Seeking Alpha
Research analyst, oil & gas, tech, mid-cap
Profile| Send Message|
( followers)  

Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Biodiesel: The Future of the Renewable Fuel Industry

Biodiesel, an engine fuel produced from vegetable oils and animal fats, can reduce the consumption of fossil fuels such as diesel, which is a nonrenewable resource, and toxic in terms of pollution emissions during combustion. Biodiesel is non-toxic and renewable, and can be used in diesel engines with little or no modification. Biodiesel can be used in pure form (denoted by B100), but it is usually blended with standard diesel fuel, as 100% biodiesel fuel is more expensive than simple diesel fuel. Hence, a blended version is preferred over a pure form.

Biodiesel blending depends on each country's minimum requirement for blending of ethanol and biodiesel. The biofuel blending mandate is an important growth driver for biofuel producers. The U.S. is among the biggest markets for biodiesel due to the Environmental Protection Agency, or EPA, blending requirement under the Renewable Fuel Standard, or RFS. Additionally, government support for biodiesel producers and blenders through tax incentives and Renewable Identification Number, or RIN, credits makes the U.S. market lucrative for these producers.

Renewable Energy Group (REGI) is the biggest producer and marketer of domestic biodiesel in the U.S. with 257 million gallons of owned/operated annual production capacity at eight active biodiesel plants. Another major biodiesel producer is FutureFuel (FF), which has a production capacity of 59 million gallons of biodiesel per year. Biodiesel products are the biggest revenue-generating segment for each company, and therefore any statutory changes in the biodiesel blending requirement can affect the top line.

Other than these domestic producers, some biodiesel producers in Canada have also benefited from the RFS mandate. Below, is the list of major biodiesel producers with manufacturing base in Canada that export biodiesel.

Canadian biodiesel producers

Capacity

Great Lakes Biodiesel

44.9 mgy

BIOX Corp.

17.7 mgy

Methes Energies (MEIL)

14.3 mgy

All three companies have registered their respective biodiesel products with EPA for importing in the U.S. Unlike the other two Canadian producers, Methes Energies also provides biodiesel technology to its clients. The company is doubling its capacity and should surpass BIOX's installed capacity next year.

RFS mandate: An important growth driver

To increase the amount of biodiesel, the government enacted the Energy Policy Act of 2005, and revised it in 2007. Every year, EPA issues the RFS mandate, which requires the blending of biofuels such as ethanol and biodiesel in gasoline and petroleum. RFS is the minimum amount of biofuel to be produced for blending with the conventional nonrenewable fuel. For 2013, EPA has set a RFS mandate for biodiesel at 1.28 billion gallons to be blended in overall transportation non-renewable fuel, thus denoting 1.12% of renewable volume obligation, or RVO. This obligation is calculated by dividing the RFS target by the total estimated supply of non-renewable diesel each year. This percentage denotes the blend wall with which blenders must comply.

Since the establishment of RFS, U.S. biodiesel production has increased at a healthy rate with the total production increasing to 1.1 billion gallons in 2012 from 112 million in 2005. The increase in total biodiesel production can be attributed to the rise in production of domestic players due to increased capacity. In addition, import of biodiesel in the U.S. has added to the overall supply in the country. Methes Energies International, (incorporated in the U.S.) through its wholly owned subsidiary Methes Energies Canada, manages two facilities in Canada. The first facility in Mississauga, Ontario, has a total capacity of 1.3 million gallons per year, or mgy, while its latest facility in Sombra, Ontario, has a production capacity of 13 mgy of biodiesel. Both facilities are registered with EPA for import. Therefore, the company markets its biodiesel produced in Canada and sells to its clients in the U.S. Registration with EPA has been an important demand driver for Methes Energies, especially for its Sombra facility, which had the highest production in November. Production at its new Sombra Facility in the fourth quarter (September, October, November) of 2013 was higher than the overall biodiesel production in the previous fiscal year.

Methes Energies operates in an environment where domestic producers have a strong presence in the country. However, Methes Energies has a significant presence in Chicago because of the city's proximity to Methes Energies' production facility in Canada, making it easy for the company to ship biodiesel there. Unlike Renewable Energy Group, Methes Energies sells to a limited customer base (mostly in Chicago), so there is no direct competition from Renewable Energy Group, which has an extensive presence all over the country. Renewable Energy Group has two facilities in Illinois: one in Danville, with a capacity of 45 mgy, and one in Seneca, with a capacity of 60 mgy. Despite having facilities close to Chicago, the American company is unlikely to become a real threat to Methes Energies in the short term because of the latter's strong client relationships.

Renewable Energy Group has eight active biodiesel facilities with production capacity of 257 mgy in the US. For the first nine months of fiscal year 2013, the company sold 186 million gallons of biodiesel, reaching close to the 188 million gallons achieved in fiscal year 2012. Renewable Energy Group is the beneficiary of RIN and generates 1.5 RIN units for each gallon of biodiesel produced. The company sold biodiesel in 43 U.S. states and in Canada in fiscal year 2012.

FutureFuel also benefited from the rise in biodiesel demand in the U.S. The company has a current annual capacity in excess of 50 million gallons of biodiesel per year. Unlike Renewable Energy Group, FutureFuel also produces chemical products for markets such as agrochemical, automotive, photographic imaging, coatings, nutrition, and polymer additives.

All three companies have benefited from the growth in demand for biodiesel in the U.S. due to the RFS mandate. Since the establishment of RFS, all three have gradually increased their capacity to increase the supply of biodiesel in the U.S.

Government incentives for promoting biodiesel production

There are three companies mainly involved in the biodiesel market: the biodiesel producer, biodiesel blender, and retail seller of blended biodiesel. Usually, biodiesel producing and blending are handled by the same company. Biodiesel is more expensive than non-renewable fuel. To support biodiesel producers, the U.S. government launched initiatives, including tax credits and the RIN facility.

  • Tax Credit: The tax credit is a refundable credit given to a biodiesel producer/blender up to $1 for every gallon of biodiesel or renewable diesel that is blended with conventional diesel.
  • RIN credit: EPA records the RFS compliance with the generation of RIN for each gallon of renewable fuel, such as biodiesel, generated or imported in the country. The RIN is used for compliance purposes to record the required production and blending requirement of biodiesel. In addition, excess RINs generated in the previous year can be carried forward to the next year for meeting the compliance target.

During the time of blending, the RIN gets separated from the renewable fuel, and these RINs can be sold at current RIN prices. This provides extra economic incentives to biodiesel blenders, above the tax credit discussed earlier. Thus, RIN prices provide a cushion to blenders and help them remain profitable. A positive RIN price means that the market price of the biofuel (net of any applicable tax credits) is greater than the price of the conventional non-renewable fuel it is blended into. Therefore, RIN prices cover up the potential loss of selling biofuel such as biodiesel. This is further explained in the example below:

(click to enlarge)

Source: farmdocdaily.illinois.edu

In the above diagram, Pbd is the price of biodiesel, while Pulsd is the price of diesel. Q1 refers to the quantity supplied without tax credit, while Q2 refers to the quantity with tax credit. The difference in the Pbd and Pulsd is first reduced by applying the tax credit of $1 per gallon, thus bringing the prices closer and increasing the quantity supplied from Q1 to Q2, as more blenders will be encouraged to blend biodiesel due to this tax credit.

Despite the tax credit, blending biodiesel remains unprofitable, so to further assist, RIN prices fill the remaining price gap at the RFS mandate quantity. The move from Q1 to Q2 will reduce the RIN price because of the reduction of price difference from the tax credit benefit.

The RIN price is an important benchmark for biofuel blending, as higher prices positively affect the profitability of the biofuel-producing company.

Growth of domestic biodiesel producers

Renewable Energy Group has a nationwide distribution system and each facility is equipped with an on-site rail-loading system, a truck-loading system, or both, providing good reach and a timely supply of biodiesel. In addition, the company also has a lease agreement with petroleum fuel terminals. Through this lease arrangement, Renewable Energy Group leases its biodiesel storage tanks to fuel distributors and customers for biodiesel blending.

On November 26, Renewable Energy Group entered into an agreement with Dutch Hill Terminals to market biodiesel and biodiesel blended heating oil in New Jersey. This is the company's sixth distribution point in the Northeast. This terminal will provide additional capacity to meet the demand from the region. The choice of New Jersey as the location was influenced by the expected rise in demand for biodiesel in this state due to upcoming legislation, which sets a 3% biodiesel mandate for heating oil. It will increase the B3 biodiesel blend (containing 3% of biodiesel) to five percent of biodiesel blend, i.e. B5 biodiesel, in the future.

Demand for biodiesel in the Northeast has been good this year. In June 2013, New York (where Renewable Energy Group also has terminals) implemented B2 legislation requiring a 2% biodiesel blend in heating oil over two years by 2015. Renewable Energy Group's sales performance is strong, with 2013 volume sales set to surpass 2012 figures. During the third quarter, the company sold 78 million gallons of biodiesel, an increase of 26% year over year.

FutureFuel, meanwhile, is strengthening its biofuel products, with segment revenue increasing 61% year over year in the third quarter of 2013. The biofuel segment now contributes 64% of its total revenue, up from 54% in the third quarter of 2012. Strong growth in biodiesel is due to the RFS mandate in the U.S. and led to the segment's strong revenue growth.

This robust revenue growth from biodiesel sales resulted in better earnings. Unlike Renewable Energy Group, FutureFuel provides good shareholder returns through dividends. Recently, the company declared a special dividend of $0.25 per share paid on December 16, 2013. This is above the normal quarterly dividend of $0.11 per share announced previously; the quarterly dividend now stands at $0.36 per share.

The company believes it will sustain its growth, thus it has increased 2014's normal quarterly dividend to $0.12 per share to be paid in March, June, September, and December. The company has been successfully deploying its cash by returning it to shareholders or pursuing acquisition.

How Methes Energies is different from Renewable Energy Group or FutureFuel

Methes Energies may be small compared to Renewable Energy Group in installed capacity or sales of biodiesel, but unlike other players, Methes provides biodiesel technology in addition to producing biodiesel. Methes Energies offers a wide range of products in biodiesel, including biodiesel equipment, feedstock to biodiesel producers, and biodiesel itself. Although most of the revenue is derived from selling biodiesel, having multiple revenue streams is expected to help grow the company's top line even with any future risk related to biodiesel.

Methes Energies' equipment offerings include two fully automated biodiesel processors, i.e. Denami 600 and Denami 3000. The company targets small to mid-sized plants, with Denami 600 providing 1.3-mgy capacity and the Denami 3000 providing 6.5-mgy capacity. The company also provides support facilities to its equipment buyers, including maintenance and a lifetime warranty on the equipment, in exchange for a royalty fee based on the client's biodiesel production. In addition, the company has growing interest from Ethanol producers for using Denami processors to convert corn oil (extracted during ethanol production from corn) into biodiesel. This will bring additional income to ethanol producers and increase the demand for Methes Energies' equipment.

Another important difference between Methes Energies and Renewable Energy Group or FutureFuel is that Methes Energies isn't directly related to the RIN credit. It produces biodiesel in Canada and sells it to U.S. distributors, which ultimately benefit from the RIN either by selling it or using it for compliance.

In 2014, Methes Energies plans to import biodiesel through its subsidiary Methes USA (incorporated in 2007). This will remove the tag of Methes Energies' marketing biodiesel produced outside the U.S. and make the company eligible for the generation of RIN for each gallon imported and sold. Methes Energies' competitors, Renewable Energy Group and FutureFuel, generate RIN technologies for producing each gallon of biodiesel. They transact these to meet compliance requirements, and after providing blended diesel, they can sell the RIN in the market at RIN prices.

(click to enlarge)

*coming in 2014

Source: Company Presentation

Expansion plans of Biodiesel producers

Renewable Energy Group has the biggest installed capacity of any player in the biodiesel industry. In addition to its eight fully operational plants, the company has four partially constructed facilities. Once completed, these four facilities will add 150 mgy of biodiesel to its overall capacity.

Methes Energies

Renewable Energy Group

FutureFuel

Annual Capacity installed

14.3 mgy

257 mgy

50 mgy

Expansion plan

To add additional 13 mgy by 2014

Has several under constructed plants

No expansion plan other than improvement in the current facility

Methes Energies, meanwhile, plans to double its Sombra, Ontario plant capacity, adding 13 mgy. The plant currently has two Denami 3000 units installed (completed by the end of 2012); to double this capacity, it had to install two additional Denami 3000s. Instead of installing the new machines, however, the company continued with two existing machines, and it made operational modifications (such as increasing the flow of throughput by changing pipe settings) instead. This decision will result in significant cost-savings, as there won't be any need to install two additional processors.

With a Greenfield approach - building a plant from scratch -- setting up a 13-mgy biodiesel facility will cost $15 million to $25 million, including all infrastructure. Although this isn't a Greenfield project, as the plant is already installed, the savings are still expected to be $4 million. This is important financially, as the company won't add much burden to its income statement and will add revenue from the increased capacity.

The company recently sold 1.1 million units, containing one share of common stock and one warrant, to institutional and accredited investors. This has helped the company pocket approximately $1.7 million. This private placement will help fund the expansion at the Sombra facility while maintaining financial strength in the coming quarters.

Methes Energies is currently operating at a loss due to higher expenses:

Fiscal Year 2012

Fiscal Year 2011

Revenue

$6.56 million

$11.79 million

Selling, General and Administration

$4.27 million

$2.44 million

Net Loss

$3.97 million

$0.81 million

Previously, the company was inclined towards re-selling biodiesel (purchasing from other producers and selling it in the market) because of its low installed capacity. With the completion of the Sombra facility, Methes Energies' share of internal production has gradually increased. This resulted in a rise of SG&A expenses due to the increased salary payouts from hiring of new employees to support the internal production.

These SG&A expenses are expected to remain constant for the next year, as the company isn't adding any new machines. Instead, it will reduce the per unit cost on account of economies of scale. The company currently has 33 employees, and this expansion won't require hiring additional staff.

What is the potential of the Sombra facility?

Looking at the expansion, the total capacity will increase to 26 mgy, and at an average price of $4 per gallon the revenue opportunity stands at around $104 million. This is 16 times more than fiscal year 2012 revenue. As stated, there won't be much change to its SG&A expenses. For the first nine months of fiscal year 2013, the gross profit margin was 9.1%. Assuming that this remains the same for the next fiscal year, with the same SG&A expenses the company is expected to become profitable.

In addition, Methes Energies has a strong pipeline in many countries. Although the company's operation is limited to U.S. and Canada, it plans to expand into Europe and other markets. International expansion has been slow for Methes Energies, but the company has been establishing itself in foreign markets primarily for its equipment. These projects will lay the foundation for the company and help it establish its international presence.

(click to enlarge)

Source: Company Presentation

In May, BioFuel Aruba signed an agreement with Methes Energies to purchase one Denami 600 biodiesel processor. BioFuel is the only biodiesel producer in Aruba and wants to expand its production from the third quarter of 2013. BioFuel has project agreements with Aruba Airports and public transport companies to blend biodiesel for their fleets. This agreement is expected to fetch around $1 million based on the price of the Denami 600 hardware.

Diversification initiatives of biodiesel producers

To reduce dependence on biodiesel, producers such as Methes Energies and Renewable Energy Group are diversifying their product line and manufacturing other renewable fuels.

Methes Energies recently announced the signing of a letter of intent to acquire assets of OTC Energy Technologies. Methes Energies will gain access to all of OTC's technology, including the process to convert several types of biomass to syngas. Syngas, derived from synthetic gas, is a mixture of hydrogen and monoxide and can be converted to ethanol, methanol, and hydrocarbons such as jet fuels and gasoline. OTC will enhance Methes Energies' technology for the conversion of biomass. Conversion of biomass into fuels such as ethanol or jet fuel is a much bigger market than biodiesel. OTC's conversion technology is proven to produce quality syngas. Currently, the biomass conversion industry faces the issue of production of quality syngas, as current technology produces many byproducts during conversion, resulting in a lower yield. However, OTC's technology produces no byproducts, providing a better yield of conversion of biomass into renewable fuels.

In addition, Methes Energies can tap OTC's clients, which require small to medium processors. This is a big opportunity for the company to boost its top line and increase market share in the overall renewable fuel market. It is estimated that OTC Technologies has a strong base of seven or eight big customers. This is just the beginning; as application of this technology increases, this list is expected to expand. It will also solve Methes Energies' current issue, as it is highly dependent on just a few customers, but this acquisition will expand its overall base and open up many new opportunities.

Renewable Energy Group has also made an important bid towards bio-synfining by signing an asset purchase agreement with Syntroleum. This is an all-stock transaction to acquire all Syntroleum's assets, with expected closure of the transaction by the first quarter of 2014. Syntroleum specializes in Fischer-Tropsch, or FT, technology that converts syngas into FT wax and hydroprocessing technology that converts FT wax or fats oils and greases into naphtha, diesel. Syntroleum also has a 50% equity alliance in Dynamic Fuels, which operates a 75-million-gallon renewable diesel-producing facility. It uses Syntroleum's bio-synfining technology to convert feedstock produced during FT process to renewable diesel products. This is similar to OTC Technologies' conversion of biomass into renewable fuels. It is a win-win for both companies, as Renewable Energy Group's strong distribution and channel partner network will boost Syntroleum's business while expanding Renewable Energy Group's product offerings.

EPA's RFS mandate for 2014

In its new draft for 2014, EPA kept the 2013 RFS target of 1.28 billion gallons of biodiesel. Unlike the industry expectation of proportionate increase in this limit, EPA froze the biodiesel RFS limit for next year. Other biofuels such as renewable fuel or ethanol and cellulosic biofuel have also been hit with RFS target for 2014 that is significantly lower than the Clean Air Act target. This law was originally passed to reduce the import of oil and emission of greenhouse gases by blending biodiesel. The fall in the demand of gasoline has resulted in a reduction in the RFS target of biofuels below the original target passed in the Clean Air Act.

Though it is just a mandate or minimum requirement for the blending of biodiesel with conventional diesel, this may affect the industry as a whole. The estimated production of biodiesel is pegged at an excess of 1.7 billion gallons in 2013. Once the mandate of 1.28 billion gallons is reached, the blender can continue to blend biodiesel, and RIN generated from that can be carried forward for complying next year. However, keeping the limit stagnant at 1.28 billion gallons may hamper the overall industry expansion. This draft is still pending approval, and it is open for public comment until the end of January.

Conclusion:

Methes Energy is positioned to post record top-line growth next fiscal year. As per the company's projection, it believes its total revenue will increase to $55 million next year. This was based on its November presentation, before the OTC Technologies acquisition, so these estimates will likely change, and the actual figure will be much bigger as sales from the newly acquired technology will bring additional revenue to the company: for example, the ethanol market is much larger than that for biodiesel. The ethanol blending wall is close to 10% in gasoline, compared to biodiesel's blending requirement of 1%-2%.

(click to enlarge)

Source: Methes Energies' presentation as on Nov 1, 2013

Currently, Methes Energies looks unattractive from the investment metric, but as the company increases its capacity and boosts its top line, these factors will change. Therefore, it is a good investment opportunity, and looking at its growth initiatives, Methes Energies could generate good returns for shareholders next year.

In respect to other players, Renewable Energy Group, a giant in the biodiesel industry, will benefit the most if the RFS mandate is raised for 2014. The company has a strong distribution network and strong client base for its strong top-line growth. However, it faces headwinds if the current RFS mandate is approved and if its current expansion plans are affected. Another caveat is its high dependence on biodiesel for revenue. Despite the headwinds, Renewable Energy Group's strong foothold in the biodiesel market will help it sustain revenue growth for next year, regardless of the current EPA hearing.

As for FutureFuel, the impact of the RFS 2014 mandate will be offset by its product diversification. The company has a history of good shareholder returns with dividends; therefore, FutureFuel should be a safe investment.

Source: What Lies Ahead For These Biodiesel Players?