Ethanol RIN Economics Don't Make Sense

 |  Includes: CRUD, FUE, OIL, USO
by: Robert Wagner

Executive summary:

  • The EPA's RFS2 RIN market isn't functioning as designed.
  • Ethanol RINs are trading well above level predicted by the theories on which the RIN mechanism was based.
  • RIN values are being distorted by the fear of a 2014 "blend wall."
  • 2014 is an election year and a "blend wall" is extremely unlikely.


The EPA's RFS2 is just a few years old, and what is so fascinating about it is that economists, investors, educators, bureaucrats, producers, blenders and "obligated parties" are all learning as we go along. The RFS2 essentially created an artificial market, and all the unintended consequences are slowly coming to light. First there was the RIN fraud, then the expiration and the retroactive reinstatement of the related Blenders' Tax Credit or BTC and then there was the "blend wall," and now we are experiencing the post "blend wall" and expiration again of the BTC.

As if that isn't enough to complicate a biofuels model, we now have the EPA backing away from some of the volume mandates or RVOs, and the Senate is proposing a 3 year producers' tax cut to replace the 1 year blenders' tax cut. Since its implementation, the EPA's RFS2 has been erratic to say the least. This is one of the greatest Soviet style centrally planned trial and error experiments done on a grand scale I have ever seen. It is totally unique for the US free market economy. Socialists are always claiming socialism will work if they can just find the right leader, well, the RFS2 is an attempt to prove to the socialists that socialism can work... if paid for by the abundant wealth of a capitalist host.

While there are many problems with the current RFS2 system, recent developments have many involved in the industry scratching their heads. The way the EPA's RFS2 is designed is to have something called a RIN produce an incentive for producers to produce a certain type of biofuel. "Obligated parties" must surrender a certain number of RINs to the EPA to meet their regulatory obligations each year. RINs come embedded in the biofuels that are produced, so each gallon of ethanol produced also comes with a D6 RIN, which can only be detached from the fuel once it is "blended." The RIN can then be turned over to the EPA or sold on the market. That in a nutshell is how the RFS2's RIN system works.

The problem is, something seems really wrong in the RIN market. Call 6 people in the industry and ask them why D6 Ethanol RINs still have value and you will get 6 different answers. I've done that experiment and find some explanations more credible than others. This article will address the credible explanations and I'll add a theory of my own.

Theoretically the RIN system should have a RIN maintain enough value to ensure profitability exists to ensure a certain amount of biofuel is produced. Typically biofuels are more expensive than conventional fuels, so a "subsidy" is needed to encourage production. That subsidy is the RIN. Once a certain RVO is reached, however, the RIN value should drop to $0.00 because no more production is needed of the more costly biofuel. That is the theory.

Based upon that theory, one would have expected that the EPA's recent announcement to reduce the 2014 ethanol RVO would have cratered the price of the D6 RIN. During the previous year, D6 RINs usually traded around $0.05, but last year they spiked up to around $1.50 on the "blend wall" issue, and currently trade around $0.56. Lowering the ethanol RVO below existing capacity should have sent the D6 RINs back to the $0.05 to $0.00 range. But it didn't.

(Image SourceClick to enlarge, similar Image)

The question then becomes why not? Clearly there is something distorting the D6 RIN market, but what is it?

Explanation #1: Under the RFS2 system, 20% of RINs can be "carried over" into the following year. That makes the effective RVO really equal to 1.2x the RVO. Last year, however, ethanol barely reached its 2013 RVO and other biofuels failed to reach their targets. Even thought the overall RVO was reached, because of the allowed "carry over," the net effective is a shortage situation. "Obligated parties" are having to bid up D6 RINs to prevent them from being carried over into 2014. "Obligated parties" have to meet their 2013 obligations so they have an inelastic demand for the RINs, and holders of RINs don't have such constraints so they are indifferent between selling their 2013 D6 RINs in 2013 or carrying them over into 2014. Right now 2013 D6 RINs are trading at a $0.025 premium over the 2014 D6 RINs, proving the markets are trying to bribe the D6 RIN sellers to come back to 2013. For all other RIN types, 2013 RINs trade at a discount to 2014 RINs. The recent EPA report shows that very few 2013 RINs have been "retired," so "obligated parties" are still settling up 2013 with the EPA.

Explanation #2: Builds upon explanation #1. The EPA has proposed cutting back the 2014 ethanol RVO, but it has not "finalized" the rule. The EPA cut back the 2014 RVO in order to avoid another "blend wall" situation. If the final RVO rule doesn't reflect the proposed cutback, we will be back into a "blend wall" situation, which may mean D6 RINs will shoot back up to $1.50 again. "Obligated parties" that have already fulfilled their 2013 EPA D6 obligations may be trying to buy up as many D6 RINs early in the year as insurance against another spike in RIN prices. Because very few 2014 RINs have been produced, they are bidding up 2013 and 2014 RINs. Evidence of this can be seen in that 2012 D6 RINs sell at a premium to 2014 D6 RINs and a slight discount to 2013 RINs. That implies "obligated parties" are buying up 2012 D6 RINs so that they can apply them to the 2013 requirement, allowing for more 2013 D6 RINs to be carried over into 2014. This "tug-o-war" is pulling RINs forward and driving up their price.

Those two explanations are the best I can find, and they are supported by objective market data. The problem I see is what the markets are really signaling. With the 2013 "blend wall" behind us, and the EPA making adjustments to the 2014 ethanol RVO to avoid another crisis, ethanol RINs should be trading around $0.00. RINs should only have value if market prices require a subsidy, and right now ethanol, even with an embedded RIN, trades at a steep discount to gasoline. Current ethanol prices make ethanol competitive with gasoline -there is no need for a RIN sweetener. What that means is that the markets don't believe the EPA is going to cut the ethanol RVO, and are hedging on another "blend wall."

In my opinion, the markets are betting wrong, just like they did in early 2013. In late 2012 an economist published a paper explaining why RIN prices should skyrocket in 2013 based upon the coming "blend wall."

Last December, Wyatt Thompson, an agricultural economist at the University of Missouri, published a paper titled "A Question Worth Billions: Why Isn't the Conventional RIN Price Higher?" In it, he predicted the price of RINs could soon increase more than tenfold from levels near 5 cents a credit.

His predictions proved conservative. Between the end of December and early March, RIN prices soared to nearly $1.05 each from about 5 cents.

The ability to predict a "blend wall" can be worth a fortune, so one of the keys to investing in the biofuel industry is the ability to do just that. In a nutshell, US refiners can sell gasoline blended with 10% ethanol in it known as E10. There is also E15 and E85, but effectively the limit on ethanol blending is 10%. Once that 10% is reached, refiners don't have a use for ethanol anymore, they can't blend anymore into the current fuel supply and they don't want to store it. That means that if the RVO is greater than 10%, they face three choices. They can 1) buy ethanol, separate the RIN, and dump the ethanol in the garbage 2) buy a RIN on the open market or 3) buy another more expensive type of biofuel with a D4 or D5 RIN embedded in it and use the D4 or D5 RIN to satisfy the D6 RIN requirement.

Option #3 is happening right now in the markets. The evidence for that is that there is basically parity between the RINs. There is very little spread between the D4, D5 and D6 RINs today, whereas normally there is a wide spread. Additionally, to start the year, D4 and D5 RINs were much lower, but only increased as D6 RINs increased. The "blend wall" doesn't only impact ethanol, it impacts biodiesel and advanced biofuels as well.

Option #1 explains a method to estimate the maximum price for a D6 RIN. A D6 RIN should never trade more than the economic cost to produce a gallon of ethanol. An economic as opposed to an accounting profit includes a required rate of return. The worst case scenario for the "blend wall" is a refiner would buy ethanol simply to get the RIN and dump the ethanol in the garbage. That would imply the RIN represented 100% of the ethanol value, and for that to be the case, the RIN must be worth the economic cost of producing ethanol.

It is option #1 that leads me to believe that there is basically 0% chance of a blend wall occurring in 2014. The reason for this has absolutely nothing to do with financial or economic analysis - nothing, nada, zip. The reason there will be no "blend wall" in 2014 is because 2014 is an election year. There is zero chance that politicians will risk news stories being run highlighting video clips of "Big Oil" dumping excess ethanol giant evaporation pools as waste. If I were the CEO of Exxon (NYSE:XOM), I'd be digging the pools right now and lining up actors to represent angry farmers hurt by falling corn prices for when the cameras show up. They might even hire some unemployed Keystone pipeline steelworkers and WVA coal minders. A "blend wall" in an election year would be a disaster, so it ain't gonna happen, no way, no how. If it does happen, you can kiss the RFS2 goodbye because a veto proof Republican Congress will kill this program with the first vote they take.

The other reason I don't think the "blend wall" will happen is because the RFS2 isn't needed for ethanol anymore. The RFS2 is to provide production incentives for costly inefficient developing biofuels. Ethanol is fully developed and competitive with gasoline. Ethanol doesn't need the RINs to encourage production, and the cost advantage ensures refiners will blend up to 10% without any regulatory requirements. Currently RBOB gasoline trades at $2.7772/gal and ethanol trades at $2.0130/gal for March delivery. Ethanol only has two-thirds the energy content of gasoline, but it also boosts the octane rating and helps gas burn cleaner. Theoretically the min price for ethanol therefore should be (2/3)*RBOB, or $1.85/gal if there were no other benefits other than energy content. Gas stations, however, don't sell fuel by the BTU content, they sell it by the gallon, so the more ethanol a refiner can safely put into a gallon of fuel, the cheaper it gets. 100% RBOB costs $2.7772/gal; E10 would only cost 0.9x$2.7772 + 0.1*$2.0130 = $2.70051, or a 2.8% discount. The current economics favor blending E10 without any regulations at all. It is simply smart business to use ethanol.

To make matters worse, the current ethanol price includes an inflated D6 RIN. Cut out the D6 RIN and ethanol would be trading almost $0.60/gal less. Right now ethanol has about a $0.47/gal operating margin, which is relatively high, so cutting out the D6 RIN would send the margins negative in the short run. As time passes, however, the markets will adjust to compensate for the loss of the D6 RIN, but they shouldn't drive ethanol any higher than they are today. Ethanol has simply become competitive with gasoline. The reason ethanol would no longer be competitive with gasoline is if gasoline falls in price, or ethanol increases in price, most likely due to more expensive corn. In both those cases, the existing regulation would work against the goal of lowering fuel costs, and higher corn prices would most likely force the EPA to adjust the mandate anyway.

In conclusion, the current economics in the ethanol and related biofuels industries are being distorted by the fear of a 2014 "blend wall." Both ethanol and biodiesel producers have been benefiting from this fear. In my opinion this fear is unjustified, and a 2014 "blend wall" is highly unlikely simply because this is an election year. A "blend wall" crisis during an election year would be a catastrophe. A 2014 "blend wall" would be a dream come true for "Big Oil." Without the fear of a "blend wall," I would expect D6 RINs to fall back to around $0.05 or less, especially if the EPA finalizes the cut in the ethanol RVO later this year. I would expect corn prices to fall as well.

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