In my previous article "Understanding The EPA's RFS2, Its Future, RINs And The Ethanol Blend Wall Pt #1" I covered ethanol and the "blend wall." In this article I'll cover biodiesel and renewable diesel.
Unlike corn ethanol, biodiesel comes in a variety of qualities defined by its feedstock. Biodiesel can be made out of many different fats, oils and greases, but the most popular are soy bean oil biodiesel or soy bean oil methyl ester or SME, canola oil biodiesel or canola oil methyl ester or CME or fatty acid methyl ester or FAME. The majority or all biodiesel is produced from soy bean oil or SME which is the highest quality biodiesel having high consistency and a low "cloud point," but it is also an expensive feedstock. Biodiesel made from "yellow grease" or other non-uniform oil sources produce FAME which is a lower quality biodiesel with a higher "cloud point" which sells at a discount to SME, especially in the cold winter months. Biodiesel prices also vary depending upon the location, so biodiesel prices are dependent upon feedstock, season and location.
The other thing to note is that unlike ethanol which usually sells at a steep discount to gasoline, biodiesel sells at a steep premium to diesel. This is because biodiesel has a similar energy content as petroleum diesel, which is 1.5 x that of ethanol. Because of this energy superiority, each gallon of biodiesel comes with 1.5 D4 RINs embedded in it. The price of biodiesel therefore has the portion of the blenders' tax credit and 1.5 D4 RINs that is passed on to the producer. Using ultra low sulfur diesel or ULSD as the base value of biodiesel, one can tease out the embedded D4 RIN and "blenders' tax credit." The SME premium over ULSD is $1.74, the sum total of 1.5 D4 RINs and the $1.00 blenders' tax credit is $2.40, so 73% of the subsidy is passed on to the producer.
|B100 SME Chicago||$4.82|
|ULSD NY Harbor||$3.08|
|Difference (D4 + BTC)||$1.74|
|D4 RIN x 1.5||$1.40|
|Blenders' Tax Credit||$1.00|
The producer keeps $1.74 and the blender keeps the residual $2.40 - $1.74 = $0.66, or 27% of the total subsidy.
Unlike ethanol, there really isn't a blend wall issue with biodiesel. The 2013 EPA quota for ethanol is over 13 billion gallons, the biodiesel/renewable diesel quota is only 1.28 billion gallons.
The important metric for evaluating the biodiesel industry are the margins. To calculate them, you have to start with the quality of biodiesel produced, SME or FAME. SME trades at a premium to FAME, but SME also uses a far more expensive feedstock on average. In the following table is an estimated margin for Syntroleum's (NASDAQ:SYNM) renewable diesel fuel, and Renewable Energy Group's (NASDAQ:REGI) biodiesel fuels. Right now we will only focus on REGI. REGI can make 1 gallon of SME biodiesel out of 7.5 lbs of soy bean oil, or 1 gallon of FAME biodiesel out of 8.0 lbs choice white grease (CWG), 8.5 lbs yellow grease (YG) and 8.2 lbs inedible corn oil.
Key Point for Investors: During the summertime the spread between SME and FAME is the lowest, so the margins for "flexible feedstock" biodiesel plants are the most competitive. Soy bean oil is an expensive feedstock, so even with the lower priced FAME, flexible feedstock biodiesel plants have a cost advantage. Most importantly is that SME makes up the majority of biodiesel produced. SME is essentially needed to meet the EPA's biodiesel Renewable Volume Obligation or RVO. This effectively creates a profit cushion for the "flexible feedstock" firms. If the RFS2 guarantees a profit for the biodiesel industry, SME will be the least profitable but it will be profitable, and if the least profitable process survives, the more profitable processes should thrive.
Feedstocks - There were a total of 836 million pounds of feedstocks used to produce biodiesel in May 2013. Soybean oil was the largest biodiesel feedstock during May 2013 with 416 million pounds consumed. The next three largest biodiesel feedstocks during the period were corn oil (91 million pounds), yellow grease (88 million pounds), and tallow (61 million pounds).
The Ethanol Blend Wall:
The ethanol "blend wall" doesn't only impact the price of ethanol and the ethanol D6 RINs, it also impacts biodiesel and renewable diesel. Biodiesel and renewable diesel produce what are called D4 RINs, which are the most flexible of RINs. RINs have what is called a "nested" structure where some can be used as others, but not vice versa. What that means is that D4 RINs can be used as D6 RINs, but D6 RINs can't be used as D4 RINs. The impact this has on the RIN market is that a D6 RIN creates a price floor for the D4 RINs. D4 RINs should never trade below a D6 RIN. As the ethanol "blend wall" sends the price of D6 RINs soaring, the D6 RINs also push up the price of D4 RINs. This effect is magnified by the fact that each gallon of biodiesel generates 1.5 D4 RINs and renewable diesel generates 1.7 D4 RINs.
The other important impact of the ethanol "blend wall" is that the price of D4 RINs won't fall off as the biodiesel RVO is approached. Under normal circumstances the price of RINs fall as the production levels near the EPA's RVO quota. The RVO for biomass based diesel is 1.28 billion gallons for 2013, and with 2 billion gallons of capacity in the biodiesel industry it should easily be met. Under normal circumstances D4 RINs should collapse in price near the end of the year, however with the ethanol "blend wall" in place, the ethanol RVO effectively becomes the biomass based diesel RVO, as blenders substitute buying biomass based diesel for the unwanted ethanol because the D4 RINs can act as D6 RINs.
Key Point for Investors:
Biomass based diesel firms will most likely benefit more from the ethanol blend wall than do ethanol producers. The increase in D4 RIN prices are magnified by 1.5 to 1.7x that of an ethanol D6 RIN. As noted above, the share of the RIN and tax credit captured by the biomass based diesel firms is also likely higher than what is captured by the ethanol producers. The margins are also higher for biomass based diesel than ethanol, so those three factors favor investing in biomass based diesel firms over ethanol firms if the "blend wall" issue continues.
Unlike the biodiesel produced by REGI, SYNM produces a "renewable diesel." SYNM's fuel is a "neat qualified" "drop-in" fuel that needs no blending. It effectively is the chemical equivalent of petroleum diesel. SYNM's fuel also generates 1.7 D4 RINs per gallon, 13% more than biodiesel. SYNM's margins when using yellow grease are also higher than biodiesel, especially during the colder months. All those factors would make SYNM the obvious investment when the ethanol "blend wall" is an issue. The problem with that theory is that SYNM has not been producing fuel since late 2012, and has not given guidance restart date since passing its original restart date of mid to late July 2013. SYNM may be in the process of selling its plant, and exiting the biofuels industry.
The Blenders' Tax Credit:
Congress just couldn't leave well enough alone, and has created a renewable tax credit for the biomass based diesel industry. It is a redundant subsidy, and does little more than disrupt the RIN and biomass based diesel industry. It is renewed annually, so it creates a great deal of uncertainty for the industry as it is being debated in Congress. Last year the markets began discounting the passage of the tax credit mid-year so the second half of 2012 saw low to negative margins for the biomass diesel industry, forcing many firms to shut down production. Because the tax credit is redundant, all it really does is lower the price of the D4 RIN by $1.00/1.5 = $0.67, so the net effect to the producer is negligible. The key issue is that during years where the tax credit is being considered for reinstatement, the uncertainty can be devastating for the industry, especially for smaller independent firms, as it was last year. On the flip side, during years where the tax credit is in place, investors can feel confident that the loss of the tax credit won't drive RIN prices lower. 2013 is a year where the tax debate should not harm RIN prices.
Other exogenous factors:
The ethanol "blend wall" has driven up the compliance costs to "Big Oil," providing them an incentive to buy up biofuels plants. "Big Oil" can mitigate some of the compliance costs of the RFS2 regulations by simply producing the biofuel themselves, and the most direct way to do that is to simply buy up existing firms. I would expect to see this trend continue, if not accelerate. The other derivative effect worth noting is that the falling corn price and increased production of ethanol will likely result in the increased production of inedible corn oil, a byproduct of ethanol production. This should help keep biomass based diesel feedstock prices low.
In conclusion, while the benefit of the ethanol "blend wall" to ethanol producers may be in question, my analysis shows that ironically the biomass based diesel firms are the more likely beneficiary. Because the RVO for ethanol won't peak out until the end of 2015, the "blend wall" issue may persist for another 2+ years, providing solid investment opportunities and profits in the biofuels industry, especially in biomass based diesel. M&A should also continue, which should provide a boost to even struggling biofuels firms. The one fly in the ointment however is the stability of the EPA's RFS2. Just recently the EPA relaxed some of its requirements, and the API is waging a campaign to get the entire RFS2 repealed. The entire theory outlined in this article requires the EPA's RFS2 to remain intact and enforced, any weakening of it will water down the effects discussed above.
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.
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.