Back in April I wrote an article titled "Biodiesel Production Bodes Well For RIN Prices And Multi-Feedstock Firms." At the time, D4 RINs were trading around $0.93. I then did a follow-up article in May titled "Biodiesel Production Bodes Well For RIN Prices And Margin." At the time D4 RINs were trading at $0.95. RIN prices traded over $1.40 within the last couple of weeks.
The thesis I outlined was that biodiesel production was trailing the RFS2 mandated quota, and that the lag bodes well for biodiesel. In the past, as biodiesel production approached the quota, D4 RINs would dramatically decrease in value. Once the quota was reached, there was no reason for blenders and refiners to buy biodiesel any more, so the value of the D4 RINs would drop. That is a bit of an oversimplification, but the overall concept is consistent with the price behavior of D4 RINs. Before the turn of the year, ethanol RINs traded near $0.05, reflecting the fact that the ethanol had reached its quota.
Last week the EPA released biodiesel production numbers for June, and production no longer lags the target quota, it exceeds it. Through June, with 50% of the year gone, biodiesel is at 54% of the target quota. D4 RIN prices promptly fell from about $1.40 to about $1.00, an almost 30% drop in a day. That is the classic relationship, and the price action appears to have validated my theory. The only problem is, I don't think the theory I outlined in previous articles is valid anymore -- the markets have changed.
The historic relationship of the quota and D4 RIN values most likely no longer holds today because of something called the "blend wall" in the ethanol markets. Unlike past years, once the D4 quota was reached, there was no longer a reason to buy the diesel fuel to get the D4 RINs. This year, however, things are much different. D4 RINs are the most versatile RINs, and can be used to satisfy other RIN category requirements. Fellow Seeking Author Thomas Hor did a great job detailing the RIN heirarchy structure with the following graphic.
D4 RINs can be used to satisfy D5, D7, D3 and D6 mandates. What that means is that the other categories of RINs can act as price floors for D4 RINs. Theoretically a D5, D7, D3 or D6 RIN should never trade at a premium to a D4 RIN (but I have seen D5 RINs trade higher than D4 RINs). Normally that isn't important because all the categories reach their target quotas and usually trade below the D4 RINs anyway. This year, however, is different because ethanol is hitting its "blend wall." The "blend wall" issue has sent ethanol RINs soaring over 2,700% prior to the recent correction.
Why that matters is that the ethanol quota dwarfs the biodiesel quota, so with high ethanol RINs (D6 RINs) the biodiesel quota becomes irrelevant. D4 RINs will be used to satisfy the D6 RIN quota, so D4 RINs will likely track D6 RINs, not the EPA quota as I outlined in my previous articles. With the EIA estimating that the biodiesel industry has a capacity of 2 billion gallons, there is a lot of capacity that can be brought on-line to help fulfill the D6 quota. If the EIA estimates are correct, and D6 RINs remain high due to the "blend wall," it is almost a certainty that the biodiesel 2013 EPA quota will be exceeded by a wide margin. There is already a "carry-over" provision that encourages firms to over produce by 20% when market conditions are favorable, but with the D6 RINs where they are, I would expect the quota to be surpassed by over 20% in 2013... if nothing changes.
I highlight "if" in the last sentence because I have always believed that political risk is the greatest risk to the biofuels industry. Fortunately, I'm no longer a lone voice in the wilderness. In his recent article, fellow Seeking Alpha author Tristan R Brown mentioned how congress was having hearings regarding EPA's RFS2 program and the "blend wall."
In his article, Tristan outlined what 4 possible solutions to the "blend wall" issue:
Several methods of overcoming the blend wall and thereby reducing RIN prices have been proposed, including
(1) increasing biomass-based diesel production to meet the volumetric difference between the blend wall and mandated corn ethanol production;
(2) using high RIN values to offer ethanol at a discount to gasoline on an energy-equivalent basis, thereby incentivizing the vehicle and infrastructure upgrades necessary to absorb ethanol at a blend rate in excess of 10 vol%;
(3) using high RIN values to spark a new wave of investment in the production of drop-in biofuels; and
(4) modifying or repealing the RFS2.
#1 is almost a certainty, and is the solution I discussed above. If D6 RINs remain high, it is almost a certainty that the excess capacity in the biodiesel industry will be put to work. Each gallon of biodiesel produces 1.5x the ethanol equivalent of RINs, and renewable diesel produces 1.7x the ethanol equivalent of RINs. Obligated parties get more bang for their buck by buying biodiesel when D6 RINs are high, and people usually don't have car problems buying biodiesel and renewable diesel like some cars do with ethanol.
#2 is partially correct in the short-run and may be correct in the long- run... as long as the RFS2 and ethanol survives. High RIN prices, the "blend wall" and a bumper crop of corn will almost certainly drive ethanol prices lower. This is a perfect economic storm to create a government induced "pour the milk in the street" manufactured surplus of ethanol. If conditions persist, lower ethanol prices are almost a certainty. Whether or not that will encourage filling stations, especially the independently owned ones, to invest in upgrading their infrastructure, and car owners to go out and buy cars that can run on cheaper ethanol blend fuels is highly unlikely in my opinion, and is certainly not a short-term fix.
#3 is almost a certainty, and as I outlined in a previous article, I would expect a wave of "Big Oil" M&A of smaller biofuels producers. With the RIN "tax" now being measured in the billions with a b dollar range, "Big Oil" is now aware of the costs associated with the EPA's RFS2 program, and the cheapest way to avoid the "tax" is to simply start producing the fuels that generate RINs. Valero (NYSE:VLO) is already implementing that model, and I would expect all members of the "Big Oil" club to follow suit.
#4 is also an almost certainty if RIN prices remain high, and highlights the point I repeatedly make about political risk. Simply read the most recent VLO conference call to get a feel for the comments being sent to Washington. I've rarely is ever heard a CEO make such bold statements. The press also hasn't been favorable to this issue, and when Congressmen from eco-friendly Colorado pens a letter-to-the-editor using the term "boondoggle" in the title, you know there is trouble:
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...But the EPA solution of going to E-15 is not practical...RINs were in the preamble of the EPA's regulations that they were not going to be significant. They were there to give the industry flexibility and they give the EPA a way to monitor and now it's become a huge issue and so it just needs to be completely redone...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, because at the end of the day, the consumer is going to pay for this.
Bill Klesse CEO Valero
Tristan himself, who usually writes favorably about these RFS2 regulations, even admits they were based upon "erroneous" assumptions. Having studied economics my entire adult life, I've learned that whenever you get a bunch of Ivory Tower Einsteins in a room that think they are smarter than the markets and get to spend other people's money on their "solutions," the expected outcome is an unintended consequence resulting from "erroneous" assumptions. The Iron Fist of Stalinistic Central Planners rarely delivers better outcomes than the altruistic invisible hand of Adam Smith, and this RIN "solution" doesn't seem to improve their record:
Naturally, the fact that corn ethanol RIN prices soared after the EPA set the 2013 corn ethanol volumetric mandate above the 10 vol% blend limit shows just how erroneous the Flex-Fuel Vehicle (FFV) assumption has turned out to be.
I always try to highlight the political risks involved with the alternative energy sector, and Tristan's article highlights why I do that. From his last article, I wrote an article about how the ethanol mandate should make your blood boil:
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.
Tristan always provides insight into how these programs are designed that should make the average voter furious, and his new article is no different. In the article, Tristan points out that one of the consequences of the ethanol "blend wall" is likely to be US refiners exporting more fuel to reduce their domestic sales so they can comply with the RFS2. These RFS2 mandates literally encourage US producers to export oil while they are at near peak prices. That would be funny if it wasn't real:
RIN prices will therefore increase until they are high enough to incentivize the consumption of the missing gallons (400 million in 2013, rising to 1.2 billion in 2014). This would most likely happen in one of two ways: (1) via the RIN value being used to discount the market price of ethanol to make it more attractive than gasoline, or (2) via refiners increasing their exports of gasoline so as to reduce their Renewable Volume Obligation under the RFS2, which can use U.S. sales as a proxy.
This quote from the article gives meaning to a phrase I often use, "The Iron Fist of Stalinistic Central Planners." It is these kinds of policies that infuriate voters and force hearings in Washington, D.C., and greatly increase the political risk to these industries:
(Non-compliance with the RFS2 isn't an option since the penalties scale according to the economic benefit gained from non-compliance, plus a fine of $37,500 per day and per violation.)
In conclusion, even though the most recent price action of the D4 RINs appears to validate my EPA quota theory, I believe that theory is no longer valid. While the D4 RINs may have sold off on the EPA production numbers, I doubt that it will take the market long to figure out that the market has changed, and the old rules no longer apply. The D4 RIN sell-off also occurred during a time when the RFS2 is being debated in Washington, so that may have played a greater role in the D4 correction than the production numbers. Looking forward, I would imagine politics will have a greater impact on the RIN prices than the biodiesel quota set by the EPA. If the "blend wall" issue is not addressed, and D6 RINs remain high, it should be a very good year for biodiesel and renewable diesel producers, who not only should see their margins increase, but also greater attention from "Big Oil" and their M&A departments. If, however, Congress acts and either suspends or modifies the RFS2 mandates, all bets are off, and I have no way to quantify the impact of that political risk. It is a true wild card.
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.
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.