Ethanol Economics Gone Wild, But Can The Party Continue?

by: Robert Wagner


Ethanol economics are defying the free market economic text books.

The fear of a "blend wall" is propping up ethanol and making biofuels companies ideal buy out targets for "Big Oil.".

Repeal or reduction of the EPA's RFS2 would likely be catastrophic to the biofuels industry.

I wrote an article earlier in the year detailing how the ethanol economics were extremely strong.

The ironic thing, however, is that ethanol economics have greatly improved since the EPA's rule. Facts are, the ethanol industry doesn't need the EPA's RFS2 mandate at current market prices. Ethanol economics stand on their own. Right now, all the RFS2 is doing is boosting already healthy margins. Higher ethanol, higher "RBOB" or gasoline prices, lower corn prices and higher renewable identification number of RIN prices have all combined to deliver a very solid economic climate.

The problem is, the strength makes no sense in any free market sense of the term. The EPA's RFS2 program has created chaos in the ethanol market. Ethanol has 2/3rd the energy content of conventional gasoline or what is called "RBOB." Ethanol also has other problems related to it as far as storage, transportation, blending and engine warranties that make it a less attractive fuel. Because of this ethanol theoretically should never sell for more than 2/3rds the price of RBOB. Research shows that that is pretty much what happens.

Figure 2, with adjustment for the blenders' credit, indicates that much of the time since 1999, ethanol rack prices on a volume basis have been below gasoline prices, thus creating the appearance that ethanol is competitive with gasoline. However, we adjust for lower energy content in Figure 3, which also shows what the differentials would look like without the federal blenders' credit. Removal of the blenders' credit and adjustment for lower energy content would make ethanol prices uncompetitive with gasoline, even at recent low ethanol prices and the large volumetric differential to gasoline prices.

That classic relationship however no longer holds, and ethanol currently sells for basically the same price as RBOB. I added arrows to this graph to highlight how the RBOB/EtOH spread has narrowed. When I first saw where ethanol was trading the other day I thought it must have been a misprint, but I verified that these numbers are correct.

Ethanol has had many factors working in its favor recently. Rail/weather issues have created a shortage, corn prices have been relatively stable and low, ethanol prices have increased.

RBOB prices have fallen and ethanol prices have increased, as have D6 ethanol RIN prices.

D6 ethanol RINs have nearly doubled since the start of the year.

The result of all these trends is that ethanol margins are at or near the highest they've been in years.

These strong margins have sent companies like Pacific Ethanol (NASDAQ:PEIX) and Green Plains Renewable (NASDAQ:GPRE) into the stratosphere.

The futures markets seem to imply that the party won't last, but for now the markets don't seem to care. Ethanol prices are dramatically lower in the future, RBOB is relatively stable and corn prices look to be headed higher. The big wild card however is what will the D6 RINs trade for in the future, and that we don't know. The illiquid nature of them prevents the futures from being much help.

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If you are scratching your head and saying "none of this makes any sense," you would be right. None of this does make any sense, the markets are totally distorted. The markets are distorted because the EPA has created a huge amount of uncertainty regarding the future renewable volume obligation or RVO for ethanol. The Congress passed the Energy Policy Act of 2005 instructing/empowering the EPA to create the RFS2 program.

The problem is, the way the ethanol mandate was written failed to take into account that fuel blenders don't/won't blend fuels to more than 10% ethanol, or an E10 level. Forcing blenders to purchase more than 10% of their volume in ethanol creates something called a "blend wall," where blenders have to buy ethanol that they can't really use. That forces ethanol prices to collapse, and D6 RIN prices to explode. Each gallon of ethanol comes with 1 D6 Ethanol RIN embedded in it, and blenders or "obligated parties" need the D6 RINs for EPA compliance. Once the "blend wall" is reached, obligated parties are simply buying the ethanol for the RINs, and not the fuel. That theoretically places the maximum cost of a D6 RIN at the cost of producing a gallon of ethanol. A D6 RIN should never cost more than a gallon of ethanol...theoretically.

This makes the regulatory cost of the RFS2 shoot through the roof as obligated parties often just buy the RINs off the open market, and forego the ethanol all together. This is an obvious problem, and "Big Oil" let Washington know that they were unhappy with the way the EPA was running the RFS2, and rightfully so. The EPA seemed to agree with "Big Oil," and proposed a cut to the ethanol mandate.

The Environmental Protection Agency on Friday proposed the first cut in the amount of ethanol that must be blended into the nation's gasoline supply - a shift that marks a huge blow to corn growers and puts President Barack Obama uncharacteristically on the side of the oil industry.

EPA's action was widely expected, and came after a flurry of White House lobbying in the past two months by both the ethanol industry and opponents of the agency's biofuels mandate, including oil companies, food and soft drink manufacturers, Delta Air Lines and AAA.

The agency said it was reacting to market conditions that include an unexpected slowdown in consumers' demand for gasoline, which means the ethanol supply could soon outpace the amount motorists could actually use. The oil industry has warned that the result could be a spike in gasoline prices unless the government scales back the ethanol requirement - a phenomenon that mandate opponents call the "blend wall."

The problem is, the EPA just doesn't seem to get it. First, no one knows if the EPA is legally allowed to just unilaterally change the regulations, so any changes are likely to end up in court. Second, the EPA proposed another specific volume mandate, maintaining the possibility of another "blend wall." Because ethanol production capacity has reached the desired maximum level, the EPA should simply make the RVO 10% of the overall fuel volume, and eliminate the possibility of a "blend wall," but it doesn't. That stubbornness, incompetence or both threatens the entire program, and greatly strengthens the hand of the opposition. It is one thing to acknowledge the system is broken, it is a whole other ball game to fail to fix it. By allowing the flaws to fester the EPA is inviting criticism.

Because of the possibility of another "blend wall" happening in 2014, combined with the relative shortage of RINs produced in 2013, D6 ethanol RINs have been extremely strong all year, resulting in extremely strong ethanol margins. The strong D6 RIN prices aren't because the "obligated parties" want to pay extra for the ethanol, it is because they are buying insurance against another "blend wall." $0.50 is a lot to spend for a D6 RIN which usually traded for $0.05 before 2013, but during the"blend wall" crisis D6 RINs shot all the way up to $1.50. These kinds of events provide a lot of ammunition for the opponents of the EPA's RFS2.

The other interesting impact this fear of the "blend wall" has had is that is has driven up the D4 Biodiesel RINs and D5 Advanced Biofuels Fuels RINs. Because of the "nesting" structure on the RINs, the D6 RINs represent the floor in RIN pricing, and lift all other RINs when they become the dominant/controlling RIN. That can be seen from the convergence of RIN prices, normally D4 and D5 RINs trade at a sizable premium to D6 RINs, now they are near parity. The near parity between 2013 and 2014 RINs also demonstrates the impact of the relative shortage of 2013 RINs and "obligated party's" efforts to being the 2013 RINs into 2014 as insurance against the "blend wall." Problem is, that is creating a shortage situation and is elevating the D6 RIN prices.

(click to enlarge) (Image Source)

The EPA just released RFS2 production numbers for February, and 2014 is on course to be another relative shortage year. I say "relative" because the RFS2 allows a 20% carryforward of RINs, so just meeting the RVO is effectively a shortage. With 17% of the year passed, 17% of the RVO has been met, but D4 and D5 RIN production is lagging, which implies D4 and D5 RIN prices are undervalued, and likely to be headed higher. That may help explain the recent strength in biodiesel producer Renewable Energy Group's (NASDAQ:REGI) stock price.

(click to enlarge) (Image Source My Personal Spreadsheet Populated with Data from the EPA's RFS2 Website)

Looking forward, the EPA's RFS2 may have unintended consequences. Simple common sense would have "Big Oil" buying up ethanol and other biofuels plants just as a hedge against the unpredictable EPA. That is in fact what is happening. Valero (NYSE:VLO) just purchased its 11th ethanol plant, and now has over 1.3 billion gallons of ethanol capacity.

March 21, 2014, 11:57 a.m. ET

Valero Purchases 11th Ethanol Plant

SAN ANTONIO, March 21, 2014 /PRNewswire/ -- Valero Renewable Fuels Company, LLC, a wholly owned subsidiary of Valero Energy Corporation , announced today that it has purchased a corn ethanol plant in Mount Vernon, Ind. from Aventine Renewable Energy-Mt. Vernon, LLC, a wholly owned subsidiary of Aventine Renewable Energy Holdings, Inc. The plant has an annual production capacity of 110 million gallons and uses Delta-T technology, similar to the process already in use at Valero Renewables' ethanol plant in Jefferson, Wis.

The Mount Vernon plant is the 11(th) corn ethanol plant in Valero Renewables' system and its second in Indiana. The addition will give Valero more than 1.3 billion gallons per year in ethanol production. The plant has been shut down for approximately two years, but Valero Renewables plans to begin a restart program and resume production within the next several months.

While ethanol companies like GPRE and PEIX sell at rich multiples, with both having P/B ratios over 1, companies like REGI have a P/E TTM of 2.40, a P/E forward of 10.08, and a P/B of less than 1. Future Fuels (NYSE:FF) and Methes Energies International Inc. (NASDAQ:MEIL) may be other companies to consider as potential buyout candidates.

Game changing events going forward for biodiesel companies are 2 pending issues. The EPA has yet to make a final ruling on the 2014 RVO. A boost of the biodiesel mandate to the 1.7 to 2.0 billion gallon level would be a huge win for the biodiesel industry. It is highly unlikely that the EPA would reduce the RVO from the proposed 1.28 billion gallons, so that bad news in already discounted in the price of biodiesel stocks. The other issue is the reinstatement of the "blenders' tax credit" or BTC. The expiration of the BTC has been devastating to biodiesel margins, but that awful news has already been discounted in the price of biodiesel stocks as well. In both cases, the EPA's RVO and BTC, the bad news is already discounted in the price of biodiesel shares. A favorable ruling in both those issues could easily double the stock prices. REGI has a capacity of around 250 million gallons, and assuming they would keep $0.50/gal of the $1.00/gal BTC, having only 40 million shares outstanding the windfall would be ginormous.

The catastrophic risk factor on the horizon for biofuels is the survivability of the EPA's RFS2. Most investors may be unaware that the EPA's power to regulate CO2, the very basis of the RFS2, isn't settled, and could be overturned by a single court hearing or landslide election. With the recent trend of stable temperatures for well over a decade and discovery that the Intergovernmental Panel on Climate Change or IPCC climate models have been effectively proven invalid and highly biased, it may be more difficult for the courts to uphold the scientific foundation of its original ruling reached before critical evidence existed to determine the validity of the conclusions reached by the climate "scientists." While ethanol economics are positive right now, most biofuels, wind and solar companies simply won't survive without government support.

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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.

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