Last July I wrote a Seeking Alpha article titled "Corn Ethanol Producers Enter A Perfect Storm" that detailed the current poor economic environment corn ethanol producers have found their industry mired in. While numerous factors have contributed to this situation, the most significant is that corn ethanol producers have exceeded the mandated volume of corn ethanol production established by the revised Renewable Fuel Standard [RFS2]. The core values of Renewable Identification Numbers [RIN], which are the tradable compliance commodities used by the RFS2 to incentivize biofuel production, lose value when production meets the mandated volume for a given year; i.e., RINs only have value when they are needed to encourage enough production to meet the mandate. (For more information on how RIN core values are determined, please see my previous article on the subject.) The corn ethanol industry had the misfortune to experience a major increase in feedstock costs (i.e., corn prices) at the same time that RIN values for corn ethanol fell to nearly zero due to the mandate being met, causing profits to quickly disappear.
Just a few months later the soybean biodiesel industry is finding itself in a very similar situation. The price of soybeans, which is the primary biodiesel feedstock in the U.S., has doubled since 2008 and steadily increased since January 2012 (see figure). Normally this magnitude of increase in feedstock cost would cause RIN values to increase as well. RIN values for biomass-based diesel (which covers both biodiesel and renewable diesel) have plummeted over the last year, however, falling from a high of $2 to $0.51 at the time of writing. Most biodiesel receives 1.5 RIN credits per gallon produced, so this fall represents a decline in product value of $2.24/gallon for biodiesel producers.
US Soybean Farm Price Received data by YCharts
There are a couple of explanations for the fall in RIN values. The first is the revelation over the last year that tens of millions of dollars worth of fraudulent RINs were sold that weren't linked to biodiesel production. The EPA's response has been to toughen its regulations on RIN trades, while obligated blenders have started to exercised more discretion in RIN purchases. These moves have decreased RIN demand and, by extension, RIN values.
More importantly, U.S. biodiesel production soared from 25 million gallons per month to more than 100 million gallons per month in 2011 (see figure). Even though monthly production has tapered off a bit in 2012, it is still on track to reach the annual mandated volume of 1000 million gallons per year [MGY] sometime in November. 94% of biomass-based diesel production is in the form of biodiesel, with the remainder coming from renewable diesel producers. RIN values have fallen in response to this production boom as it has become clear that the 2012 biomass-based diesel mandate will be met before the end of the year. As a reminder, core RIN values are a flexible subsidy in that they are only high enough to incentivize sufficient production under the mandate and no more, so as to prevent the type of taxpayer-financed windfall profits that the corn ethanol industry earned under fixed subsidies such as the VEETC (the so-called "ethanol blenders' credit"). When the mandate is being met ahead of schedule RIN values can be expected to fall to the level necessary for it to be met on schedule.
US Biodiesel Production data by YCharts
While this practical demonstration of the RIN's self-correction mechanism is good news for the transportation fuel consumers who ultimately absorb the cost of the RINs, biodiesel producers are now struggling. Renewable Energy Group (REGI), which is the largest biodiesel producer in the U.S. (and the only publicly-traded dedicated U.S. biodiesel producer, as far as I'm aware), acknowledged the fall in RIN values earlier this month when it revised it's previous Q3 guidance of $10-15 million in quarterly profits down to losses of $2-7 million. Its stock price, which had spiked in September following the EPA's decision to increase the RFS2's biomass-based diesel mandate by nearly 30% in 2013, fell sharply on the revision news (see figure). Not surprisingly, biodiesel facility shutdowns have not been far behind.
REGI data by YCharts
The good news for biodiesel producers is that the EPA has set the mandated biomass-based diesel volume for 2013 at 1280 MGY so, other things being equal (specifically the price of retail diesel fuel), RIN values will need to increase at some point in the next year to incentivize the increased production needed to meet the 2013 mandate. While some of this increase will likely be met by renewable diesel production, which will introduce roughly 300 MGY in new capacity by 2014 and receives 13% more RINs per gallon than biodiesel, biodiesel producers will still be responsible for meeting the vast majority of the mandate.
That said, RIN values are unlikely to return to the heady levels seen in 2011 anytime soon for a couple of reasons. The biomass-based diesel industry is currently on track to produce 1197 MGY in 2012 (although this number will undoubtedly fall if more facility shutdowns occur). RIN values won't need to increase by much to incentivize the additional 100 MGY in mandated production in 2013. Second, the EIA reports that the U.S. biodiesel industry has 2100 MGY in operable capacity [pdf] at present. In other words, the industry has been operating at less than 50% capacity. While this capacity has remained relatively unchanged since early 2010, it does suggest that RIN values will not need to increase by much to meet the 2013 mandate; less value is needed to incentivize the use of existing capacity than to incentivize the construction of new capacity, for example.
With that said, two wild cards should be mentioned because of their potential long-term impacts on biodiesel producers. First, the biodiesel industry is pressuring Congress to reinstate the biodiesel blenders' tax credit (worth $1 per gallon of biodiesel blended with petroleum-based diesel fuel), which expired at the end of 2011. Such a reinstatement would have the effect of creating a subsidy floor for biodiesel producers of $1/gallon, while RINs could still operate to increase the total subsidy received further. I consider this to be rather unlikely due to the current political environment in Washington DC, however; Congress will have enough on its plate trying to avoid the fiscal cliff due at year's end without also reintroducing an unpopular subsidy program.
The second wild card is that the EPA has the responsibility of establishing future volumes under the biomass-based diesel mandate; unlike the other category volumes, which were established by Congress, those for biomass-based diesel were left blank through 2023 (although they cannot be lower than 1000 MGY). Were the EPA to revise the mandate drastically higher in 2014 (to, say, 2000 MGY), then I would fully expect to see the sort of increase in RIN value that was seen in 2011, when the mandate required production to increase from 300 MGY to 1000 MGY. This seems unlikely due to public concerns over food versus fuel and indirect land-use change, but it's possible.
Several parallels exist between the corn ethanol and soybean biodiesel industries at present. Both are expected to exceed the volumes of their respective mandates in 2012, and both will be able to meet their 2013 mandates with relatively small increases in current production. RIN values for both biofuel categories are relatively low (and have fallen sharply for the biomass-based diesel category) despite substantial increases in feedstock costs over the last year. This new operating environment has placed substantial pressure on margins in both industries, which have witnessed facility shutdowns in recent months in response. Finally, the biodiesel industry is currently operating at only half of its operable capacity, so RIN values will not need to increase by as much to incentivize the increase in production required by the 2013 mandate as they would if new capacity was necessary.
Two wild cards that investors in companies such as REGI should be aware of are the possible reinstatement of the biodiesel blenders' credit, and the "blank slate" nature of the biomass-based diesel mandate's future volumes. The former scenario would have the effect of giving biodiesel producers a minimum subsidy of $1/gallon while still allowing them to benefit from any increase in RIN values, and the latter scenario leaves open the possibility of a drastic increase in RIN values resulting from the EPA mandating much higher biomass-based diesel volumes in future. While neither of these events is likely, the positive impact that they both would have on the profitability of biodiesel production makes them worth watching.