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It would appear that I misjudged the Environmental Protection Agency [EPA] under new administrator Gina McCarthy. Back in August, when the EPA announced that it would consider the U.S. ethanol blend wall (as the point at which ethanol consumption equals 10 vol% of gasoline consumption is known) when determining the volumetric blending mandates for 2014 under the revised Renewable Fuel Standard [RFS2], I wrote on SA that:

While it is possible that the volumetric mandate will be rolled back in 2014 ... I consider this to be unlikely in light of the Obama Administration's 5-year record on the subject of GHG emissions. As this article demonstrates, the EPA has a number of options available to it [for accounting for the blend wall in the volumetric mandate], only one of which includes a volume rollback. The EPA has said nothing to suggest that such a rollback is inevitable and any fall in D6 RINs to their 2012 prices will be premature as a result.

Specifically, I believed that the EPA would consider offsetting any reduction to the ethanol mandate with an increase to the advanced biofuel and/or biomass-based diesel mandates. In addition to achieving greenhouse gas [GHG] emission reductions of at least 50% relative to petroleum as compared to corn ethanol's 20% reduction, biomass-based diesel is not faced with a looming blend wall. (Most auto warranties permit biodiesel blends of up to 20 vol%, while renewable diesel can be used at even higher blend rates.) Such an offset would allow the EPA to maximize reductions to the transportation sector's GHG emissions while still accounting for the ethanol blend wall. While the agency was (and still is) under very strong pressure from the refining lobby (especially the American Petroleum Institute, or API) to reduce the volumetric mandate and therefore minimize refiners' costs of compliance with the RFS2, it hasn't had a record under the Obama administration of caving to fossil fuel companies, leading to my position.

This scenario admittedly began to look less likely two months later when a document stating that the EPA was considering a full rollback (i.e., a complete reduction of the corn ethanol mandate below the blend limit volume without any offsetting increases to the other mandate volumes) was leaked to the press. Given that the leak occurred several weeks before the EPA's official release of its proposed rule for the 2014 volumetric mandates, I still believed there to be a decent likelihood that the EPA's volumes would surprise to the upside. It is now clear that I was wrong, however, following the official release of the EPA's proposed rule on Friday. While I consider myself to be a rather jaded political observer, I'm still surprised by the completeness of the EPA's capitulation to the refining lobby. Practically, the EPA couldn't have reduced the proposed volumes by much more than it did, as a complete waiver of the mandate was never an option since its prerequisite conditions are not present.

The new numbers

As a reminder, the RFS2 was created in 2007 to replace a growing fraction of U.S. petroleum-based transportation fuel consumption with biofuel consumption. Four different nested biofuel categories were created by the program, each defined by its feedstock and greenhouse gas [GHG] emissions relative to petroleum. The largest by mandated blending volume is the total renewable fuel category (see figure). As the only one of the four that corn ethanol can qualify for, this category is commonly known as the "corn ethanol" category, although fuels qualifying for the other categories can also qualify for it. The second is the "advanced biofuel" category, which cane ethanol qualifies for. The advanced biofuel category also covers the "biomass-based diesel" and "cellulosic biofuel" categories, so fuels in the latter two can also qualify for the former (the advanced biofuel category volume being greater than the sum of the biomass-based diesel and cellulosic biofuel category volumes). As originally established, the mandated blending volumes for all four categories increase on an annual basis (although the corn ethanol category was capped at 15 billion gallons in 2015 and thereafter to limit the use of corn starch as a biofuel feedstock).


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

The EPA's proposed rule will, if finalized, greatly reduce the required volumes for 2014 and beyond (see table). While the reduction of the 2014 cellulosic biofuel category was inevitable due to a lack of commercialization, in the past these reductions were offset by an effective increase to the advanced biofuel category volume, which was left unchanged despite the reduction to one of its constituent parts. The EPA is proposing to no longer do so in 2014; the 1.73 billion gallon decrease to the cellulosic biofuel volume is almost matched by a 1.55 billion gallon decrease to the total advanced biofuel volume. Furthermore, the share of the total renewable fuel category that can be met by corn ethanol is reduced from 14.4 billion gallons to 13.01 billion gallons. The combined effect of these reductions is to reduce the full total renewable fuel volume from 18.15 billion gallons to 15.21 billion gallons. The biomass-based diesel volume nominally remains unchanged, although the reduction to the "other" advanced biofuel category, which its fuels also qualify for, results in an effective reduction to it as well. Finally, the EPA has also proposed volumetric ranges of plus or minus roughly 250 million gallons around the total renewable fuel and advanced biofuel categories and requested public comment on the most appropriate volume within those ranges.

Category Original 2014 volumes (billion gallons) Revised 2014 volumes (billion gallons)
Tot. ren. fuel 18.15 15.21
Corn ethanol 14.40 13.01
Tot. advanced biofuel 3.75 2.20
Biomass-based diesel 1.28 1.28
Cellulosic biofuel 1.75 0.02
"Other" advanced 0.72 0.26

All categories are listed in terms of ethanol-equivalent except for the biomass-based diesel category, which is listed in terms of biodiesel-equivalent. Sources: Schnepf (2012) and EPA (2013)

While the ethanol blend wall is the purported reason for the reductions, the revised volumes are even lower than the blend wall. The EPA is proposing to reduce total biofuel blending as a percentage of gasoline consumption to roughly 9.2% (see table), or less than the ethanol blend wall limit. Furthermore, this percentage doesn't account for the consumption of higher-ethanol blends such as E85 (i.e., up to 85 vol%) by owners of flex-fuel vehicles [FFVs]. While such consumption has been low, it is not negligible. In 2011 U.S. E85 consumption reached 0.09 billion gallons, while Minnesota drivers alone are on pace to consume 0.02 billion gallons in 2013. Accounting for this consumption suggests that U.S. consumers can use an overall ethanol blend slightly above 10 vol% before hitting the blend wall.

Category 2014 percentage standards
Cellulosic biofuel 0.01%
Biomass-based diesel 1.16%
"Other" advanced biofuel 0.17%
Total renewable fuel 9.20%

Source: EPA (2013)

The most puzzling aspect of the EPA's proposed rule remains the unchanged biomass-based diesel volume, however. In 2012 and early 2013 it appeared that the advanced biofuel mandate would not be met due to low cane ethanol production in Brazil. Producers of biomass-based diesel stepped into the gap, however, yielding 1.2 billion gallons in 2012 (out of 1 billion mandated) and an estimated 1.8 billion gallons in 2013 (out of 1.28 billion mandated). The biomass-based diesel volumes that were produced in excess of their mandated volumes contributed to the "other" advanced biofuel and corn ethanol categories instead due to the RFS2's nested nature. Further growth is possible as existing biodiesel capacity of at least 2 billion gallons is available in the U.S. alone and new biodiesel and renewable diesel capacity is coming online each year.

The EPA portrayed [pdf] its decision to keep the biomass-based diesel category flat in 2014 and 2015 as an effort to provide blenders with flexibility by giving them the option to fulfill their "other" advanced biofuel requirement with either cane ethanol or biomass-based diesel while simultaneously eliminating the need for new capacity construction. Given its large reduction to the total advanced biofuel volume in 2014, however, the EPA is actually setting the two fuel categories to compete over smaller-than-expected market share, as any biomass-based diesel production beyond 1.28 billion gallons under the mandate must now come at the expense of either cane or corn ethanol. While such a zero-sum game between corn and cane ethanol was inevitable due to the ethanol blend wall volume being lower than the combined ethanol volumetric mandates, it is very surprising to see biomass-based diesel forced into the fight as well. After all, these are fuels that achieve at least a 50% reduction in GHG emissions relative to diesel fuel, face no short-term blend wall, and are frequently sourced from inedible waste feedstocks. In other words, they face none of the disadvantages of corn ethanol and yet the EPA is proposing to treat both categories in a similar manner.

Implications for consumption growth

The precedent set by the EPA's proposed rule will, if finalized, effectively doom the long-term goals of the RFS2 to failure by removing the existing incentives for capacity growth. As an example, take the dilemma that has faced cellulosic biofuel producers as they have attempted to reach commercial scale in recent years. While the RFS2 mandates 16 billion gallons of annual cellulosic biofuel blending by 2022 and therefore requires blenders to purchase the fuel, it incentivizes the actual production via Renewable Identification Numbers [RIN]. RIN prices function as the difference between a biofuel's production cost and its market value, ensuring that producers at least break even. 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, so those obligated blenders that fail to blend enough biofuel to generate sufficient RINs must instead purchase them from a blender holding excess RINs. Given this mechanism, biofuel producers have an increased financial incentivize to produce more biofuel for blending when production is falling short of the mandated volume.

The problem with cellulosic biofuel RINs is that they only have a market price so long as production is occurring. However, the capacity investments that make such production possible only occur when investors know that the RIN price is high enough to prevent production from incurring financial losses. This dilemma has kept would-be cellulosic biofuel producers in a state of limbo and prevented investment in capacity, which is why the EPA on Friday proposed to revise the cellulosic biofuel volumetric mandate for 2014 down by 99%. Even in 2013, a year in which KiOR (KIOR) has produced reportable volumes of cellulosic biofuel, there is still no cellulosic biofuel RIN market price, their value instead being calculated by the producer as the sum of advanced biofuel RIN prices and the value of cellulosic biofuel waiver credits (the latter being determined by legislative formula).

By reducing the total renewable fuel, corn ethanol, and advanced biofuel volumetric mandates for 2014 below their 2013 volumes (see table), the EPA has substantially reduced demand for RINs, ensuring that their prices will remain low in the future. There is a growing body of evidence suggesting that this year's high RIN prices, including for the corn ethanol category, were being passed onto consumers in the form of discounted ethanol prices so as to incentivize the consumption of E85. Furthermore, data out of Minnesota, which is the country's FFV capital, indicated that this was resulting in increased E85 consumption. In other words, ethanol producers were using high RIN prices to incentivize the type of consumption necessary for their product to overcome the ethanol blend wall, as increased E85 consumption would result in increased ethanol-compatible infrastructure, in turn resulting in greater demand for etc., and so on. As one recent policy brief put it, such pricing would enable ethanol to "break the blend wall."

Category 2013 volumetric mandate (million gallons) Revised 2014 volumetric mandate (million gallons)
Tot. ren. fuel 16.55 15.21
Corn ethanol 13.80 13.01
"Other" advanced biofuel 0.83 0.26

Low RIN prices resulting from the EPA's proposed rule will eliminate this incentive; indeed, data from Minnesota suggests that E85 consumption in that state peaked in August while RIN prices peaked in late July (see figure). By reducing the combined ethanol volumetric ethanol below the blend wall, then, the EPA is ensuring that ethanol consumption will be unable to overcome the blend wall in the future. This is particularly bad news for ethanol producers, as gasoline consumption is projected by the Energy Information Administration [EIA] to steadily decline over the next 20 years due to improved automobile fuel efficiency and growing utilization of battery-electric vehicles. An ethanol market that is limited to the blend wall is therefore a shrinking market over the timeline of most investors. Worse still, corn ethanol, cane ethanol, and cellulosic ethanol producers will all be fighting each year for a share of a continuously smaller pie; without exports, any increase in the production of one under the mandate must be offset by a matching decrease in the production of the others if the blend wall is not to be encountered.


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Source: EcoEngineers (2013)

Barring an unprecedented and miraculous moonshot in cellulosic biofuel investment and production, then, the EPA's proposed rule ensures that the RFS2's volumetric mandates will not be met in the coming years. Indeed, the overall volume is now more likely to decline due to shrinking gasoline consumption, making the Congressional goal of 36 billion gallons of biofuel blending in 2022 unachievable. While it could certainly be argued that the latter has been inevitable for at least a few years now due to the failure of the cellulosic biofuels mandate to date, the EPA's proposed rule ensures that cellulosic ethanol will be a minimal contributor even if cellulosic biofuel production surges.

Investment implications

Companies can be broadly divided into three categories according to the type and degree of the impact that the EPA's proposed rule will have on them if it is finalized. Corn ethanol producers will be the most negatively affected. In addition to now being participants in a shrinking market, their use of corn starch to produce ethanol places them at the bottom of the RFS2's "food chain", if you will. Independent producers such as Green Plains Renewable Energy (GPRE), Pacific Ethanol (PEIX), and REX American Resources (REX) are particularly vulnerable; diversified producers such as The Andersons (ANDE) and ADM (ADM) less so due to their ownership of other operating groups in addition to corn ethanol. While corn ethanol exports could provide all of these producers with a release valve of sorts in the future, it is not an ideal one; as an agricultural product, corn ethanol faces a number of trading restrictions that are acceptable under international free trade agreements.

Corn and soybean prices will also be pushed down as demand for the former eases, pushing its price down and causing farmers who switched to a corn-corn crop rotation to take advantage of its high price return to a corn-soybean rotation, increasing soybean supply. While this is not expected to have a net benefit on corn ethanol producers since ethanol prices are also falling in response to decreased anticipated demand, investors can gain exposure to both commodities via Teucrium's corn (CORN) and soybean (SOYB) ETFs. It should be noted, however, that the prices of both have fallen in recent months due to reduced demand expectations.

Companies with no exposure to corn ethanol production might also be impacted: in September the New York Times reported that banks such as JPMorgan Chase & Co. (JPM) and Morgan Stanley (MS) had both profited from high RIN prices thanks to their RIN trading and biofuel blending operations. Similarly, BP (BP) reported profiting from high RIN prices earlier in 2013. While low RIN prices will eliminate a source of income for these three companies, their large scales and diversified operations will prevent this impact from being significant.

Biomass-based diesel producers such as FutureFuel (FF), Renewable Energy Group (REGI), and renewable diesel joint venture partners Darling International (DAR), Syntroleum (SYNM), and Tyson Foods (TSN) will fare better than corn ethanol producers under the proposed rule due to the lack of change in the biomass-based diesel volumetric mandate, although the sharp reduction to the advanced biofuel mandate could depress their share prices in the short-term (see, for example, REG's wild share price action on Friday). Furthermore, the biomass-based diesel volumes contained in the EPA's final rule still have the potential to surprise to the upside, as the agency specifically requested public comments on higher future volumes for the category. Amyris (AMRS) and Solazyme (SZYM) are unlikely to be affected; while both produce biomass-based diesel, they also are unique in that their diversified product portfolios are heavily focused on non-fuel products.

Independent refiners will be the primary beneficiaries of the proposed rule, as many of them failed to implement their own blending practices after the RFS2 was passed and were therefore required to spend large sums on RINs after prices surged in the first three quarters of 2013. At one point Valero (VLO) estimated that it would need to spend up to $800 million on RINs in 2013, although the benefit from low future RIN prices will be partially offset by the company's large corn ethanol capacity. Similarly, PBF Energy (PBF) and Alon USA Energy (ALJ) both reported earlier this year that they expected to spend tens of millions of dollars on RINs in 2013 to meet their respective obligations. Low RIN prices will therefore remove a significant cost from their income statements in 2014. The share prices of the three refiners largely shrugged in response to Friday's announcement, however, having already jumped in response to the October 10 leak (see figure).

PBF Chart
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PBF data by YCharts

The impact on cellulosic biofuel producers is more difficult to quantify. Cellulosic ethanol producers such as Abengoa (OTCPK:ABGOY) and DuPont (DD) will be forced to battle for market share as mentioned above, although both companies have diversified operations. KiOR does not enjoy such diversity but, as a producer of cellulosic hydrocarbons, is not beholden to the ethanol blend wall. That said, the collapse in advanced biofuel RIN prices since late July will have a negative impact on cellulosic biofuel producer incomes so long as cellulosic biofuel RINs operate as a function of them, as is currently the case.

Conclusion

The EPA formally proposed on Friday to reduce the RFS2 volumetric mandates for 2014 below both the original volumes for that year as well as the 2013 volumes. If finalized, the proposed volumes will make it very unlikely that the original RFS2 volumes will be achieved between now and 2022. Furthermore, by incorporating the ethanol blend wall into the RFS2, the proposed rule will ensure that the combined ethanol volumetric mandate will decline on an annual basis due to an anticipated fall in gasoline consumption, forcing corn, cane, and cellulosic ethanol producers to fight for share of a shrinking market. Finally, the proposed reductions will keep RIN prices low, eliminating the incentives for increased ethanol blending and the consumption of higher ethanol blends. Even producers of cellulosic hydrocarbons could be negatively impacted by the low RIN prices, as cellulosic biofuel RIN values currently operate as a function of advanced biofuel RIN prices. Refiners, however, are major beneficiaries under the proposal. The proposed rule will now undergo a 60-day public comment period, although the EPA's narrow volumetric ranges suggest that the final rule will largely resemble the proposed rule, with the possible exception of the proposed biomass-based diesel mandate.

Source: There Goes The Biofuels Mandate