(Editors' Note: This article includes micro-cap stocks. Please be aware of the risks associated with these stocks.)
adjective, verb, Bernanke, Bernankein'
1) Bookworming when decisive action is needed.
Source: Urban Dictionary
If I were to change the above Urban Dictionary definition for "Bernanke," I would expand it to read "Bookworming when decisive action is needed, and having the markets respond as if decisive action was taken." On August 6, Environmental Protection Agency [EPA] Administrator Gina McCarthy "Bernanke'd" the Renewable Identification Number [RIN] market and signed off on a final rule that, in addition to finalizing the national renewable volume obligations [RVO] under the revised Renewable Fuel Standard [RFS2] for 2013, made the following comment about the ethanol blend wall:
"We expect that in preparing the 2014 proposed rule, we will estimate the available supply of cellulosic and advanced biofuel, assess the E10 blend wall and current infrastructure and market-based limitations to the consumption of ethanol in gasoline-ethanol blends above E10, and then propose to establish volume requirements that are reasonably attain able in light of these considerations and others as appropriate. EPA believes that the statute provides EPA with the authorities and tools needed to make appropriate adjustments in the national volume requirements to address these challenges. We are currently evaluating a variety of options and approaches consistent with our statutory authorities for use in establishing RFS requirements for 2014."
RINs, which are the tradable compliance commodities that are generated for each gallon of biofuel produced, and which obligated blenders (i.e., refiners) must submit each year to demonstrate that they have blended enough biofuel with gasoline or diesel fuel to meet their portion of the annual RVO, promptly lost 25% of their value (see figure). This came just as RIN prices were beginning to rebound from a 34% drop that occurred in late July. With 6.4 billion RINs generated under the corn ethanol [D6] mandate category alone in 2013, the last three weeks have seen -- in the parlance of financial journalists everywhere during crashes -- at least $3 billion in value erased from the RIN market. (Of course refiners, who are required by federal law to purchase the RINs, see this as a $3 billion de facto tax break.)
Regardless of one's opinions on the RFS2, $1.6 billion (the loss in D6 RIN value over the last 48 hours) is a rather large loss to result from a single ambiguous paragraph tucked away in a routine bureaucratic document. It's rather appropriate that this week's drop in RIN value came just as the broader markets embarked on a 3-day losing streak due to equally ambiguous comments from Federal Reserve officials on the possible timing of a tapering of the most recent round of quantitative easing [QE3]. Before delving further into what the EPA's paragraph means, however, a brief review of the facts is necessary.
The RFS2 was created under the Energy and Security Act of 2007 [EISA] as a means of furthering the goals of energy security and environmental security via the substitution of fossil fuels with biofuels. An earlier program, the RFS1, was created in 2005 and became obsolete almost as soon as it was enacted due to the tremendous growth in corn ethanol production that was occurring at the time. The RFS2 upped the ante by mandating the blending of increasing volumes of several types of biofuels and defining each category according to feedstock, biofuel type, and greenhouse gas emissions [GHG] relative to gasoline or diesel fuel (depending on biofuel type). The RFS2 was viewed at the time as a collaborative effort between both parties in the U.S. government, refiners, and biofuel producers. It's not an exaggeration to say that the RFS2 was the last big "team effort" in Washington, D.C. (By comparison, the Waxman-Markey cap-and-trade bill died in Congress less than two years later.)
At the time the RFS2 was considered to be a major improvement over the fixed subsidies, or "blenders' credits," that had defined biofuel policy until then (the corn ethanol version expired at the end of 2011, while the biodiesel version was recently retroactively renewed through the end of this year). The blenders' credits awarded blenders a set amount of money for each gallon of biofuel that they blended with fossil fuel; the blenders would capture some of the implicit value and pass the rest to biofuel producers, who would in turn capture their own share and pass the rest to farmers. This had two distorting effects. First, because the subsidy was fixed, the credits were awarded regardless of whether they were needed to incentivize biofuel production, resulting in windfall profits for all parties involved when petroleum prices were high. Second, the blenders' credits were paid directly from the IRS (i.e., U.S. taxpayers). This created a scenario in which a wealthy bicycle commuter (such a species does actually exist in many urban areas) ended up shouldering far more of the credit's cost than did the working class driver of a SUV getting all of 15 miles per gallon. In addition to being incredibly unfair to the former, the blenders' credits also committed the far worse crime of creating economic inefficiencies, as prices work best only when they accurately and adequately apportion costs. While the blenders' credits were created in part to counter the inefficiencies that result from U.S. taxpayers rather than drivers paying for the cost of petroleum shipping lane security, they ultimately just created inefficiencies of their own.
The RFS2 introduced a flexible subsidy in the form of the aforementioned RIN. This subsidy is unique in that it increases in value when production economics are unfavorable and decreases in value when they are not needed to encourage production. Other things being equal, RIN values increase when feedstock costs increase and decrease when petroleum prices increase. RINs were created to ensure that biofuel producers and blenders always receive enough of a subsidy to blend the mandated volumes of biofuel when fossil fuels, but not a penny more. (Political horse-trading kept the blenders' credits around for several years after they were due to be replaced by the RINs.) Republicans liked the RFS2 because it was a boon to rural development, Democrats liked it because it restricted GHG emissions from the transportation sector, refiners liked it because petroleum demand was growing and participation allowed for them to burnish their "green" credentials, and biofuel producers liked it because it created a larger market for their product. Naturally, the biofuel industry surged after the legislation was signed into law. According to one report, global biofuel investment in 2007 alone reached $39 billion, and investment continued to increase on a quarterly basis until Q3 2008.
The financial crisis
Fast forward to 2013, of course, and most of the discussion around the RFS2 is either confused or fiercely antagonistic. While a number of biofuel companies have gone public during the interim, most are bleeding cash; only one, Renewable Energy Group (NASDAQ:REGI), is still trading above its IPO price. What caused things to fall apart? While it seems almost facile to attribute recent developments to the 2008 financial crisis and subsequent recession, those two events were responsible either directly or indirectly for almost all of the causes of the RFS2's current problems.
The most immediate effect of the financial crisis was the near-collapse of Chrysler and GM (NYSE:GM) and their subsequent bailout by the U.S. government. Washington DC exerted an unprecedented amount of control over the rescued automakers under the terms of the bailout and, among other things, heavily pushed for them to increase the fuel economy of their conventional vehicles and produce more hybrid-electric vehicles. Both of these measures have had the effect of reducing gasoline consumption in the U.S. They combined with a second consequence of the financial crisis, the "jobless recovery" and extremely slow economic rebound, both of which reduced vehicle ownership and miles driven, to reverse the trend of gasoline consumption. Rather than increase over time, as was projected before the crisis, gasoline consumption is now expected to steadily decrease (see figure).
Projected U.S. gasoline consumption in AEO 2012. Source: EIA (2012)
The third consequence of the financial crisis was that it caused investment in biofuels R&D and commercialization to disappear overnight as venture capital firms and large companies became more concerned with their own survival. While many large petroleum companies announced large investments of their own in the sector the following year, this too dried up after interest failed to return to its pre-crisis levels. It's likely that many of 2007's fledgling biofuels companies would have survived had the financial crisis not pulled the rug out from under them, although that's not to say that they would have been successful in the longer term.
Finally, one lingering effect of the financial crisis is a complete lack of bipartisanship in Washington, D.C. The massive rescue and stimulus bills that were pushed by Presidents Bush and Obama during the crisis years caused the federal debt to soar, prompting a strong backlash from fiscal conservatives in the GOP. Any government policy that either spends taxpayer money or increases the costs of doing business in the U.S. now has a giant bulls-eye on it. For most of its history the RFS2 flew under the radar since its costs were both quite low and not paid by taxpayers. This former aspect changed in 2013 due to the first three consequences described above, however, and the RFS2 now has the unfortunate honor of being dubbed the latest "Big Government boondoggle."
The ethanol blend wall
Falling gasoline consumption has completely changed the economic calculus on the RFS2. Refiners were willing to participate in the RFS2 when increased biofuel production simply meant that they would receive a slightly smaller piece of an ever-growing pie; now that their normal market is shrinking, however, they have a strong financial incentive to oppose anything that shrinks their individual market shares relative to the whole. Worse, since the RFS2 volumetric mandates were created at a time when gasoline consumption was expected to continue growing, the annual volumetric mandates overestimated the amount of biofuel that the U.S. transportation fuel infrastructure can handle. Recall that ethanol is a gasoline substitute rather than a replacement; as such, it can only be used in all unmodified vehicles when blended with gasoline at a 1:10 ratio (10 vol%, or "E10"). (E15 can be used in newer vehicles but has gained virtually no traction on the market since its implementation in 2011.) The practical effect of this technical shortcoming is that U.S. ethanol consumption is limited to 10% of gasoline consumption. Falling gasoline consumption therefore must mean falling ethanol consumption, which is at odds with the growing ethanol consumption mandated by the RFS2. This "blend wall," as the point at which ethanol consumption reaches 10% of gasoline consumption is commonly known, is expected to be reached sometime in the coming months. By 2015, the RFS2 will require roughly 3.4 billion more gallons of ethanol consumption than the blend wall permits.
As discussed above, RIN prices increase to the level at which they incentivize sufficient biofuel blending to meet the annual volumetric mandates. The realization that the blend wall's arrival was imminent caused D6 RIN prices to soar from $0.04 at the beginning of January to $1.45 last month, an increase of 3,500% in six months. Refiners, who are required to purchase RINs (or the underlying biofuel gallons) under the RFS2, thus saw their collective annual costs of compliance increase from $300 million in 2012 to a maximum of $20 billion in 2013. An understandable uproar ensued, with several refiners reporting in their Q2 conference calls that their RIN costs had become one of their largest operating costs. Congress held hearings on the subject and the GOP called for the RFS2 to be "reformed". The stage was set for Tuesday's EPA announcement.
The EPA to the rescue?
What exactly does the EPA paragraph quoted above mean? Well, like many of Federal Reserve Chairman Ben Bernanke's past vague pronouncements on the economy and quantitative easing that have sent the markets into a tizzy, it really means that the EPA is going to spend some time determining how to best do what it is legally obligated to do. Section 211(o)(7)([A]) of the Clean Air Act, under which the EPA derives its authority to administer the RFS2, states that:
The Administrator, in consultation with the Secretary of Agriculture and the Secretary of Energy, may waive the requirements of paragraph (2) in whole or in part on petition by one or more States, by any person subject to the requirements of this subsection, or by the Administrator on his own motion by reducing the national quantity of renewable fuel required under paragraph (2)-
(i) based on a determination by the Administrator, after public notice and opportunity for comment, that implementation of the requirement would severely harm the economy or environment of a State, a region, or the United States; or
(ii) based on a determination by the Administrator, after public notice and opportunity for comment, that there is an inadequate domestic supply.
The referenced paragraph (2) sets the volumetric mandates for the RFS2, so the above simply means that the EPA Administrator is obliged to reduce these volumes when it is determined that either the mandate will cause severe harm to the economy, or that there is insufficient domestic supply to meet the volumes. Arguments could be made for both requirements under the blend wall, as $20 billion is a large cost and, while the U.S. has sufficient feedstock to produce the required biofuel volumes, it doesn't have the infrastructure necessary to supply the full amount to consumers.
Contrary to the assumption implied by the RIN market's reaction over the last 48 hours, however, I'm not convinced that this necessarily means that the EPA has completely given up on the future volumetric mandates. True, it is likely that one of the options that the EPA is considering involves reducing the renewable fuel (corn ethanol) and other advanced biofuel (cane ethanol) volumetric mandates under the RFS2 to a level that is roughly equal to 10% of U.S. projected gasoline consumption in 2014. Such a move would reduce the total volumetric mandate for that year by up to 3.7 billion gallons. Were this scenario to be implemented, we would likely see D6 RINs fall back to their January low of $0.04, especially since the corn ethanol crush spread has greatly improved since then (see figure).
U.S. ethanol capacity is more than sufficient to meet a production volume equal to the blend wall volume, so D6 RIN prices would remain low so long as the crush spread remained attractive. Independent corn ethanol producers such as Green Plains Renewable Energy (NASDAQ:GPRE), Pacific Ethanol (NASDAQ:PEIX), and Rex American Resources (NYSE:REX) would face a shrinking market size, and the least profitable such as Biofuel Energy Corp. (NASDAQ:BIOF) would likely be forced into bankruptcy, but obligated blenders (see table) would experience a substantial and rapid reduction in costs (recall that each blender's RVO is determined by its share of the transportation fuel market).
Top 10 U.S. Publicly-Traded Refiners by Capacity
|Refiner||Million bbl/day||% of U.S. total||2012 operating income (billion)|
|Phillips 66 (NYSE:PSX)|
|Marathon Petroleum (NYSE:MPC)|
|PBF Energy (NYSE:PBF)|
|Royal Dutch Shell (NYSE:RDS.A)|
Sources: EIA, Google Finance
Such a waving of the white flag by the EPA would be uncharacteristic of the organization's record under the Obama administration, however, for two reasons. First, it would send to Congress the message that the EPA is unwilling to push expensive GHG emission restrictions, such as its proposed rules on emissions from new and existing power plants, in the face of Congressional opposition. Second, it would mean that the EPA no longer wishes to reduce GHG emissions from the transportation sector by the maximum possible amount. While corn ethanol's carbon footprint is only slightly smaller than that of gasoline, there are several other qualifying fuels not limited by ethanol blend wall that achieve emission reductions of 50%+ relative to gasoline. It is for this latter reason in particular that I expect the EPA to consider some more creative methods of getting around the ethanol blend wall.
In the short-term, the most obvious alternative scenario would involve the EPA reducing the ethanol mandate but partially-offsetting the decreased volume with an increase to the volume of the biomass-based diesel category. As I've discussed previously, U.S. producers of biodiesel and renewable diesel are only using 33-50% of the available U.S. capacity to meet their category's 2013 volumetric mandate of 1.3 billion gallons. While there is insufficient domestic feedstock available to increase such production by the 2.5 billion gallons that will be necessary to fulfill the ethanol mandates in 2014 (3.7 billion gallons of ethanol equals 2.5 billion gallons of biodiesel on an energy basis), there is still plenty of room to increase the biomass-based diesel mandate. Furthermore, qualifying biomass-based diesel has a carbon footprint that is at least 50% smaller than that of diesel, as opposed to 20% for corn ethanol relative to gasoline, so any compensating offset would reduce the transportation sector's GHG emissions still further.
The RFS2 gives the EPA the flexibility to set the biomass-based diesel volumetric mandate on an annual basis so long as it doesn't fall below 1 billion gallons (the volumetric mandates for the other categories were set in the legislation), so the EPA has the ability to increase this YoY as it sees fit. Alternatively, it could just increase the total renewable fuel volume to a level equal to the blend wall plus potential biomass-based diesel production. D6 RIN prices would still fall since the biodiesel crush spread is also attractive at present; at the beginning of the year the biomass-based diesel (D4) RINs were trading for roughly $0.55, so using biomass-based diesel to fulfill some of the missing ethanol gallons would benefit both refiners and category producers such as Renewable Energy Group; Dynamic Fuels -- a JV between Syntroleum (NASDAQ:SYNM) and Tyson Foods (NYSE:TSN); Diamond Green Diesel -- a JV between Valero Energy and Darling International (NYSE:DAR); Amyris (NASDAQ:AMRS); and Solazyme (NASDAQ:SZYM).
While there is insufficient lipid feedstock for biomass-based diesel to make up the missing ethanol gallons on its own, the EPA recently created a new qualifying "biofuel" category that could easily fill the gap in the long-run: electricity. The increasing numbers of battery-electric and plug-in hybrid electric vehicles on U.S. roads has prompted the EPA to consider the GHG emissions resulting from electric transportation. Most of U.S. electricity is still sourced from coal, which has an even larger carbon footprint than petroleum, so the EPA has proposed to allow electricity produced from lignocellulose-derived biogas to qualify as a cellulosic biofuel under the RFS2. Initially this was seen as a means of increasing the number of cellulosic biofuel RINs generated for that chronically-underperforming category. However, there is no reason that a similar rule couldn't be proposed to overcome the blend wall, particularly since electricity isn't constrained by the ethanol blend wall.
The EPA would need to expand its previously-proposed biorenewable electricity rule for it to have an impact on the blend wall. First, lignocellulose-derived biogas is an incredibly limited feedstock. This would need to be expanded to lignocellulose as a combustion feedstock, for example. Second, "electricity" would need to be expanded to "process energy." The easiest method of implementing this would be to allow corn ethanol producers to earn RINs for sourcing their process energy needs from biomass rather than coal and/or natural gas. The EPA has previously calculated that the use of 33,147 Btus of biomass per gallon of output (Btu/gal) at a corn ethanol dry mill facility would replace 25,672 Btu/gal of natural gas or 34,773 Btu/gal of coal. Ethanol producers already earn 1 RIN for every 76,100 Btus of ethanol produced (i.e., ethanol's number of Btus per gallon), so the EPA could instead allow ethanol producers using biomass to earn 1.4 RINs per gallon of ethanol output (i.e., an amount equal to the energy content of the ethanol plus that of the biomass used to produce it). Based on the 1.4 RIN/gal figure, sufficient RINs to achieve the 2014 mandate would be generated if 70% of corn ethanol production under the 2014 blend wall (13.2 billion gallons) was to employ biomass for process energy rather than fossil fuel. Most corn ethanol producers have plentiful access to lignocellulose in the form of corn stover, which is currently left on the fields due to the lack of any financial incentives for using it to generate electricity or process energy. Based on a biomass energy content of 10,000 btu/lb, and assuming that only 2 tons of stover can be sustainably harvested from an acre of corn (roughly 40% removal in Iowa), then 7.7 million acres of corn would produce sufficient stover to provide the necessary process energy. By comparison, U.S. farmers have planted 97.4 million acres of corn in 2013.
I don't intend for the above "back-of-the-envelope" calculation to be in any way conclusive. Rather, its purpose is to show that the EPA's statement that the RFS2 provides it with the tools to make "appropriate adjustments" to the 2014 volumetric mandate doesn't necessarily mean that the blend wall just defeated the RFS2. While it is possible that the volumetric mandate will be rolled back in 2014 (and the EPA is most certainly considering such a scenario as an option), I consider this to be unlikely in light of the Obama administration's 5-year record on the subject of GHG emissions. As this article demonstrates, the EPA has a number of options available to it, only one of which includes a volume rollback. The EPA has said nothing to suggest that such a rollback is inevitable and any fall in D6 RINs to their 2012 prices will be premature as a result.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in REGI over the next 72 hours. 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.