Where are margins now?
I recently wrote an article about the loss of the "blenders' tax credit." In it I tried to detail the expected market reaction to the event and explained how investors interested in this sector could follow how things developed over time.
By tracking the trends in the margins, investors can better understand how the industry is surviving the loss of the tax credit. If the RFS2 is functioning as planned, RIN and/or feedstock prices should adjust to compensate for the loss of the tax credit. Right now margins are compressed, but as demonstrated in early 2012, they should eventually rebound.
Almost 2 weeks into 2014, we now have some data to examine. Iowa State University/CARD maintains a biodiesel margin database, and the recent update does show soybean oil based biodiesel or SME having highly compressed margins. The last entry for 2013 had OPEX margins of $0.59. The most recent entry on 1/10/2014 shows an OPEX of $0.04. The loss of the blenders' tax credit has essentially wiped out all of the OPEX margin. Short-term adjustments were expected, but comparing early 2014 to early 2012 shows that the drop in the margin is greater than what has happened in the past. The blenders' tax credit also expired at the end of 2011, but margin remained above $0.30 for all of January. SME is the grade of biodiesel most biodiesel plants produce, so as of right now, it is likely that at least 50% of the biodiesel plants are experiencing negative net margins.
Feedstocks - There were a total of 1,009 million pounds of feedstocks used to produce biodiesel in October 2013. Soybean oil remained the largest biodiesel feedstock during October 2013 with 551 million pounds consumed
This is both good news, and bad news, depending on what feedstock is being used to produce biodiesel. The reason for this is because of the layered profit margins that exist in the industry. Biodiesel can be made out of various feedstocks, soybean or other "virgin" oils are typically the most expensive. Because of capacity restraints, in order to reach the EPA's RVO for biodiesel of 1.28 billion gallons, some SME must be produced. According to the EIA, during the first 10 months of 2014, the quantity of high cost virgin oils used to produce biodiesel was 3x that of low cost non-virgin oils. Using the EIA's numbers and assuming 8.2 lbs of feedstock is required to make 1 gallon of biodiesel, non-virgin oils accounted for about 260 million (306 annualized) gallons of biodiesel, far below the 1.28 billion gallon annual mandate. (Note: it only takes 7.6/lbs of virgin oil to make a gallon of biodiesel.)
What this means it that to reach the 2014 RVO of 1.28 billion gallons, some SME must be produced, in fact a lot of SME must be produced. SME won't be produced, and the 2014 RVO won't be reached if SME margins remain at or near $0.00/gallon. One has to assume that over time the margins for SME must increase to encourage production of biodiesel, but for right now, many SME plants are in trouble. There is no way to sugarcoat the margins for SME, they are ugly, and they are almost certain to result in losses and shut downs in the industry if they persist.
As I mentioned above however there is a "layering" of profit margins in the biodiesel industry. In macro economics aggregate supply curves are created out of all the firms in an industry, with some being more and others being less efficient than the others. As the price of the product falls, the marginal producers start taking losses and have to shut down. Supply then shifts left and the price starts to increase. That is how a normal market works. There is a gradual gradient of efficiencies across the entire market, so the supply adjustments are usually gradual and measured.
The biodiesel industry isn't like that. As noted above, SME makes up the majority of biodiesel production, and because feedstock makes up the majority of costs, and soybean oil is a commodity, there is very little efficiency difference from one firm to the other. When the SME margin goes negative, the majority of the biodiesel industry is experiencing a negative margin, so a large percentage of production is threatened. Unfortunately we won't know until late February when the EPA releases its numbers just how much production has been cut.
That phenomenon creates what I call a "profit umbrella," and results in a "kinked" supply curve. Even though SME has a negative margin, other feedstocks do not. Progressive fuels limited maintains a daily report that tracks the feedstock prices. Using the current prices for Yellow Grease, Choice White Grease, Distillers Corn Oil, and making the needed lbs/gal adjustment, I calculate the current OPEX margins to be $0.48/gal for Yellow Grease, $0.61/gal for Choice White Grease and $0.19/gal for Distillers Corn Oil. From those margins one can visualize a supply curve. At low biodiesel prices only Choice White Grease would be used, so the far left of the supply curve would be Choice White Grease FAME (a quality of biodiesel) and rather inelastic, as the price increases $0.13/gal, Yellow Grease would become profitable and the sudden increase in supply would kink the supply curve a little to the right as it becomes more elastic, then another $0.29/gal and Distillers Corn Oil becomes profitable and the sudden surge in supply kinks it a little more to the right as it once again becomes more elastic and then finally after another increase in price of $0.10/gal and SME becomes profitable, at which time the supply curve takes another kink and becomes much more elastic.
Thanks for the Econ Lesson, but so what?
This is important because the subsector of biodiesel producers that use "flexible feedstocks" are profitable when SME producers are not. Renewable Energy Group (NASDAQ:REGI) is a leading biodiesel producer, and they are a majority flexible feedstock firm.
Renewable Energy Group is a leading North American biodiesel producer with a nationwide distribution and logistics system. Utilizing an integrated value chain model, Renewable Energy Group is focused on converting natural fats, oils and greases into advanced biofuels.
While SME plants are shutting down, many REGI plants will still be able to produce at a profit. As more and more SME plants shut down, D4 RIN prices should increase and so should the profit margins of the flexible feedstock plants. REGI represents a producer that creates the left portion of the above supply curve. In order to get to the quantity required for the EPA's RVO of FAME+SME = 1.28 billion gallons, FAME gets produced first because of its profit margin advantage.
The markets have already begun to adjust. Feedstock prices are all well below their 2013 peaks and 2014 D4 RINs trade for a $0.12 premium over the 2013 D4 RINs. Going forward I would expect SME plants to shutter production, 2014 D4 RINs to increase in price and feedstock prices to remain low, and maybe even head lower. Bottom line, to reach the proposed EPA's 2014 RVO of 1.28 billion gallons, SME will have to have a profitable margin.
Fly in the ointment
Two events could greatly alter the prospects for biodiesel in 2014. The first is the reinstatement of the blenders tax credit, and the second is the EPA boosting the RVO above 1.28. If either or both of those things occur, the prospects for the biodiesel industry greatly improve.
In conclusion, biodisel margins are currently compressed, but I would not expect them to remain so for long. SME producers will start to shutter operations, the EPA will report reduced biodiesel production numbers, the D4 RINs will be bid up, and the profit margins will increase. Because REGI has a P/E of 2.6, and has lost over 30% of its value, the markets may have thrown the baby out with the bathwater. REGI is almost certain to report strong earnings for Q4 2013, and with the markets and analysts expecting losses in the biodiesel industry I expect REGI to bet expectations for both Q4 2013 and Q1 2014. The yet to be scheduled Q4 2013 conference call may discuss the margins REGI is witnessing in Q1 2014. If they do, and the margins are positive, I would expect his to be a nice surprise to the market.
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.
Additional disclosure: REGI is buying Syntroleum (NASDAQ:SYNM) in Q1 2014. I own SYNM, and if/when the merger is completed I will own REGI. I do not plan to sell my shares of SYNM before the merger.