Ethanol RIN Prices Up 2740% Year To Date

Includes: FUE, PEIX, REGI
by: Robert Wagner

(Editor's Note: This article includes a micro-cap stock. Please be aware of the risks associated with these stocks.)

Ethanol RINs are probably the best investment you've never heard of, and they are up over 2700% year to date. To be fair, they only started trading on the exchanges in mid-May 2013, but even since that time, they are up substantially. What is an ethanol RIN, you ask? An ethanol RIN is a regulatory tool used by the EPA to ensure a certain level of ethanol is produced to reach the Renewable Fuels Standards 2 (RFS2) quota. Each gallon of ethanol produced also generates 1 RIN that can be either sold with the ethanol or separated and sold on the exchange. To meet the regulatory requirements "obligated parties" such as blenders and refineries are required to purchase a certain number of RINs each year, depending upon the number gallons of conventional fossil fuels they sell. Each year the EPA boosts the quota of ethanol required, so each year it is more and more difficult to reach the quota, requiring more and more investment in the ethanol infrastructure. The RINs are an incentive to build out the ethanol capacity to reach the EPA quotas.

2013 started the year with ethanol RINs trading around $0.05. By the time they started actively trading on the exchanges -- symbol D62 on the CME/NYMEX in mid-May -- they were up to around $0.85. Currently ethanol RINs trade for over $1.40, listed as D6 RINs on this report from Progressive Fuels LLC. $0.05 to $1.42 in a little over 7 months is an annualized return of over 4,000%. I recently wrote about how nonsensical the Wincklevoss Twin's Bitcoin ETF idea was, but an ethanol RIN ETF/N has some real potential, and I would not be surprised to see one eventually come to market. Ethanol RINs make the Bitcoin look like amateur night at the financial bubble bar.

Ethanol Economic Basics:

Ethanol producers rely on something called a "crush spread." In simplified terms, it quantifies the decision of either selling corn or converting it to ethanol and its associated byproduct "distillers' dried grains," or DDG. If a producer can make more money selling the corn than they can the ethanol and DDG that they can convert it to, ethanol production would stop. If the producer can make more money selling ethanol and DDG than selling the corn, then they will produce ethanol and DDG. Much like the situation antique dealers face today when they have to decide to either sell antique silverware or melt it down for the silver content.

The "crush spread," however, isn't complete, and is at best a "ball-park" figure. The "crush spread" doesn't include fixed and other variable costs that may make up 30% of the cost of the ethanol, and it doesn't include the value of the ethanol RIN. Not including the RIN used to not matter much, as it traded between $0.05 and $0.01 much of the time, but since the start of 2013, the "crush spread" has failed to capture the true economics of ethanol production.

The recent collapse in corn prices should have driven the price of ethanol RINs down as ethanol production should have surged and along with it the production of ethanol RINs. However, that didn't happen because ethanol RINs don't exist in the free market, they exist in the world of EPA regulations. The problem with ethanol is that the EPA sets an aggressive quota for a fuel that nobody seems to want. The markets never demanded ethanol, the iron fisted EPA is attempting to force everyone to use it. The problem is the existing infrastructure isn't capable of handling the supply of ethanol. Fuel stations don't have the ethanol tanks, only select cars can use ethanol and many pipelines can't carry ethanol. Because of this, the EPA quota or "blendwall" far exceeds the demand. The result has been that ethanol prices have fallen due to the lack of demand relative to supply, and producers and blenders have chosen to use purchased or inventory RINs to meet their requirments.

Ethanol weakened against gasoline by the most in a week as refiners facing a decline in demand used certificates that allow them to meet U.S. targets without actually blending the biofuel.

The economics of EPA regulations also has a couple of other impacts. The increased quota should encourage "obligated parties" to attempt to sell more E85, which is 85% ethanol fuel verses the E10, which is only 10% ethanol. 1 gallon of E85 has 8.5x more ethanol than E10, so far fewer gallons need to be sold to meet the regulatory requirement. The problem is very few stations sell E85, and very few cars can use E85. Worst yet, many owners of cars that can use E85 don't even know they can, and even fewer actually use it.

Roughly 7 million cars on the road today can run on E85. If you were unaware, you're not alone. A recent GM study found that roughly 70 percent of its flex-fuel vehicle owners didn't know they could use E85, and fewer than 10 percent did so.

And why should they? It is hard to find.

On a national level, E85 is hardly widespread. The highest concentration of filling stations is in corn-growing states such as Illinois, Iowa and Minnesota. Overall, there are roughly 2,100 E85 stations across 44 states, according to the U.S. Department of Energy. Availability remains poorest in the South and the Northeast - where it's hard to produce ethanol locally.

And it gets awful gas mileage, is expensive and requires burning food when people in the world are starving. I won't even get into how farmers are plowing, planting, herbiciding, pesticiding and fertilizing previously preserved wetlands, forests and fields with diesel burning tractors and hauling it with diesel burning trucks to produce this "environmentally friendly" fuel. Brazil is burning down the rain forest to plant sugarcane to make ethanol for export to the US to capture the RINs.

At its current price per gallon, E85 doesn't save you money, and it might cost you more. As of August 2012, a gallon of E85 was approximately 11 percent less than the cost of a gallon of gasoline nationally, according to However, E85 produces 27 percent less energy per gallon than gasoline, so on average it ends up costing more.

For example, the flex-fuel 2010 Chevrolet Impala equipped with a 3.5-liter V-6 engine gets an EPA-estimated 18/29 mpg (city/highway) on gasoline and 14/21 mpg when burning E85. The acceleration is pretty much the same, but the car's range is shortened. In other words, you'll be filling the tank more often when using E85.

The Consequences:

One of my most vivid memories as a youth was watching milk farmers pouring their milk in the streets to protest some government policy that had resulted in the collapse of milk prices. Not much has changed since then, and apparently the central planning totalitarians that occupy the ivory towers that think this nonsense up have very short memories. The ethanol RIN system will likely result in a situation similar to what recently led European milk farmers to pour their milk in the streets.

Think that's crazy? Think my analysis is absurd? Think my free market bias clouds my judgment? The US EIA explains that these programs are designed to drive the cost of ethanol down in expectation that cheaper E85 will resort in more of it being sold.

The EIA also noted that higher ethanol RIN prices, which have averaged close to 70 cents per gallon over the previous two weeks, provide incentive for two changes in the market. First, the EIA said that higher RIN prices should lower the market price of E85 relative to E10, stimulating E85 sales.

The problem here is that "obligated parties" want the RINs, they don't want the ethanol. "Obligated" parties can avoid costly infrastructure upgrades by simply buying the RINs. If they simply buy the RINs to meet the regulatory requirements, the result is that ethanol is being produced, or more accurately over-produced, not because of demand for ethanol, but because "obligated parties" have an economic gun being held to their heads. That is a classic pour the milk in the streets government manufactured surplus.

The results should be obvious. The "obligated parties" are sure to complain, and they are. Ironically, even with a surplus of ethanol, gas prices are still going higher because of the cost of the RINs and other factors.

A leading U.S. oil executive urged legislators on Tuesday to relax a requirement to use renewable fuel in gasoline, blaming an "out of control" market in biofuel credits known as RINs for adding to fuel costs in a recent run-up in gasoline prices.

At a Senate Energy Committee hearing, lawmakers sought answers for why a surge in domestic crude oil production to the highest level in over two decades had failed to bring down fuel prices. Average U.S. gasoline rates jumped 15 cents over the past week to $3.64 a gallon on Monday, data showed.

Oil refiner Valero Energy Corp Chief Executive Bill Klesse said the government's renewable fuel mandate is affecting prices in the refined fuel market, repeating a long-standing source of aggravation for the energy industry.

Theoretically, to make E85 attractive to the consumer, it would need to be priced in the market at a level that:

1) Compensates for the lower mileage and energy content.

2) Compensates for the hassle of more frequent fill-ups and "range anxiety" associated with finding an E85 station.

3) Compensate the consumer for purchasing a new E85 vehicle.

While #2 and #3 are highly subjective and depends upon the individual's unique circumstances, #1 can be calculated.

Diesel fuel produces 128,450 BTUs/gal, gasoline 116,090 BTUs/gal and ethanol 76,330 BTUs/gal. Using current prices, the break even prices for ethanol are:

BTUs Multiplier Price Adj Ethanol Pre/Disc
ULSD 128,450 0.59 $ 3.07 $ 1.83 $ 0.70
Gas 116,090 0.66 $ 3.11 $ 2.04 $ 0.48
Ethanol 76,330 1.00 $ 2.53

To make ethanol priced in relative BTUs, it will have to fall another $0.70 to make it competitive with ultra low sulfur diesel (ULSD) and $0.48 to make it competitive with reformulated blendstock for oxygenated blending gasoline (RBOB). On an energy content basis, ethanol is worth about $2.00/gal or less. What that means is that to reach the goals set by the EPA, ethanol will most likely have to go lower by at least $0.48/gal, and that ignores the costs associated with #2 and #3 listed above.

The baseline assumes that use of these higher-level blends will only increase significantly if the consumer-level cost of these fuels is at a slight discount to conventional fuels, even after taking into account the lower energy value of ethanol-blended fuels.

What this means is that the ethanol market is likely going to defy some basic laws of economics. Lower ethanol prices will not result in lower ethanol production, the RINs will ensure profitability and production is maintained as ethanol prices fall. Regardless of whether or not consumers want ethanol, it will be produced. "Obligated parties" may simply buy RINs instead of ethanol and write off the cost instead of investing in the infrastructure needed for higher ethanol sales. This dynamic is likely to keep ethanol RIN prices high, and ethanol prices low, just as it is intended to.

One other economic consequence is that high ethanol RIN prices will encourage more blending of other biofuels. Other biofuels like biodiesel produce what are called D4 RINs, which are the most flexible version of RINs. D4 RINs can be used to satisfy D6 ethanol RIN requirements, but D6 RINs can't be used as a D4 RIN. What this should result in is much more stable pricing for D4 RINs. Before D4 RINs were highly volatile because of the relatively low EPA quota set for D4 applicable fuels. Once the quota was near being reached, D4 RIN prices would collapse. With the much larger D6 RIN market now being an option, the elasticity of the D4 RIN demand is much higher, and more resistant to price swings as new supply comes to market. It will also provide an incentive for D4 RIN producers to expand beyond the quota set by the EPA for their fuels, and compete for some of the much larger ethanol market share.

Second, ethanol RIN prices near the price of biodiesel RINs may motivate increased biodiesel blending.

What are the risks?

As with all these anti-market regulatory schemes, there are always the political risks. The RIN mechanism is only as secure as the next presidential political election. As I tried to highlight above, there are many reasons for the tax payers to resent these command and control iron fisted policies, especially when they result in higher, not lower costs for energy. One landslide election, and the RIN mechanism can be signed out of existence with a stroke of a pen.

In conclusion, while I'm not a big fan of the iron-fisted, counter-productive and anti-market EPA regulations, they do provide investment opportunities. The first investment opportunities would be the ethanol producers, but they must balance the benefits of falling corn and rising RIN prices with falling ethanol prices. Many ethanol companies like Pacific Ethanol (NASDAQ:PEIX) have failed to rally with the RINs since the start of the year. Biodiesel companies like Renewable Energy Group (NASDAQ:REGI), on the other hand, have benefited greatly with the increase in RIN prices, and have done well since the beginning of the year. Owners of ethanol RINs obviously have done the best since the beginning of the year, racking up a return of over 2,700% year to date. While they are currently only available on the futures markets, I would not be surprised to see an ETF/N based upon RINs created. The last investment opportunity would be a market neutral position pairing a short ethanol position with either a long RBOB or ULSD position. That would capture the widening of the spread, which is likely to occur if the EPA is successful in making ethanol a viable fuel source attractive to consumers.

Disclaimer: This article is not an investment recommendation. 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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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