The New York Times introduced the general public to the confusing reality that is the Renewable Identification Number [RIN] market late last week by publishing a lengthy article on the extreme price volatility that has characterized it this year. While the article unfortunately doesn't include any new revelations relating to trade volumes and timing, instead rehashing the rumors and off-the-record statements that the biofuels and refining industries have been rife with over the last several months, it is the first national media piece to put these ambiguous statements under an unambiguous headline: "Wall St. Exploits Ethanol Credits, and Prices Spike." Specifically, the article attributes the surge in corn ethanol [D6] RIN prices since January and subsequent volatility to speculative trading by two banks in particular: JPMorgan Chase & Co. (NYSE:JPM) and Morgan Stanley (NYSE:MS). (Representatives from both banks denied profiting from RIN transactions.) Barclays PLC (NYSE:BCS) and Citigroup (NYSE:C) are also identified as registered RIN traders, although speculative trading is not directly attributed to either by The Times. The Times article goes on to report that JPMorgan and Morgan Stanley stockpiled RINs while they were inexpensive (they started 2013 trading around $0.05) and then sold them over the summer as they approached $1.45 for a return of up to 2,800% (see figure):
"Traders for big banks and other financial institutions, [industry executives, brokers, traders, and analysts] say, amassed millions of the credits just as refiners were looking to buy more of them to meet an expanding federal requirement. Industry executives familiar with JPMorgan Chase's activities, for example, told The Times that the bank offered to sell them hundreds of millions of the credits earlier this summer. When asked how the bank had amassed such a stake, the executives said they were told by the bank that it had stockpiled the credits."
Source: EcoEngineers (2013)
A quick recap
As a reminder, RINs are the tradable compliance commodities that operate as the flexible subsidy "carrot" underlying the revised Renewable Fuel Standard [RFS2]. In theory, RIN values move inversely with biofuel product margins, increasing when margins decrease and decreasing when margins increase. In this way, they serve to incentivize producers to produce enough biofuel to meet the RFS2's annual volumetric mandates but without allowing them to incur windfall profits (which is an inherent problem with fixed subsidies, such as the now-defunct ethanol blenders' credit). Each RIN is generated when a gallon of biofuel is produced but does not become tradable (or "separated" in the RFS2's parlance) until that biofuel is blended with a gallon of gasoline or diesel fuel. At this point, the RINs can either be submitted to the EPA to demonstrate compliance with the RFS2's volumetric mandate, if held by an obligated blender (as the refiners who are obligated to blend biofuel under the program are known), or sold to a third party (with the latter option commonly used by non-obligated blenders and obligated blenders holding excess RINs). The RFS2's creators believed that making RINs tradable at the point of blending would make them easily accessible to obligated blenders, who would then pass most (or even all) of the RIN's value to the biofuel producers.
When speculators win, do blenders lose?
The question of which market forces are currently driving RIN prices is one of great importance to investors in the biofuels and refining industries. One explanation for the sharp increase in RIN prices this year is that it was caused by the market's realization that the ethanol blend wall, as the 10 vol% de facto blending limit with gasoline is known, will be reached either this year or the next. Since the revised RFS2 mandates the consumption of more ethanol than the blend wall permits, the arrival of the blend wall will effectively create a RIN shortage, as blending more ethanol than consumers are able/willing to consume will result in an unsellable product. According to this explanation, RIN prices began to increase when this knowledge became widespread as refiners with insufficient blending capacity scrambled to purchase sufficient RINs to demonstrate their compliance with the RFS2 for the year. The Times article suggests that big banks greatly compounded this problem by purchasing hundreds of millions of RINs (in the case of JPMorgan) and then stockpiling them while prices increased due to RIN demand outstripping supply.
A second explanation is that higher RIN prices increased when the industry realized that the blend wall was imminent because higher prices will be needed to incentivize the necessary increases to blending capacity and higher-ethanol blend infrastructure (e.g., flex-fuel vehicles, E85 pumps, etc.) by fuel blenders. Without these capacity increases and infrastructure modifications, the blend wall will remain in place and prevent the RFS2's volumetric mandate from being met. The fact that biofuel producers (as opposed to biofuel producers with blending capacity) haven't benefited from the large increase in RIN prices supports this explanation, although the fact that there has yet to be a significant increase in the consumption of E15 and E85 suggests that it is not conclusive.
If The Times is correct and speculators rather than a need to incentivize consumption of higher-blend fuels are driving high RIN prices, then blenders have only benefited minimally from them and the RFS2 won't be able to push ethanol past the blend wall as long as this remains the case. If we assume that big banks and other speculators have indeed stockpiled RINs in anticipation of higher prices, then they either purchased those RINs from blenders (either non-obligated blenders or obligated blenders with excess RINs) at low prices or acquired them via their own biofuel blending activities. In the case of the former the actual biofuel blenders would have not received the full RIN value and thus been unable to either increase their blending capacity or pass the RIN value through to consumers to incentivize increased consumption of higher-blend fuels. The same would be true in the case of the latter, given the article's implication that speculators have reaped large profits from their stockpiled RINs. In both cases, the refiners that ultimately purchased the RINs from the speculators for submission to the EPA would have found themselves in the position of subsidizing the trading profits of big banks rather than the consumption of higher-blend fuels. Either way, this particular reading of The Times article is that the RFS2 is broken since it was designed to subsidize biofuel production and consumption, not bank profits. On that note, it is unlikely to be a coincidence that D6 RIN prices have fallen by 16% in the two trading days since the article's publication.
The price of procrastination
The Times article portrayed the refining industry as victims of the RFS2's unintended consequences, leading with a picture of a smiling Thomas O'Malley, Chairman of refiner PBF Energy (NYSE:PBF). Mr. O'Malley is an outspoken critic of the RFS2, going so far as to sarcastically suggest in a recent earnings call that the program will cause people to "starve to death while we are driving" (as if Americans now eat field corn). Before we take too much pity on the independent refiners such as PBF Energy and Valero (NYSE:VLO), both of which have spent hundreds of millions of dollars on RINs to date this year, it is worth recalling that they are currently in that position because they have essentially ignored the RFS2 since its inception. D6 RIN prices didn't exceed $0.04 until 2013 and traded as low as $0.02 in 2011 and 2012. Given this extremely low price, some refiners opted to meet their annual blending requirements by purchasing RINs on the open market rather than generating them via their own biofuel blending activities. This was an inexpensive compliance method until the aforementioned 2,800% increase in D6 RIN prices, at which point those refiners with insufficient blending volumes saw their costs of compliance under the RFS2 increase by a similar amount. (It should be noted that not all refiners have found themselves in this position; while most of those refiners achieving RFS2 compliance via biofuel blending have been silent on the subject, BP (NYSE:BP) reported profiting from RIN sales in Q2 2013, suggesting that it actually blends a greater volume than required under the RFS2.) The refining industry helped design the RFS2 in 2007, so it is a bit disingenuous to portray those who refrained from blending sufficient biofuels to meet their annual RIN requirements as victims. However, the outperformance of JPMorgan and Morgan Stanley (not to mention many independent biofuel producers) and underperformance of PBF Energy and Valero relative to the S&P 500 index in 2013 (see figure) must add insult to injury.
PBF data by YCharts
The merits of speculation
There is growing evidence that this year's high D6 RIN prices are having one of their desired effects: the rate of U.S. biofuel blending is increasing. Those refiners such as PBF Energy that entered the year with insufficient blending capacity for the purposes of the RFS2 intend to increase sales of blended product in future quarters. While it is too early to say that E15 and E85 blends have increased, biomass-based diesel (which covers both biodiesel and renewable diesel) production is on pace to produce 300 million gallons more than required under the RFS2 for 2013, making it likely that the excess biodiesel will be used instead to generate 450 million in D6 RINs (each gallon of biodiesel equals 1.5 gallons of ethanol for RIN generation purposes) in furtherance of the corn ethanol mandate. (The nested nature of the RFS2 allows for biomass-based diesel, or D4 category fuels, to also qualify for D6 RINs.)
Why would blending capacity be increasing if big banks are driving RIN prices up? A possible answer is that speculative trading can prevent actual shortages (and more extreme volatility) by causing price increases to front-run actual shortages. Price spikes resulting from speculative trading cause production of the expensive commodity to increase in response, thus ensuring that a shortage doesn't actually occur. In the event that RIN stockpiling by the financial sector caused the surge in RIN prices, then it also prompted the installation of additional blending capacity and, as a consequence, increased the overall supply of RINs. As The Times shows in this figure, Morgan Stanley effectively called the top in RIN prices from a contrarian perspective when it released a research report that, among other things, indicated D6 RIN prices could move as high as $5. D6 RIN prices have fallen by 53% since the report was released. One logical interpretation is that RIN prices have fallen since then due to an increase in biofuel blending and RIN separation, which has itself occurred in expectation of high RIN prices. The Times article even includes a quote from a bank analyst stating that big banks have begun blending their own fuels in an effort to generate RINs (probably because non-obligated blenders eventually realized that they could get better prices for their RINs on the open market):
"Edward Westlake, an analyst at Credit Suisse, said many big financial firms have gone beyond RINs trading and pushed into blending fuel to create them as well. 'Building a tank and blending doesn't cost a lot of money,' Mr. Westlake said, 'and there are folks on Wall Street who own tanks who are benefiting from the RINs.'"
Of course, nothing will prevent these banks-turned-blenders from stockpiling the RINs they generate via blending activities, although the sharp fall in RIN prices across the board since mid-July suggests that such stockpiling isn't occurring at present.
The most obvious beneficiaries of the biofuel blending expansion described by The Times are refiners. D6 RIN prices have fallen to a 5-month low and are currently trading 57% below their mid-July high. The cost of compliance under the RFS2 for refiners with insufficient blending volumes have fallen by a similar amount. Furthermore, this summer's high RIN prices have pushed many of these blenders to begin doing their own blending as a means of generating separated RINs, thus enabling them to avoid the RIN markets entirely. Valero and PBF Energy, both of which reported high RIN costs in H1 2013, should see a notable reduction in RIN costs in Q3 and especially Q4 2013 due to their increased blending volumes.
Producers of biodiesel and renewable diesel also benefit. Biodiesel does not face many of the infrastructure limitations that confront ethanol, which makes it easier to blend and distribute for retail. Furthermore, the current U.S. biodiesel consumption volume is only half of that permitted by the "weak" 5 vol% biodiesel blend wall, and in reality most diesel engine warranties now permit blends of up to 20 vol%. While lower D4 RIN prices resulting from an increase in blending volumes do negatively affect producers with significant blending capacity such as Renewable Energy Group (NASDAQ:REGI), this will be offset by increased biodiesel demand (and REG has also been increasing its production capacity in 2013). Biodiesel producer FutureFuels (NYSE:FF) does not have immediate production capacity expansion plans and will not be able to take advantage of increased biodiesel demand, but it will be assured of a market for its current production for the time being. Similarly, renewable diesel producers Diamond Green Diesel - a joint venture between Valero and Darling International (NYSE:DAR) - and Dynamic Fuels - a joint venture between Syntroleum (NASDAQ:SYNM) and Tyson Foods (NYSE:TSN) - will also be assured of strong demand for their biofuels.
The implications for independent ethanol producers such as Green Plains Renewable Energy (NASDAQ:GPRE), Pacific Ethanol (NASDAQ:PEIX), and REX American Resources (NYSE:REX) are less certain due to the ethanol blend wall. Unlike biodiesel, ethanol faces hurdles related to both its technical shortcomings and a lack of consumer acceptance that must be overcome if widespread consumption of blends in excess of 10 vol% is to occur. It is difficult to say what D6 RIN price will be required to incentivize both the necessary infrastructure upgrades and increased consumer acceptance of ethanol, but lower D6 RIN prices will make both of these events less likely to occur by reducing the value of the incentive. This is not to say that current D6 RIN prices are insufficient to overcome these hurdles, but at present the data is not showing a trend in that direction. The corn ethanol crush spread has returned to its pre-drought level (see figure) so lower RIN prices won't necessarily result in lower product margins, but continued industry earnings growth remains unlikely.
CORN data by YCharts
The recent article in The Times identifying big banks and other financial firms as the parties responsible for this summer's "RINsanity" failed to introduce any solid evidence, instead relying on rumors and anonymous statements that most industry players and observers are already aware of. It did contain additional information on how several different industries, including banking, are responding to high RIN prices by increasing their biofuel blending volumes. This increase should keep the price of D6 RINs below its July highs while increasing demand for biofuels such as biodiesel and renewable diesel, thereby benefiting both refiners (via lower RFS2 compliance costs) and biobased diesel producers (via increased demand). Even if big banks have been the cause of "RINsanity," rather than break the RFS2 they may have instead pushed it into action.
Disclosure: I am long REGI. 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.