Biodiesel Margins Are Improving

by: Robert Wagner

At the end of 2013 the biodiesel "Blenders' Tax Credit" or BTC expired. The result was that margins collapsed, leaving soybean oil based biodiesel plants functioning at break even at best margins. The EPA essentially created the biodiesel industry with its RFS2 program, and the BTC is not part of the RFS2. Theoretically the loss of the BTC should not have mattered. The RFS2 is designed with internal mechanisms that are intended to guarantee a profit margin sizable enough to maintain a production level necessary to reach the EPA's biodiesel quota or what it calls renewable volume obligation or RVO.

As the theory goes, the EPA created something called a RIN or renewable identification number to track "obligated party's" progress towards reaching their annual RVO. To satisfy the RVO obligation the "obligated party" must provide the EPA with a certain number of RINs. You can buy RINs on the open market, but the way most "obligated parties" get their RINs is by buying biodiesel fuel. Each gallon of biodiesel therefore comes with 1.5 D4 RINs attached to it. A biodiesel gallon is like a McDonald's Happy Meal, where you pay $4.50 for $2.00 worth of food, and they throw in a toy to make you forget you are paying $4.50 for $2.00 worth of food.

The RFS2 is designed to be a self-sustaining, self-regulating and self-sufficient system, it is designed to operate on its own without help from any other program or subsidy. Theoretically the BTC is an unnecessary and redundant biodiesel program that should have had no impact on biodiesel margins. The introduction of the BTC should have caused the price of D4 RINs to fall by an amount necessary to maintain a stable biodiesel margin, and the loss of the BTC should have resulted in the price of a D4 RINs to increase by the amount necessary to maintain a stable biodiesel margin. With or without a BTC, biodiesel margins should have been maintained. That at least is how it works on paper.

In realty it doesn't exactly work like that, there is a lag or delayed reaction time in the system. When I wrote the original article I detailed what I expected to occur going forward:

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.

While we won't know Jaunuary biodiesel production numbers until later this month, we can see that the predicted market reactions are starting to happen.

2014 D4 RINs have increased from $0.45 to $0.51, resulting in a boost of $0.06 x 1.5 = $0.09 to the margin of both SME and FAME. Chicago SME Biodiesel has increased from $3.13 to $3.28 for a boost of $0.15 to the margin. Chicago FAME has increased from $3.08 to $3.24 for a boost of $0.18 to the margin. Soybean oil has decreased slightly from $38.62 to $37.65, increasing the margin of SME by $0.08. Yellow grease dropped from $23.50 to $22.50 adding $0.08 to the FAME margin. The SMA margin has increased by $0.15 + $0.15 + $0.08 = $0.38/galThe FAME margin has increased by $0.09 + $0.18 + $0.08 = $0.35/gal. Even with those gains SME is still struggling, but FAME produced from Midwest yellow grease should be turning a nice profit.

One thing to note however is that prices related to biodiesel can be all over the place. Right now one source has yellow grease prices at $26.00, another has it at $22.50 and another at $22.50. Each $1.00 difference results in a $0.08 difference in the margin.

Flies in the ointment: Even though margins have begun to recover, there is still uncertainty as to whether or not the BTC will be reinstated, and the EPA just completed its comment period for the proposed 2014 RVOs. Both of those issues remain unresolved and their resolution will have a significant impact on the prospects of the biodiesel industry.

Looking forward

Because the RVO and RIN system is still in place, I would expect margins to expand from here as they did in early 2012. The big wild cards still in the deck are the final RVO for biodiesel and what happens with the tax credit. Unfortunately, it may be awhile before we get an answer to either of them. It took until August in 2013 to set the final 2013 RVO, and the 2012 tax credit extension wasn't passed until early 2013. The ideal situation for the biodiesel industry would be for the EPA to send the biomass based diesel RVO at 1.8 to 1.9 billion gallons, or something at least close to the final 2013 production level, and for congress to either signal that the blenders' tax credit will remain permanently expired or that it is extending it for an extended period of time, the key being that congress makes some statements signaling to the markets that no longer will the tax credit be an on-again-off-again system, but has some permanence, certainty and stability to it.

In conclusion: If the EPA's RFS2 system works as designed, the biodiesel industry should see margins continue to recover going forward. With or without the BTC, "obligated parties" still need to meet their RVOs. If the "obligated parties" are going to reach their RVOs they have to have biodiesel fuel to purchase. To have biodiesel fuel to purchase biodiesel producers must be making a margin sizable enough to make them want to produce biodiesel fuel. Bottom line, if margins remain at break even or even loss levels, there will be no biodiesel produced to fulfill the RVO. That isn't going to happen. Margins will be headed higher from here, biodiesel production will be profitable and the 2014 RVO will be reached, regardless of the outcome of the BTC.

If the unthinkable happens and the EPA actually reduces the biodiesel RVO like it did to ethanol, then all bets are off and my analysis is invalid. That however is extremely unlikely, and I've never even heard it mentioned that the biodiesel might be cut. That however would be a game changer for my analysis.

Disclaimer: This article is not an investment recommendation or solicitation. 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. Full Disclaimer and Disclosure Click Here.

Disclosure: I am long SYNM. 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.

Additional disclosure: I own calls on REGI.