At one point this year ethanol RINs were up over 2,700% from 12/31/2012, and yet most people have never even heard of them, let alone understand them. This article will explore Renewable Identification Numbers or RINs, and the EPA's Renewable Fuels Standard 2, or RFS2 regulation that created them.
For Seeking Alpha readers that want to follow these issues on a regular basis, there are two Seeking Alpha authors that do a great job routinely writing articles based upon current events.
Tristan R. Brown does an outstanding job explaining the details that go into writing the EPA laws, and the "intended" consequences of them.
Thomas Hor also does an outstanding job keeping abreast of the impacts the RFS2 will have on companies.
The standards ensure that transportation fuel sold in the United States contains a minimum volume of renewable fuel as required by the Energy Independence and Security Act of 2007.
To implement the RFS2 the EPA relies on 2 tools: 1) a quota of select biofuels that must be blended into conventional fuels and 2) Renewable Identification Numbers or RINs that are attached to every gallon produced of qualified biofuels, and then either separated and sold or retired once the fuel is "blended" into the fuel supply.
Theoretically the RINs should guarantee a profit substantial enough to ensure the EPA's quota is reached and encourage the expansion of capacity to meet future quotas. This is what investors should be most interested in, the EPA has the power of the US government to guarantee profits for these industries, not individual firms, but the industry as a whole. This makes the biofuels industry unique, and subject to an entirely different risk/return profile than an industry that organically emerges from normal free market forces. No other industry has the EPA threatening their customers with crippling sanctions and penalties if they don't purchase its product.
(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.)
Key Point for Investors: The biofuels industries targeted by the RFS2 have the power of the federal government ensuring that the industry will generate enough profits to maintain and expand production. Expanding industries generally must generate above market returns in order to attract capital.
To put everything together an investor must understand:
1) The biofuel being produced, its feedstock and its operating costs
2) The competing fossil fuel the biofuel replaces
3) The type of RIN the biofuel generates and how many per gallon
4) Is there an associated "blenders' tax credit" and when it expires.
5) The current EPA RFS2 quota level, and any future increases
First we will start with the simplest example corn ethanol. Ethanol (EtOH) is used as an oxygenator of Reformulated Blendstock for Oxygenate Blending or RBOB gasoline. Blending about 3% EtOH into a gallon of RBOB provides the needed oxygenation. Above 3%, EtOH then competes as a fuel. EtOH only has 2/3rds the energy content as RBOB, so it tends to get lower miles pre gallon, and thus must sell at a discount. The theoretical value of EtOH based upon energy content is then 2/3rds the price of RBOB:
|Theoretical Px EtOH||$1.98|
That of course is a top value because EtOH blended gasolines require more frequent fill-ups, harm some engines and are generally avoided by consumers so there is an inconvenience/dislike factor.
The actual price of EtOH, however, turns out to be above the theoretical price. Currently (at the time of this writing 08/16/2012), EtOH trades at a $0.25 premium to its theoretical energy value.
|Break Even %||67%|
|Break Even Px||$ 1.98|
|EtOH Premium||$ 0.25|
That $0.25 premium is assumed to be the premium paid to the producer by the blender for the embedded D6 RIN, which comes with each gallon of EtOH.
The cost benefit analysis calculation to the EtOH producer is quantified by what is called a "crush spread." One bushel of corn produces 2.8 gallons of EtOH plus 17 lbs of dried distillers grains or DDG, so the breakeven price would be 1 bushel of corn = 2.8 x gallon of EtOH + 17lbs DDG. The "EtOH crush spread" measures the difference between the price of 1 bushel of corn and 2.8x the price of EtOH. Note that calculation does not include the DDG price.
The price of corn is then subtracted from the converted price of ethanol (in dollars per bushel) to obtain the corn crush.
The current "crush spread" has been dramatically increasing with the collapse in the price of corn.
Currently about $4.75 will buy a bushel of corn, which can be turned into $6.24 worth of ethanol plus $2.15 worth of DDG.
Using this ethanol plant model, current margins are:
|Other Variable Costs||$0.59|
With the projected bumper corn crop this year, this margin would be expected to increase if corn prices continue to slide.
August's WASDE report projected the 2013 corn crop at 13.763 billion bushels, which would be a record crop, if realized, and a 2.98 billion bushel increase from 2012's drought-stricken crop. The report estimates the 2013 corn yield at 154.4 bushels per acre, a reflection of the late planting season and cool, dry weather in the western Corn Belt, according to Davis.
The economics however aren't that simple, as this graphic from the Energy Research Foundation highlights (Note: this was written in 2009 when a blenders' tax credit was in force).
As noted above, EtOH has value up to 3% of a gallon as an oxygenator, but after that it falls in value and must compete with RBOB. Most cars can't use fuel blends with greater than 10% EtOH, so above 10% EtOH drops in value to compensate for lower energy content, higher capital costs due to lower fuels sales per pump and storage tank and simply lower demand because few consumers demand E85. The 10% threshold is what is called the "blend wall." Beyond 10%, the demand for EtOH dramatically drops, as should the price of EtOH.
The problem is, the EPA has set a statutory quota for EtOH that exceeds the 10% "blend wall." This creates a "surplus" problem where EtOH is mandated to be consumed but isn't demanded, and still must be produced. Under normal market conditions, EtOH production would simply stop as the price of EtOH would fall to a level that made production unprofitable. That however isn't an option with EtOH, it has to be produced to reach the quota. The function of the D6 RIN is to ensure there are enough profits in the EtOH market to stimulate production. This table highlights the impact of lower EtOH prices on the EtOH margin.
|Multiplier||Px T0||Margin T0||Px T1||Margin T1|
In order for the EtOH margin to be maintained ensuring EtOH production, the embedded value of the D6 RIN must increase.
|Multiplier||Px T0||Margin T0||Px T1||Margin T1|
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.
Key Point to Investors: The "blend wall" may create a predictable investment opportunity whenever it occurs. I'll explain the "may" later, but note the bolded and underlined part of the above quote as a clue.
The other factor is the price of corn. Corn prices have been falling, and are expected to continue to decline. This takes some of the pressure off the RINs, so the cost of corn must also be considered when investing based upon the expectation of reaching the "blend wall." As this table demonstrates, if corn prices fell to $4.05/bushel, D6 RINs could fall to $0.00 and EtOH producers would still be able to maintain their current margins.
|Multiplier||Px T0||Margin T0||Px T1||Margin T1|
Another factor to consider is the price of RBOB. Higher RBOB prices make E85 fuels more attractive (theoretically). EtOH uses corn as a feedstock, so the correlation with RBOB is asymmetric. The correlation is higher when RBOB prices are above EtOH production costs and rising and there is a positive "crush spread," but low when RBOB falls below EtOH production cost and falling and there is a negative "crush spread."
This table demonstrates how rising RBOB prices may disrupt the D6 RIN prices even if the "blend wall" is reached.
|Px T0||Px T1|
The higher theoretical value allows EtOH producers to maintain their margins even with falling D6 RIN prices.
|Multiplier||Px T0||Margin T0||Px T1||Margin T1|
The above examples cover the "theoretical" workings of the EtOH market from the producer's side and where EtOH is based upon its relative energy content, and consumers treat it as an RBOB equivalent. However, that isn't how the real world works. Today EtOH goes for $2.23/gal and a D6 RIN goes for $0.80, meaning the "blender" is paying $0.80 for the D6 RIN and $1.43/gal for EtOH. $1.43 is a $1.43/$1.98 = 28% discount to EtOH's theoretical value. Theoretically this should result in a fall in the price of E85 vs regular unleaded fuel. Theoretically that should result in greater demand for E85 vehicles. My bet is that the theoretical model of the EPA is flawed. I seriously doubt people are going to rush out to buy new flex fuels cars because E85 is cheaper than E10.
Even if they were willing to, the EPA has created a chicken or the egg situation. Filling stations aren't going to invest in E85 pumps and tanks and have them sit idle until there are enough flex fuels vehicles on the road to make them economical, so flex fuel owners waste half their savings driving around experiencing "range anxiety" trying to find an E85 pump. Even if every car on the road is a flex fuel vehicle, I doubt that most people would buy E85 anyway unless it is at a very large discount to other fuels simply because people like convenience and using E85 makes people fill up more often, and most people don't like to watch money drained from their pockets on a more frequent basis, even if it is less money. My bet is most people that own flex fuel vehicles will simply buy regular gas, and that is what studies have shown.
The last major fly in the ointment of the "blend wall" valuation model are the politics. The entire mechanism detailed above can change instantly with the stroke of a pen, thus I used the term "may" in the key point for investors above. That is in fact what just happened recently, as the congressional hearings made the EPA blink, and signaled some flexibility as to the enforcement of the mandated RFS2 quota structure. Markets hate uncertainly, and this "flexibility" is certain to cause problems for firms that invest hundreds of millions of dollars building EtOH and other biofuels plants, but are unable to reliably estimate the revenues from the RFS2 regulations.
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.
With the new "flexibility" the results were predictable and swift. Immediately "Big Oil" stocks rallied and biofuels firms stumbled.
Not surprisingly, the share prices of independent corn ethanol producers such as BioFuel Energy (BIOF), Green Plains Renewable Energy (GPRE), Pacific Ethanol (PEIX), and Rex American Resources (REX) all underperformed the S&P 500 in the days following the EPA's announcement... On the other hand, independent refiners such as PBF Energy (PBF), Phillips 66 (PSX), and Valero (VLO), all of which attributed underperformance in the first half of 2013 to higher RIN prices, outperformed the S&P 500 on the news
The harsh reality of this "blend wall" situation is that it provides the opportunity for "Big Oil" to use it as evidence of the failure of the RFS2 program. One consequence of the "blend wall" is that "Big Oil" can avoid the issue by simply exporting refined fuels, thus driving up fuel prices for domestic users. I find it hard to understand how the EPA can expect the public to maintain support for such a program. However, "Big Oil" is far more politically astute and has already started a "public awareness" campaign to ensure that voters are aware of the costs the RFS2 is placing on them, and calling for a full repeal of RFS2.
"The RFS is broken beyond repair, and we are calling on the EPA to use its waiver authority to provide a stop gap measure for this unworkable mandate," Greco said. "Higher ethanol requirements could lead to a reduction in the domestic fuel supply, increased costs, and severe harm to the U.S. economy.".."While a waiver for 2014 will provide short-term relief from the RFS mandate, the program is outdated and needs to be repealed once and for all," Greco said. "Under the current RFS regime, ethanol requirements will continue to increase while gasoline demand continues to decline. That's why we need a full repeal by Congress."
Key point to investors: As the recent Congressional hearings highlight, the political risk to the biofuels industry simply cannot be overstated. The economic dynamics can change overnight, and never provide reliable visibility beyond the next election. Congressional hearings can be called on a moment's notice, so these firms are always subject to the whims of Congress. To make matters worse, the entire foundation of RFS2 is based upon manmade CO2 causing global warming, its only mechanism of causing "climate change." Current global temperatures are at the same level they were in 1988 when atmospheric CO2 was 351 parts per million (PPM). Today atmospheric CO2 is 397 PPM, or a full 397/351 = 13% increase and global temperatures are flat. Clearly there is a problem with the causal relationship. If/when there are hearings by a less supportive Congress on the "science" supporting the RFS2, I would expect some dramatic changes if not repeal of the entire program. The "science" is that bad.
In conclusion: I started this article expecting it to be a comprehensive article covering the RFS2, RINs and the "blend wall," but it is simply too much for one article so I will break it up into a series. This first installment focused on key points for investors regarding the "blend wall" issue. They are:
1) The RFS2 is intended to "guarantee" profits for the targeted biofuels industry.
2) Prices for RBOB and corn, as well as the % of EtOH blended in the total fuel supply and the RFS2 mandated quota all work to influence the price of D6 RINs and profitability of EtOH plants.
3) Politics play a huge part in shaping the economics of this industry so as the recent EPA hearings prove, betting on the "blend wall" to drive D6 RINs and EtOH firm's profits higher is never a sure bet. In fact, high D6 RIN prices are most likely going to trigger an investigation/hearing which intends to reverse the price of D6 RINs.
Investors interested in investing in these markets should understand the economics and politics behind them. D6 RIN prices would be expected to increase in value with the "blend wall" but that is only if the EPA doesn't waiver. High RIN prices should benefit EtOH producers, corn, agricultural supply companies, equipment manufacturers and fertilizer companies, and harm "Big Oil." If the EPA waivers, the opposite would be expected. Looking forward to the end of 2013, I would expect RINs to have peaked, as the expected bumper crop of corn should take the pressure off the RIN prices as detailed above.
Future articles will further explore the RFS2, other forms of RINs, other biofuels and other investment strategies and ideas.
Secondary beneficiaries of the "Blend Wall:"
- CF Industries Holdings, Inc. (NYSE:CF);
- CVR Partners LP (NYSE:UAN);
- Rentech Nitrogen Partners LP (NYSE:RNF)
- Nitrogen Company, LP (NYSE:TNH)
- Deere & Company (NYSE:DE);
- AGCO Corporation (NYSE:AGCO);
- Kubota Corp. (OTCPK:KUBTY);
- The Toro Company (NYSE:TTC);
- Husqvarna (OTCPK:HSQVY)
- Caterpillar, Inc. (NYSE:CAT)
Firms that would benefit of the EPA waivers and corn, grain and beef prices collapse:
- Tyson Foods, Inc. (NYSE:TSN);
- Smithfield Foods (NYSE:SFD);
- Hormel Foods Corp. (NYSE:HRL);
- Pilgrim's Pride (NASDAQ:PPC);
- Archer Daniels Midland (NYSE:ADM);
- Hillshire Brands Co (NYSE:HSH)
- General Mills, Inc. (NYSE:GIS)
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.