(Editors' Note: This article discusses micro-cap stocks. Please be aware of the risks associated with these stocks.)
The revised Renewable Fuel Standard [RFS2] became a popular topic of discussion in the investing community after several refiners attributed their underperformance in Q2 2013 to their costs of compliance under the program. Refiners are required under the program to blend a volume of biofuels determined by their market share with gasoline and diesel fuel for retail. Each blended gallon generates a Renewable Identification Number [RIN] that is submitted to the Environmental Protection Agency [EPA] to demonstrate compliance with the program. RINs are tradable compliance commodities in that entities holding more RINs than required can sell the excess to refiners with a deficit. The arrival of the ethanol "blend wall," which limits the maximum ethanol blending volume to 10 vol% of gasoline consumption, caused refiners and other obligated blenders to scramble to purchase enough RINs for the year while the market was still capable of absorbing the ethanol. Corn ethanol [D6] RINs soared as a result from $0.04 at the end of 2012 to $1.45 in July 2013. Refiners such as Valero (VLO) and PBF Energy (PBF) found themselves spending up to 3,500% more on RINs in 2013 than they had anticipated in 2012, as a result, hurting their quarterly earnings.
Shock has since turned to anger over this new and unexpected "tax" on refiners, prompting criticism of the EPA by the American Petroleum Institute and the holding of Congressional hearings on reforming or repealing the RFS2. Biofuel producers have been accused by at least one refining executive of using high RIN prices to pad their own income statements in the form of higher ethanol prices, further heightening the controversy. At the same time, however, some refiners have announced plans to mitigate their RIN expenses by expanding their biofuel blending volumes. There is an obvious logical disconnect between biofuel producers capturing most or all of the value of high RIN prices and refiners minimizing their own RIN purchases by increasing their blending volumes. As a reminder, RINs are generated when a gallon of biofuel is produced but do not become tradable until the biofuel is blended for retail. The question of which companies are benefiting from high RIN prices is important to investors and this article examines the issue further in order to identify the beneficiaries.
Do biofuel producers benefit?
There is no question that biofuel producers have benefited from the RFS2, which has created a mandatory market for their product. While ethanol became a popular fuel oxygenate after MTBE was phased out due to water contamination issues, the RFS2 at the very least has provided a buffer against volatility to biofuel producers. With that said, I recently questioned the conventional wisdom that biofuel producers have benefited from higher RIN prices. In addition to the issue of minimizing RIN purchases by increasing blending volumes, a number of other factors point to biofuel producers not being the primary beneficiaries. Ethanol's price premium over gasoline on an energy-equivalent basis (a gallon of ethanol having roughly 67% of the energy content of a gallon of gasoline) has trended higher since the beginning of 2012 but remains below its historical highs (see figure).
Furthermore, the arrival of the blend wall has converted RINs from a production subsidy to a consumption subsidy. While RINs were initially created to provide biofuel producers with a flexible subsidy operating as a function of input costs and output prices, the price increase since the beginning of the year has been in response to the blend wall rather than a poor operating environment for producers; high RIN prices are needed to incentivize E15 and E85 consumption by retailers and consumers, rather than biofuel production. While this doesn't mean that biofuel producers can't capture the value of higher RIN prices, it does make it less likely.
Another look at the ethanol premium
A commenter to my previous article on the subject pointed out that the presence of the Volumetric Ethanol Excise Tax Credit [VEETC], or ethanol blenders' credit, up until the end of 2011 may have artificially increased the ethanol price premium. While this is debatable (a large body of peer-reviewed literature exists on the subject and ultimately breaks on the question of whether biofuel producers, blenders, or E10 consumers captured most of the credit's implicit value), it's worth another look. 2012 was notable in that the ethanol blenders' credit no longer existed and D6 RINs were virtually worthless throughout the year; in other words, ethanol producers received no explicit subsidies during that year. It is useful to compare the ethanol price premium in 2013 against 2012 to determine whether there has been any substantial change between the two years. As the following table shows, the 3,500% increase in RIN prices was not reflected in a substantially higher ethanol premium, either on a quarterly or annual basis.
|Time period||Ethanol premium (energy eq. basis)|
|CY 2013 (to date)||126.0%|
|Q3 2013 (to date)||118.4%|
The ethanol premium was 10% and 20% higher YoY in Q1 and Q2 2013 relative to 2012 but 8% lower YoY in Q3 (to date). The annual ethanol premium in 2013 to date is only 6% higher than in 2012. This suggests that ethanol producers have enjoyed a slightly higher premium relative to gasoline in 2013 than in 2012, although certainly not of the magnitude that one would expect if it was tied directly to the 3,500% increase in RIN prices that occurred between January and July 2013.
The argument that ethanol producers have been the primary beneficiaries of higher RIN prices further weakens when daily RIN prices are compared with the daily ethanol price premium. I only have RIN price data since May, although RIN prices have experienced a high degree of volatility during the time period covered (see figure).
Source: EcoEngineers (2013)
While there is a correlation between RIN prices and the ethanol price premium on an energy-equivalent basis, it is both very weak (R2=0.10) and negative, meaning that higher RIN prices are weakly correlated with a lower ethanol price premium (see figure). Obviously, correlation is not the same as causation, but the lack of a strong positive correlation greatly weakens the argument that ethanol producers are the primary beneficiaries of higher RIN prices.
Who does benefit?
RIN purchases always require a counterparty to sell the RINs, so if ethanol producers aren't the primary beneficiaries of higher RIN prices then some other party must be. Furthermore, if higher RIN prices are not driving ethanol price premiums higher, as would happen if RIN prices were being implicitly captured, then it is likely that they are instead being explicitly captured. The next step is to look at companies with large blending capacities to see if they are benefiting from RINs and, if so, to what extent.
While many investors associate blenders with refiners and non-blenders with ethanol producers under the RFS2, the reality is far more complex. The majority of "obligated blenders" are refiners; however, any party with blending or transmixing capacity can separate RINs from the biofuels that it blends. Companies in a number of sectors own blending terminals, including refiners, biofuel producers, and pipeline operators. Several of the latter have reported benefiting from RIN sales in the first half of 2013. Kinder Morgan Energy Partners L.P. (KMP) reported in its Q1 conference call that it had separated 700,000 RINs per month in that quarter from its transmixing operations, which it then sold for $1.9 million, or an average selling price [ASP] of $0.90. Like other pipeline operators, Kinder Morgan charges a fee for actual blending (as opposed to transmixing) and never takes title of the RINs subsequently separated, otherwise it would be able to sell those as well. However, this shows that the company's customers are able to sell those RINs instead. Kinder Morgan installed another 15 million gallons per year of biodiesel blending capacity in Q2 2013, representing 22.5 million in annual separated RINs (each gallon of biodiesel receives 1.5 RINs).
Buckeye Partners L.P. (BPL) reported selling two million RINs per month (half corn ethanol, half biomass-based diesel) from its blending activities in the first half of 2013, earning $3.5 million in Q1 (ASP of $0.58) and $5 million in Q2 (ASP of $0.83). BP (BP) also reported that it benefited from higher RIN prices in Q2 2013, although volume and price details were not made available in its conference call.
Biofuel blenders benefit, biofuel producers don't
Perhaps the best example of how blenders have benefited from high RIN prices can be seen by comparing the recent performance of biofuel producers with blending capacity against those without. Were biofuel producers capturing higher RIN values implicitly in the form of higher ethanol price premiums, then we would not expect to see major differences in the 2013 performance of the various independent biofuel producers. In reality, however, there has been a vast divergence between those with blending capacity and those without in 2013.
Green Plains Energy (GPRE), an independent corn ethanol producer, operates nearly 700 million gallons per year of terminal blending capacity through its subsidiary BlendStar, which likely explains its stock price outperformance in 2013 (up 105% YTD). Similarly, biodiesel producer Renewable Energy Group (REGI), which is up 161% YTD, distributes much of its biodiesel via its own blending terminals distributed across the U.S. Pacific Ethanol (PEIX), Biofuel Energy Corp. (BIOF), and Valero (VLO) are examples of corn ethanol producers without large blending capacities. Valero's situation best illustrates the disparate impact on blenders versus producers given its status as both a refiner and a corn ethanol producer. Despite its large ethanol production capacity, the company was still required to purchase $125 million in RINs in Q2 2013, and it has projected needing to spend up to $800 million on RINs for the full year. Neither Pacific Ethanol nor Biofuel Energy are required to purchase RINs under the RFS2, but their relative lack of blending capacity has likely contributed to their share price underperformance in 2013 (see figure).
There is a steady stream of evidence suggesting that the beneficiaries of the recent increase in RIN prices are a diverse group of companies characterized by their biofuel blending capacity rather than their biofuel production capacity. This seemingly mundane difference has translated into an additional revenue stream for those companies with blending capacity at the expense of those refiners without. The conventional wisdom that biofuel producers have benefited in 2013 at the expense of the refining industry greatly oversimplifies a complicated reality. Some refiners and pipeline operators have benefited from high RINs, as have some biofuel producers. Likewise, some refiners have been heavily penalized and other biofuel producers have recognized no net benefit. In all cases, however, these impacts have manifested as higher RIN prices rather than a substantially higher ethanol price premium. Companies will be affected by the RFS2 according to blending capacity rather than biofuel production capacity so long as the blend wall continues to drive RIN prices.