Seeking Alpha
Research analyst, alternative energy, long/short equity, commodities
Profile| Send Message| ()  

The U.S. biofuels industry was badly shaken last week by the leaked news that the EPA is unexpectedly proposing to reduce the revised Renewable Fuel Standard's [RFS2] volumetric mandates for total renewable fuel and advanced biofuel in 2014. D6 (corn ethanol) Renewable Identification Number [RIN] prices, which peaked at $1.45 back in July, quickly fell by 25% to $0.32. Refiner share prices jumped on the news, as many refining companies have incurred large RFS2 compliance costs this year due to the steep increase in D6 RIN prices that occurred between January and July. Reuters described the proposal as an "historic retreat" by the EPA and a "victory for refiners."

As a reminder, the RFS2 was created in 2007 to replace a growing fraction of U.S. petroleum-based transportation fuel consumption with biofuels. Four different biofuel categories were created by the RFS2, each defined by its feedstock and greenhouse gas [GHG] emissions relative to petroleum. The RFS2 requires "obligated blenders" (i.e., refiners) to blend set volumes of biofuels belonging to each category into the transportation fuel stream (see figure) according to their respective share of the U.S. fuel market. RINs, the prices of which operate as a function of biofuel production costs and market values, were created under the RFS2 to incentivize sufficient biofuel production to meet the blending mandate by biofuel producers. A RIN is "created" when a gallon of qualifying biofuel is produced and "detached" when that biofuel is blended (or sold) for retail. Obligated blenders are required to submit sufficient RINs to the EPA at the end of each year to demonstrate their compliance with the annual mandate.

(click to enlarge)

RFS2 mandate by biofuel category. Source: Schnepf (2012)

Corn ethanol RINs were almost worthless from 2010 to the end of 2012 and many refiners refrained from performing their own blending as a result, finding it easier to just purchase sufficient RINs from non-obligated blenders each year to demonstrate their compliance with the mandate. This strategy backfired in early 2013 when it became apparent that the RFS2 was mandating more ethanol consumption than the U.S. ethanol blend wall permits. (Ethanol is an imperfect fuel substitute for gasoline and is practically limited to a 10 vol% blend as a result. The ethanol blend wall is therefore reached when U.S. ethanol consumption equals or exceeds 10% of U.S. gasoline consumption by volume.) Corn ethanol RIN prices soared and those refiners who failed to do their own blending found their compliance costs soaring as well; Valero (VLO), for example, reported at the end of Q2 that it would need to spend $800 million on RINs for the full year, far more than it had spent on them in past years. The main lobbying group for the refining industry launched a full court press against the RFS2 in Washington DC over the summer in response, a move that appears to have borne fruit based on the EPA's recently-leaked proposed rule.

Enshrining the blend wall in law

The EPA's proposed rule, which has yet to be approved by the White House, would reduce the total renewable fuel mandate for 2014 by nearly 3 billion gallons, from the 18.15 billion required by the RFS2 to a revised 15.21 billion. The corn ethanol mandate would account for roughly half of this reduction, falling from the original 14.4 billion gallons to 13 billion gallons (for comparison, the 2013 mandate requires 13.8 billion gallons of corn ethanol, although the industry is currently on track to produce roughly 13 billion gallons). The share of the advanced biofuels mandate attributable to sugarcane ethanol would be reduced from 1 billion gallons to at most 170 million gallons, while that attributable to biomass-based diesel would remain at 1.28 billion gallons (with each gallon of biodiesel yielding 1.5 RINs due to its higher energy content relative to gasoline). The proposed rule appears to be guided by the EPA's previous announcement that it would account for the ethanol blend wall when determining the 2014 volumetric mandates. The Energy Information Administration [EIA] forecasts U.S. gasoline consumption in 2014 to fall to 131.9 billion gallons, so the proposed rule's combined volume of corn and cane ethanol (13.17 billion gallons) would be very close to the volume of consumption permitted by a strict 10 vol% blend wall (13.19 billion gallons).

It's difficult to view the EPA's proposed rule as anything but a complete capitulation to the ethanol blend wall. Gasoline consumption has fallen in recent years and is expected to continue to do so due to changing driving habits and higher CAFE standards. The volume of ethanol consumption permitted by the ethanol blend wall in the form of E10 fuel must fall in future years as well, with the gap between mandated consumption and the volume permitted by the blend wall reaching 6.5 billion gallons by 2022 (see figure). The proposal would thus enshrine the blend wall firmly in law, making it a firm cap on U.S. ethanol consumption by removing any incentive for ethanol producers to overcome it. While the prospect of the blend wall's arrival was largely ignored in past years due to the conventional wisdom on ethanol consumer acceptance and flex-fuel vehicle [FFV] adoption rates, this proposal would transform it into a fait accompli virtually overnight.

(click to enlarge)

Ethanol mandates and the E10 blend wall. Note that the advanced biofuel volumes exclude the biomass-based diesel volumes. Sources: Schnepf (2012), EIA (2013)

Good politics, bad policy

It's easy to understand why the EPA would fold to the refining industry so quickly (although that doesn't make the move any less surprising). The RFS2 has been the subject of annual lawsuits filed against the EPA by the refining lobby due to the complete failure of the cellulosic biofuel mandate to date. The EPA is also dealing with multiple lawsuits related to its proposals to regulate greenhouse gas [GHG] emissions from both new and existing power plants. Finally, the American public's faith in the federal government seems to reach a new low each month (especially following the recent government shutdown and debt ceiling brinkmanship). New Administrator Gina McCarthy may have decided that enforcing a difficult mandate on the powerful refining industry was simply a bridge too far, and that it is better to live to fight another day.

Political savvy does not necessarily make for good energy policy, however. In fact, from a policy perspective, the EPA's proposed rule could not have come at a worse time for the biofuel industry (which is likely why it was leaked rather than intentionally released). While the refining industry attributed the surge in RIN prices earlier this year to "RINsanity" and pointed to it as evidence that the RFS2 is broken, high RIN prices have finally provided the industry with an incentive to overcome the E10 blend wall. While many refining executives sharply criticized the ethanol mandate in their Q2 conference calls, they also reported making large investments in blending capacity as a means of generating their own RINs (and thus avoiding the need to purchase them on the market). In other words, high RIN prices were driving refiners to increase the volume of biofuel that they blended into the U.S. transportation fuel supply, which is the stated goal of the RFS2. Furthermore, as several agricultural economists have recently pointed out, high RIN prices have also provided refiners with a strong financial incentive to increase the installation of E85 infrastructure at retail stations (the value of the annual RIN purchases exceeding that of the one-time capital expenditures).

Most importantly, there is early evidence that high RIN prices are finally serving to incentivize biofuel consumption rather than just production. Specifically, it appears that blenders are using RINs to reduce the market price of E85 relative to gasoline, thereby making it more attractive to consumers. Data released earlier this month from Minnesota, which is the country's primary user of FFVs and E85 blends, shows that the state's E85 consumption in August reached an all-time high for the month (E85 consumption in Minnesota is seasonal and historically peaks in June or July before falling sharply in August) and is near its all-time historical high for any month. According to the USDA, the increase in E85 consumption in 2013 has been negatively correlated with E85 pump prices, which finally fell below energy equivalence in August. Increased E85 consumption is widely seen as one of the simplest routes to overcoming the E10 blend wall, so the fact that the data is finally moving in the direction indicating such an increase is notable. A few more months of data are necessary to determine whether the August data is part of a new trend or just a statistical outlier, of course, but that in no way mitigates its importance. It is hard to believe that the EPA could give up on the RFS2's ability to overcome the E10 blend wall even as the first signs of it doing just that are appearing, but that's what the proposed rule would do.

The most surprising part of the EPA's proposed rule is that it would keep the biomass-based diesel mandate steady at 1.28 billion gallons. Biofuels qualifying for the mandate under that category must reduce GHG emissions relative to petroleum by at least 50%, making them very attractive from an environmental perspective. Furthermore, the rise of biomass-based diesel production in recent years has created a new industry as companies such as Darling International (DAR) and Tyson Foods (TSN) have collected waste cooking oil and animal processing residue for use as biofuel feedstock, literally turning yesterday's trash into today's commodity. Unlike ethanol, biodiesel is still far from the "soft" biodiesel blend wall of 5 vol% imposed by some automaker warranties (current consumption equals 2.5 vol% of diesel consumption), with blends of 20 vol% now permitted by the majority of automakers. Current biodiesel production also utilizes only half of its existing U.S. capacity, meaning that additional production can be brought online quickly and inexpensively. Offsetting a reduction in the 2014 ethanol mandates by increasing the biomass-based diesel mandate thus offers the EPA a means of avoiding the ethanol blend wall while further decreasing the country's GHG emissions (corn ethanol's carbon footprint from newer facilities is only 20% smaller than that of gasoline, and that from the older facilities grandfathered into the RFS2 can actually be larger than that of gasoline). By keeping the category's 2014 mandate at 1.28 billion gallons and reducing the total advanced biofuel's mandate to 1.45 billion gallons of biodiesel-equivalent, the EPA's proposed rule actually calls for less production next year (current biomass-based diesel production is on pace to reach 1.61 billion gallons in 2013). While the reduction in the ethanol mandate can be explained by the arrival of the E10 blend wall, biomass-based diesel does not suffer from that problem. As far as GHG emissions go, the EPA's bizarre proposal to reduce the advanced biofuel mandate in 2014 (which the biomass-based diesel category is nested within) leaves quite a bit of low-hanging fruit unpicked.

Proposed rules are not final

As disheartening as the EPA's proposed rule is for biofuel investors, it should be noted that proposed rules are not final. They must first be approved by the White House and then submitted for a period of public comment. This latter step is not window-dressing, as those who covered the industry in 2009 know all too well. In that year the EPA released a proposed rule for determining which biofuel pathways would qualify for which biofuel category under the RFS2. Due to the way in which the proposed methodology would have calculated indirect land-use change [ILUC] emissions, it quickly became apparent that new corn ethanol facilities would not have met the 20% GHG emission reduction threshold (existing facilities would be grandfathered in). In 2010, following a lengthy public comment period, the EPA released a final version of the rule in which new corn ethanol facilities were calculated to (barely) achieve the necessary reduction threshold. While proponents of the original ILUC methodology attributed this to corn ethanol industry pressure, the collapse in Brazilian deforestation rates that has occurred since 2004 even as annual U.S. corn ethanol production has quadrupled provides strong evidence that the EPA had actually corrected a deeply flawed methodology.

Similarly, the EPA's leaked proposed rule must undergo a period of public comment should it be approved by the White House. I have no doubt that the biofuel industry will respond by providing numerous examples of how the proposed rule will hurt the long-term feasibility of the RFS2 as well as the EPA's stated goal of reducing U.S. GHG emissions. That said, the EPA has just over five weeks to receive White House approval, accept public comments, and produce a final rule on the 2014 mandates if it is to meet its original November 30 deadline (which was set prior to the recent government shutdown). It's no coincidence that the refining industry recently threatened a lawsuit if that deadline isn't met; it rather likes the proposed rule and no doubt prefers that the public comment period remain as short as possible. Given how quickly the EPA bowed to refining industry pressure regarding the E10 blend wall over the summer, it is possible that it will rush the process and thereby prevent further study into the questions detailed above.

Investment implications

It comes as no surprise that independent refiners have handily outperformed the S&P 500 since the EPA's proposed rule was leaked, with the degree of outperformance strongly linked to the strength of each refiner's criticism of the RFS2 over the summer (see figure). The share prices of Valero and PBF Energy (PBF) have increased by 14.3% and 17.7% in the last two weeks, respectively. Western Refining (WNR) and Phillips 66 (PSX) have both seen their share prices increase by more than 10%. While the narrowing spread between WTI and Brent crude prices over the last few months remains a primary driver of refiner earnings, a final rule from the EPA that closely resembles the proposed rule would provide them with substantial support by driving D6 RIN prices back down to their pre-2013 level.

VLO Chart

VLO data by YCharts

Corn ethanol producers have held up well since the leak (see figure), likely because they have been passing most of the RIN value to consumers in the form of discounted ethanol. Shares in Green Plains Renewable Energy (GPRE), REX American Resources (REX), and The Andersons (ANDE) have all increased in price since the leak, although only REX has outperformed the S&P 500. While the enshrinement of the E10 blend wall in law would greatly limit the future growth prospects of corn ethanol producers and cause the weakest to go out of business due to a steadily shrinking market size, its immediate impact would be less significant. The exception to this, however, would be the return of drought conditions to the U.S. Midwest and/or a sustained fall in petroleum prices, as the shrinking ethanol mandate would prevent RINs from supporting their margins in response to a falling corn crush spread.

GPRE Chart

GPRE data by YCharts

Finally, the performance of biomass-based diesel fuel and feedstock producers has been mixed over the last two weeks (see figure). Biodiesel producer FutureFuel (FF) and feedstock provider DAR have outperformed the S&P 500, the latter on news of continued capacity growth. Share prices of biodiesel producer Renewable Energy Group (REGI) and renewable diesel producer Syntroleum (SYNM) have both declined, which in the case of the former is especially reasonable given its ability to generate biomass-based diesel [D4] RINs for later sale. The future earnings of REGI in particular are sensitive to the content of the EPA's final rule, as it has been steadily expanding its production capacity over the last year in anticipation of increased biodiesel demand. While the EPA's proposed rule wouldn't reduce the size of the biodiesel market, it would increase the exposure of producers to the highly volatile agriculture and energy markets (which the RFS2 was designed in part to minimize). Furthermore, by limiting the supply of RINs made available to producers, the EPA's proposed rule would limit opportunities for future earnings growth.

REGI Chart

REGI data by YCharts

Conclusion

As currently drafted, the EPA's leaked proposed rule on the RFS2's 2014 volumetric mandates would abandon the program's original goal of providing sufficient incentive to the biofuel and refining industries to overcome biofuels' financial and technical hurdles. The proposed rule would enshrine the E10 blend wall in law and, in the process, replace a growing annual corn ethanol mandate with a shrinking one. Furthermore, the proposed rule would take the unwarranted step of also reducing the advanced biofuel, and thus biomass-based diesel, volumetric mandates. The latter fuel category greatly reduces GHG emissions relative to petroleum, uses a growing amount of non-food biomass as feedstock, and is nowhere near its own blend wall, making the proposal particularly unexpected. Investors in refiners, corn ethanol producers, and biomass-based diesel producers should pay close attention to the EPA as the November 30 deadline for its final rule approaches, as all will be impacted to varying degrees by its contents.

Source: Did The EPA Wave The White Flag On The Biofuels Mandate?