Biodiesel Margins, Ethanol RINs And An EPA RFS2 Update

Includes: GPRE, REGI, SYNM
by: Robert Wagner

Editor’s 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.

One of the great mysteries in the land of biofuels is why do ethanol RINs still have value. Last year the EPA proposed cutting the ethanol mandate for 2014. D6 Ethanol RINs usually traded around $0.05 until the "blend-wall" issue sent them upward towards $1.50. If you think the Bitcoin was a great investment in 2013, RINs weren't far behind.

Theoretically reducing the ethanol production mandate or "RVO" should have sent the D6 Ethanol RINs to the mat, or at least to the level that existed prior to the "blend-wall" which the reduced RVO is supposed to prevent from happening again in 2014. The problem is, D6 RINs haven't fallen as the theory would have predicted. To make matters worse, corn prices have fallen and ethanol margins are robust. The RFS2 RIN program wasn't designed to make farmers rich, it was designed to stimulate the growth of the ethanol industry. The EPA is now trying to effectively shrink the ethanol industry, so robust margins and valuable RINs simply don't make sense within the confines of the theories on which the RINs and RFS2 are founded.

Currently according to Progressive Fuels LLC 2014 D6 Ethanol RINs are trading at $0.5350, 10x the level that existed before the "blend-wall." Because of the "nested" structure of RINs, this has driven up all other RINs as well, most importantly the D4 and D5 RINs associated with biodiesel and advanced renewable fuels. Currently the 2014 D4 RINs trade at $0.58 and the D5 RINs trade at $0.56. The twisted dynamics of this RFS2 market has the ethanol market driving profitability in the biodiesel market. 2014 D4 RINs have been driven higher from $0.35 to as high as $0.60 because of the D6 Ethanol RINs. This is welcomed relief considering biodiesel margins collapsed with the expiration of the "blenders' tax credit."

I've talked to various people in the industry about this phenomenon and got various answers as to why D6 Ethanol RINs still have value, and I think the best answer is that there is a shortage of RINs and that "obligated parties" are bidding them up as insurance against another "blend-wall" and the possibility that the EPA may not reduce the 2014 Ethanol RVO after all.

Proving this concept is very difficult because of how the EPA accounts for the RFS2 program. Under the program 20% of the RINs produced in one year can be carried over into the following year. This results in years where the RINs produced exceed the number of RINs "retired." This graphic highlights how in 2012 far more RINs were "generated" than "retired."

What that means is that there is a surplus available at the start of 2013. Fast forward to the end of 2013 and the 2013 RVO was barely reached, but because of the surplus that existed at the start of 2013, there is still a surplus number of RINs available to carry over into 2014, but that surplus is less than the allowed 20% carry forward, so that is how a surplus of RINs actually creates a shortage. This graphic shows how the 2013 RVO of 16.55 billion gallons was just barely reached.

Most importantly, there are only 291 million RINs "retired" for 2013. That implies that "obligated" parties are still settling up their 2013 obligations. The problem is, people that hold the RINs, the producers and the blenders, don't really have a reason to sell them, and the people that buy them, the obligated parties, don't know if they want to pay $0.50 for a D6 RIN to satisfy the 2013 RVO or to buy them as a hedge for 2014 in case of another "blend-wall" occurrence or if the EPA reverses its intention of reducing the 2014 Ethanol RVO. In a way, it is kind of like a short squeeze. The holders of RINs know the "obligated parties" are required by law to buy RINs or face a prohibitive penalty, and they know there effectively is a shortage, so they can afford to wait for higher RIN prices to sell. Some of those RINs were generated previous to the blend wall, so their cost was far less than what they are trading at today. Simply allowing some of the 2013 D6 RINs to "expire" that cost $0.05, will maintain a storage that is supporting $0.50 RIN prices.

Warning: What I just described is an obvious flaw in the design of the EPA's RFS2, a program that has already experienced many cases of fraud. It is clear to me that when the EPA designed this program the people they hired are idealistic graduate students that live in ivory towers and have no clue as to how real markets work, or that evil exists in the hearts of some men. Like the Bitcoin, the RIN market is idea for market manipulation, and I just outlined how one would do just that. One only needs to allow their low cost RINs to "expire" to create a shortage that in required to be fulfilled by law. Obligated parties have no option but to bid up the price of RINs or face the wrath of the EPA enforcers. That being said, if I am writing about this technique, I am sure that the EPA is aware of it, or will soon be aware of it if this article gets selected for publication, and will be watching owners of RINs to make sure that they aren't being horded and allowed to "expire" without good reason.

The major investment theme that this RIN short squeeze generates, however, isn't in ethanol companies. While the high D6 RIN prices and wide ethanol margins are certainly good for ethanol companies like Green Plains Renewable Energy (NASDAQ:GPRE), that information is already known to the markets. Things are looking good for ethanol even though the EPA is proposing cuts to its RVO. GPRE has a current P/E TTM of over 18, and a forward P/E of over 11. The real opportunity I see is upside surprises in the biodiesel companies. We've already see early signs of that happening.

Because of the strong production and "blenders' tax credit" in Q4 2013, earnings for biodiesel firms should be strong and likely to exceed expectations. The problem is, everyone should know that. The real opportunity that I see is that after the expiration of the "blenders' tax credit" the biodiesel margins collapsed and the markets punished biodiesel producers, sending them into deep corrections. As I write this, biodiesel operating margins for soybean oil based biodisel are negative according to Iowa State University, and major biodiesel producers like Renewable Energy Group (NASDAQ:REGI) are selling at fire-sale valuations. REGI has a current P/E TTM of less than 3, and a forward P/E of 8.

In my opinion REGI is almost certain to report stronger than expected earnings for Q4 2013, sending its TTM P/E even lower. That however isn't the opportunity I see, even though I would expect a pop in the PPS of REGI when it does report strong earnings. This, as the referenced article above highlights, is already happening to related companies. The real opportunity I see is in upward revisions to future earnings. Right now the markets have discounted terrible forward earnings for biodiesel companies, and the negative margins referenced above appear to support that bearish conclusion.

The flaw with the market's conclusion is that the most widely published biodiesel margins are for soybean oil based biodiesel or SME, and those margins give a misleading picture of the industry as a whole. While the majority of biodiesel produced in the US is SME, the majority of biodiesel produced by REGI isn't SME; it is what is called FAME and is made out of feedstocks other than virgin soybean oil. The fact that the majority of biodiesel is SME is an advantage to REGI because they use lower cost feedstocks like yellow grease and inedible corn oil. To maintain consistency I used the Iowa State University CARD spreadsheet linked above and edited it to reflect biodiesel margins for other feedstocks, the feedstocks used by companies like REGI.

The current CARD calculation has SME generating a -$0.02 operating margin, I show yellow grease operating margin of $0.46, tallow of $0.35 and inedible corn oil of $0.19. Additionally REGI recently announced its intentions to buy Syntroleum's (NASDAQ:SYNM) assets which includes a 50% share of the Dynamic Fuels renewable diesel plant. Right now I calculate the operating margins for that plant around $0.57 if they can ever get it to run at full production.

According to CARD, the average SME margin for 2013 was $0.74 which included the discounted "blenders' tax credit," so the current non-soybean oil FAME margins are still lower than what existed in 2013, but they are improving. As this chart demonstrates, D4 RIN prices, which are discounted into the margin, are rapidly increasing. Every $0.01 change in the price of a D4 RIN adds $0.015 to the biodiesel margin, all else held equal.

So while things look awful for SME producers right now, that isn't true for the entire biodiesel industry, namely those that produce FAME. The other aspect the markets don't seem to grasp is that the biodiesel industry isn't like other industries, free market principles don't apply. Unlike most other industries, the biodiesel industry has the full coercive power of the EPA backing it. Continued negative margins for SME simply isn't sustainable. What will happen is that SME producers will shut down, the EPA will report weak biodiesel production numbers well below the level needed to reach the 2014 RVO, the D4 RINs will be bid up in anticipation of the 2014 RVO not being reached, margins will improve, and SME will start to be produced again. The key here is that FAME producers will be producing at profitable margins when SME producers shut down. Improving SME margins will simply strengthen FAME margins. When SME producers survive, FAME producers thrive, and SME has to survive to reach the RVO.

The fly in the ointment to this theory is the possibility of the reinstatement of the "blenders' tax credit," but that really isn't a fly in the ointment to well capitalized companies like REGI. While margins were compressed in 2012 without the "blenders' tax credit" those who continued to produced were greatly rewarded when the "blenders' tax credit" was reinstated and made retroactive. After adjustments were made for the retroactive tax credit, every quarter of 2012 was profitable for REGI, and they went on a buying spree buying up companies that couldn't survive the lean times. SYNM shut down production during that lean time and never restarted the Dynamic Fuels plant, and is now being purchased by REGI. Government folly can have disastrous effects on companies. That is the lesson the graduate student in the ivory towers must learn most before they write any more of these confusing and market distorting laws. People can and do lose real money because of their mistakes.

In conclusion, the EPA's RFS2 program is an absolute mess, and the mess it has created generates confusion and uncertainty in the markets. That confusion and uncertainty however generates investment opportunities. The confusion and uncertainty generated by the EPA's indecision on the 2014 RVO, the unknown fate of the now expired "blenders' tax credit" and this being an election year, all present opportunities and risks for investors. Right now the D6 RINs are driving the D4 RINs higher, rapidly improving the margins for biodiesel. Because SME margins are currently negative, however, production is almost certain to decrease and the excess RINs from 2013 will be rapidly consumed to fulfill the 2014 SME production short fall. Once that happens, RINs will continue their trek upwards. Facts are, the RFS2 program doesn't allow for the RVO not to be reached, and for the RVO to be reached, SME must be made profitable. While a rapid resolution to the "blenders' tax credit" issue is unlikely, my understanding is that it will be part of a broader tax reform package, it has historically been made retroactive, so it is more a timing of cash flow issue to well capitalized firms, and may actually present an opportunity. REGI should report better than expected earnings on February 27, 2014. It is likely that they will make comments regarding current margins as well. If they do report better than expected 2014 margins, and report solid operating margins for their current production, I would imagine the markets will rapidly adjust their estimates for future earnings, and send REGI's PPS higher with them.

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. Past performance is no guarantee of future results. For my 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, REGI is buying SYNM so if that purchase is completed I will own REGI in the future