided reliance on the aforementioned assumptions resulted in widespread surprise when the blend wall was officially hit earlier this year. Refiners are obligated under the RFS2 to blend certain volumes of biofuel with the gasoline they produce in proportion to their sales. Compliance is demonstrated via Renewable Identification Numbers ((RIN), which are tradable compliance commodities that are attached to each gallon of biofuel following its production and separated following its blending with gasoline; refiners are required to submit sufficient RINs to the EPA at the end of the year to cover their portion of the volumetric mandate. Refiners with insufficient RINs can purchase the balance from those with too many.
The arrival of the blend wall confronted refiners with the prospect of being required to purchase more ethanol from biofuel producers than consumers could use. Corn ethanol RIN prices soared by more than 2,700% in a matter of weeks as refiners scrambled to purchase and blend ethanol (or the corresponding RINs) while market capacity still existed. This surge in RIN prices has resulted in a corresponding increase to the annual cost of compliance for refiners from $330 million (at 2012 RIN prices) to $14 billion (at current RIN prices).
Climbing the Wall
The status quo is unlikely to remain unchanged for long, given that continued increases in the annual volumetric mandates through 2022 will only serve to increase refiners' costs of compliance under the RFS2 so long as RIN prices remain high. That said, by now it has become apparent that the conventional wisdom on how the industry would surmount the blend wall no longer holds true. Alternate means of doing so will need to be identified and developed in short order.
Given the unanticipated nature of the blend wall's arrival, the present situation creates a few unique scenarios for those investors wishing to play the blend wall (and willing to stomach a certain amount of risk and volatility). Four specific investment scenarios exist: 1) biomass-based diesel production increases to meet the difference between the blend wall and corn ethanol production, 2) ethanol producers use high RIN values to reduce ethanol's market price below that of gasoline on a gasoline-equivalent basis, 3) high RIN values spark a wave of investment in producers of drop-in biofuels, and 4) the RFS2 is either modified or prematurely ended. This article covers the first scenario.
Biomass-Based Diesel to the Rescue?
This first scenario is the most likely to occur but also the most limited in scope. The RFS2 is divided into four biofuel categories: 1) renewable fuel, 2) advanced biofuel, 3) biomass-based diesel, and 4) cellulosic biofuel. The categories are nested so that biomass-based diesel and cellulosic biofuel both count as advanced biofuel and all three count as renewable fuel. For example, biodiesel can be used to satisfy a refiner's volumetric obligation for the biomass-based diesel category, the advanced biofuel category, or the renewable fuel category. Corn ethanol is only allowed to meet the renewable fuel category and has been responsible for virtually all production under it as a result. Historically biodiesel and renewable diesel were just used to meet the biomass-based diesel category due to differences in RIN prices (in 2011, for example, biomass-based diesel RINs traded at a premium of up to $1.4/RIN over advanced biofuel RINs and $1.78/RIN over renewable fuel RINs). Each gallon of biodiesel qualifies for 1.5 RINs due to its high energy content relative to ethanol (each gallon of renewable diesel qualifies for up to 1.7 RINs).
The increase in renewable fuel RIN values since the beginning of the year has brought the renewable fuel, advanced biofuel, and biomass-based diesel RIN prices into equilibrium, eliminating the price disparity between the categories that existed in 2011 and 2012. Biomass-based diesel production, which is on pace to reach 1.33 billion gallons for 2013, utilizes just under 50% of U.S. capacity when including both biodiesel and renewable diesel. (While imports can also contribute to the biomass-based diesel category, domestic production was responsible for 92% of the RINs generated under the category in 2012.) Most importantly, current production is equivalent to just 2.3% of diesel consumption (based on 2013 biofuel production and EIA estimated diesel consumption for the same year) while U.S. engine warranties permit biodiesel blends of at least 5 vol%. Renewable diesel, which is on pace to reach 120 million gallons in 2013 (and will likely be higher due to additional production coming online), is chemically identical to petroleum-based diesel and does not encounter blending limits. Based on these blending assumptions for biomass-based diesel fuels, then, the U.S. can handle another 1.4 billion gallons of biodiesel and much higher volumes of renewable diesel.
Given the leeway that the biomass-based diesel category has before encountering its own blend wall, several voices in academia and the media have proposed producing sufficient biodiesel and/or renewable diesel to meet the difference between the volumetric mandate for corn ethanol production and the blend wall. Given the higher energy content of biomass-based diesel fuel, less production capacity would be needed to generate the necessary RINs than if additional corn ethanol were produced for the same purpose. For example, there is a difference of 400 million gallons between the 2013 blend wall (13.4 billion gallons of ethanol) and the 2013 volumetric mandate for corn ethanol (13.8 billion gallons). Were biodiesel used to make up this difference, only 267 million gallons would need to be produced over the 1.3 billion gallon biomass-based diesel volumetric mandate to generate the missing 400 million RINs for the corn ethanol category, equaling total biodiesel production of 1.57 billion gallons in 2013.
The difference between the blend wall and the corn ethanol mandate is expected to increase to 1.2 billion gallons in 2014 (the mandate requires 14.4 billion gallons while the 10% blend wall will be 13.2 billion gallons of ethanol based on EIA consumption projections), so the volume of additional biomass-based diesel production would need to increase to 800 million gallons in that year, although that would still just result in total biomass-based diesel production of 2.1 billion gallons (assuming that the category's volumetric mandate remains 1.3 billion gallons in 2014). This is still just roughly 67% of current U.S. capacity and excludes the use of imports to meet the mandate. Based on estimated future gasoline consumption and the 15 billion gallon annual cap on corn ethanol's participation in the RFS2, new biomass-based diesel capacity wouldn't be required until the next decade under this scenario.
Note that the above doesn't consider the advanced biofuels volumes not attributable to either biomass-based diesel or cellulosic biofuel, which reaches 1.5 billion gallons by 2015. At present this is largely met by imported Brazilian cane ethanol, which encounters the same blend wall as U.S. corn ethanol. At present, companies such as Gevo are attempting to produce corn biobutanol, which qualifies as an advanced biofuel but is capable of being used in higher blends than ethanol. Should these high-energy advanced biofuels fail to achieve commercialization by 2015 then biomass-based diesel will need to increase production by another 1 billion gallons, in which case additional U.S. capacity would be needed if the renewable fuel, advanced biofuel, and biomass-based diesel categories are all to be met.
Renewable Energy Group (REGI) is one of the largest U.S. producers of biodiesel. The company has an annual nameplate biodiesel capacity of 212 million gallons. Its share price has largely moved in line with its quarterly diluted EPS since its IPO in early 2012 (see figure below). RIN prices, by broadly functioning as the value needed to incentivize sufficient production to meet the RFS2 volumetric mandates, ensure that biofuel producers such as REG will always receive sufficient income per gallon of biofuel sold under the RFS2 to remain profitable. Given REG's positioning in the U.S. biodiesel market, it is well-suited to maximize its profitability because of both of the increased demand and higher RIN prices that would result from biomass-based diesel being used to meet the difference between the corn ethanol mandate and the blend wall in the coming years. RIN prices would insulate REG from both a fall in petroleum prices and any increases to feedstock costs resulting from a substantial increase to biomass-based diesel production.
A number of renewable diesel producers are also positioned to take advantage of the scenario considered by this article. While renewable diesel capacity in the U.S. is much lower than biodiesel capacity, renewable diesel receives 1.7 RINs per gallon (compared to 1.5 RINs per gallon for biodiesel) and does not face biodiesel's blending constraints. A number of companies have begun producing renewable diesel on a commercial scale in recent years, including Dynamic Fuels -- a JV between Syntroleum (SYNM) and Tyson Foods (TSN) -- Diamond Green Diesel -- a JV between Valero Energy (VLO) and Darling International (DAR) -- Amyris (AMRS), and Solazyme (SZYM). None of these companies are as well-positioned as REGI due to their diversified product lines and, in the case of the last two, lack of commercial-scale production at present. However, for investors willing to take on country risk in addition to industry risk, Neste Oil (OTC:NTOIF) is the world's largest producer of renewable diesel and jet fuel. The company operates four large facilities in Finland, Rotterdam, and Singapore. Neste's renewable diesel can be (and has been) used under the RFS2, although its reliance on palm oil feedstock has opened it to controversy in the past.
Playing Commodity ETFs
A substantial increase in biomass-based diesel production would presumably result in a significant rise to agricultural commodity prices, particularly corn and soybeans. Economists at the University of Illinois Urbana-Champaign calculated back in February that 35.5 billion pounds of lipid feedstock would be needed in 2015 by biomass-based diesel producers under a scenario in which they increase production to meet the difference between the blend wall and the RFS2 mandate, including both the renewable fuel and advanced biofuel categories. This would be an increase of 260% over the 9.8 billion pounds needed to meet the 2013 biomass-based diesel volumetric mandate.
By comparison, in 2010-11 the USDA estimated the total U.S. supply of lipid feedstocks to be 33.1 billion pounds. While many types of lipids can be used as biomass-based diesel feedstock, soybean oil remains one of the most attractive options due to its large supply and the ability to increase production relatively quickly; other lipid feedstocks, such as recycled cooking oil and animal processing wastes, are byproducts of unrelated processes and thus far less flexible when it comes to supply. Given the likely continued reliance on soybean oil as feedstock should biomass-based diesel be used to overcome the blend wall, investors could gain exposure to higher soybean prices by purchasing shares of the Teucrium Soybean Fund (SOYB), which tracks soybean futures prices. Furthermore, an increase in soybean production on existing cropland could come at the expense of corn production since the two are frequently rotated on a seasonal basis, so investors could also consider purchasing shares of the Teucrium Corn Fund (CORN), which tracks corn futures prices. (While continuous soybean production is not without its risks, it has been done in the past in response to favorable growing and/or market conditions.)
The arrival of the ethanol blend wall in the U.S. has caused RIN prices, particularly those of the corn ethanol category of the RFS2, to skyrocket as refiners have raced to meet their mandate obligations. High RIN prices have greatly increased refiners' compliance costs under the program. Several options have been proposed in recent months as means of overcoming the blend wall, including the production of sufficient biomass-based diesel to meet both its own category as well as the difference between the corn ethanol category and the blend wall. Sufficient biomass-based diesel capacity exists in the U.S. to do so in the future, assuming that the biomass-based diesel volumetric mandate doesn't increase.
Furthermore, foreign capacity could also be utilized via imports of biomass-based diesel. A number of companies are positioned to benefit from such an increase in expansion, particularly Renewable Energy Group. The biomass-based diesel production increase required to overcome the blend wall would also strain domestic supplies of lipid feedstocks, putting upward pressure on corn and soybean prices. The Teucrium Fund offerings for these respective commodities are available for investors seeking to gain exposure to increased biomass-based diesel production in this manner.