Refiners: Acquire Renewable Energy Group To Turn RIN Lemons Into Lemonade

Summary

• Refiners face a regulatory gauntlet, and RINs have become their highest operating expense.
• Refiners that make ethanol can be trapped - knee deep in a river of RINs and dying of thirst.
• Unlike ethanol producers, biodiesel producers have an ability to separate and control RINs.
• REGI creates enough RINs to satisfy the obligation of many refiners.
• The company is currently trading at less than 50% of its replacement value.

Introduction

The petroleum industry is faced with a gauntlet of compliance that grows more burdensome every year. It shouldn't surprise us when we see the petroleum industry fight regulation - it is a learned behavior from years of harsh treatment. If we were forced to walk a mile in their sandals, we would understand. Meanwhile, we enjoy the freedom of driving our cars 15,000 miles a year while we pay less for gasoline than we pay for milk.

Gauntlet (defined) - a form of punishment when someone is forced to run between two rows of people who are armed with sticks which they use to strike out at the runner

The pinnacle of a refiner's regulatory burden is found in the Renewable Fuel Standard ("RFS"). To the refining industry, the RFS is burdensome in its scope, its reach, its complexity, its deficiencies in fraud protection, and perhaps most painful, its financial costs. We won't outline the RFS in detail here, because it is quite complicated (and boring) and we don't want to lose our audience. There are plenty of sources (including the EPA) which provide a good overview of the RFS and how Renewable Identification Numbers ("RINs") work to satisfy regulatory compliance.

Please don't misunderstand, we fully support the RFS vision to promote growth in renewable fuel consumption. The RFS regulation has improved in many ways over the years, and we anticipate that the EPA will continue to tweak the system to make it more transparent, fair and effective. Moreover, we have spent the last decade launching, promoting and growing a renewable fuel business. We believe that renewable fuels are good for the environment, the economy, and for energy security. We also believe that the RFS - whether modified or not - is here to stay. Jeff Stevens, CEO of Western Refining (WNR), agrees. In his most recent quarterly update, he said, "we've come to the conclusion that [the RFS] is probably here to stay for a while... so we've continued to focus on retail and wholesale assets essentially controlling the RIN and the RIN expense..."

Some refiners have taken steps to expand blending operations to cover their RIN obligation, but that approach is not always practical or possible for others. Other refiners have decided to fight the RFS tooth and nail, and we anticipate that this battle will continue. Quoting the GEICO commercial - "it's what they do." Nevertheless, it is pragmatic for refiners to take steps that enable it to survive and thrive with or without a modified RFS. The RFS has given the refiners a lot of lemons. The time has come to make lemonade.

Valero's Ethanol Trap

By owning and operating numerous ethanol plants, Valero (NYSE:VLO) is unique from many other refiners. One might think that ethanol plant ownership helps VLO to more easily satisfy its RIN obligations, but that is not the case. Unless a refiner connects significant blending operations to its ethanol production, it might find itself knee deep in a river of ethanol RINs and dying of thirst. Allow us to describe the general flow of ethanol and RINs using VLO as an example.

A VLO plant produces ethanol and the ethanol gallons are sold with RINs, eventually arriving at a blending terminal. The terminal separates the RIN (an electronic number) from the ethanol when it is blended with gasoline. The blending terminal now controls the RIN as a financial asset, which it sells to the highest bidder. Here is the issue in a nutshell: VLO loses control of the ethanol RIN when the ethanol is sold. The blender captures the lion's share of the RIN value simply by controlling the blending infrastructure.

This is a reason why VLO is leading the fight to modify some of the RFS rules. Even though VLO generates considerable RINs through ethanol production, it does not have enough physical infrastructure to blend all of it. As a result, VLO continues to sell ethanol with RINs, and then must cover its obligation by purchasing paper RINs from the market. In today's market, VLO might lose $0.90 per gallon of ethanol because of this disconnect. Not surprisingly, refiners are divided on RFS reform based upon whether or not they control blending operations. Due to competing interests on a complicated topic, this issue is not likely to be resolved quickly.

For other refiners, like CVR Refining (CVRR), an expansion into blending infrastructure is impractical. Refiners like this have only one option: purchase RINs from blenders, brokers, and Wall Street aggregators. CVRR and others allege that the RIN market can be rigged, and say that independent refiners are caught in the "mother of all short squeezes."

Ethanol production has not been the physical RIN hedge that Valero and others had hoped it might become. And it is impractical and impossible for all refiners to own significant blending operations. Fortunately, refiners have another option to create RINs: biodiesel production.

Biodiesel Producers Can Generate and Retain RINs

Unlike ethanol, the biodiesel market has evolved in ways that enable the biodiesel producer to retain possession of the RIN. In VLO's case, its joint venture with Darling Ingredients (DAR) enables it to control 100% of the RINs from its 50% ownership of the largest biomass-based diesel plant in the country. While we do not know the specifics of VLO's commercial contracts, we believe that the company is able to separate and control the RINs from Diamond Green Diesel. Some or all of VLO's "renewable diesel" moves through pipelines - another topic for another day.

Beyond VLO's situation, there is significant demand for what is called "RIN-less B99" in the diesel market. RIN-less B99 can be bought and sold at a blending terminal, usually at a discount to regular diesel. The blender makes a margin by purchasing RIN-less B99 at a price discounted to diesel, for example $0.20 per gallon. In this transaction, the blender makes a guaranteed margin, and very importantly, the seller of biodiesel separates and maintains possession of the RIN.

By selling RIN-less B99, the biodiesel producer legitimately and lawfully retains the RIN as an asset, which it can sell directly to the refiners (the obligated parties) or RIN aggregators. To make a practical observation: biodiesel producers often carry RIN inventory - ethanol producers do not. Biodiesel producers therefore have more control over their RINs than ethanol producers. If a biodiesel producer were owned by a petroleum refiner, then the value of the separated RIN can be transferred from one internal entity to another. In this way, the value of these RINs would not be shared with any blender, broker or speculator, and would not be subject to price manipulation.

In addition, a petroleum refiner who owned a biodiesel production can capture the full value of biodiesel RINs - even if it does not have the physical infrastructure for blending. This is a significant advantage, particularly in comparison to ethanol.

For RIN compliance and other purposes, biodiesel offers additional benefits:

• Biodiesel fuel can be assigned RINs of many different categories. Biomass-based diesel can create a D4 (biodiesel), D5 (advanced biofuel), and even a D6 (conventional - ethanol) RIN. This results in significant compliance optionality.
• Biodiesel (D4) RINs sell at a premium to ethanol (D6) RINs.
• If a refiner had a surplus of biodiesel RINs and a deficit of ethanol RINs, they could simply swap a biodiesel RIN for an ethanol RIN, and receive the economic premium for the swap, which today is about $0.10/RIN.
• Biodiesel creates 1.5 RINs per gallon, and renewable diesel creates 1.7 RINs per gallon. With current biodiesel RIN values of $1/RIN, the RINs are worth $1.50/gal and $1.70/gal.
• The public is generally in favor of biodiesel, and is generally suspicious of corn-based ethanol.

REGI - A Strategic Acquisition?

Renewable Energy Group (REGI) has consistently grown its biodiesel production capacity, and now accounts for nearly 30% of the U.S. biodiesel market. REGI recently gave guidance for 160 million gallons of product sales in 2016 Q3, which equates to an annual volume of 640 million gallons. Of this amount, REGI currently has 452 million gallons of production capacity under its control. Therefore, assuming 1.5 RINs/gallon, REGI controls 675 million RINs of production and roughly 960 million RINs in annual sales. Petroleum refiners don't like to think small, and REGI presents a refiner with its only opportunity to quickly acquire significant U.S. biodiesel and RIN production capacity.

The table below estimates total RIN compliance for several independent refiners, including: Delek (DK), CVRR, Alon USA (ALJ), WNR, Tesoro (TSO), and PBF Energy (PBF). The RFS obligates each refiner to meet compliance for a variety of categories, but the general high-level obligation is currently 10.1% of a refiner's total production. CVRR, with approximately 190,000 barrel per day refining capacity, has an annual obligation to purchase 290 million RINs to satisfy its obligations.

We don't know how much of REGI's 675 million gallons of biodiesel (and 960 million RINs) is currently sold in way that enables it to retain the RIN, and it is likely that it does not maximize this opportunity. But if REGI can separate and control 40% of its total RIN production, then it would control enough RINs to cover the annual RIN Obligation of at least four refiners. Since REGI controls 30% of U.S. biodiesel production, it would be in a unique position to negotiate commercial terms with its buyers and increase the amount of RIN-less B99 that it sells.

Apart from any RIN compliance or other synergies, we consider REGI to be a deep value opportunity. We recently wrote an article about REGI, which can be seen on this link. We have included an updated graph below, which shows the past and forecast gross margins from biodiesel production, and expand upon some valuation ideas below.

REGI has the flexibility to make biodiesel and renewable diesel from a variety of fats and oils. It makes the majority of its bio-mass based diesel from rendered fats, used cooking oil, and distiller's corn oil from ethanol plants. The graph above shows past and forecast production margins for three of REGI's most prominent options. Production margins have risen considerably, and they are forecast to be near $0.70/gal for used cooking oil biodiesel (the red line) for the rest of 2016. Corn oil biodiesel has the best carbon scores, and therefore is most valuable when sold into the California market with LCFS credits. REGI's production margins of corn oil LCFS biodiesel are likely above $1.25/gal (the blue line). Lastly, renewable diesel made at REG-Geismar may have production margins over $1.25/gal as well (the black line). For those who think in terms of $/bbl, these gross margins (inclusive of variable costs) are in the range of $30/bbl to $50/bbl. These are very healthy crack spreads.

Based upon these forecast margins, REGI has provided guidance for Q3 adjusted EBITDA in the range of $30 million to $45 million. We believe that REGI will come in at the high end of this range for each of the next two quarters. As such, we forecast that REGI will have trailing 12-month EBITDA in the range of $110 million at the end of 2016.

At a share price of $8.75, REGI has a market capitalization near $340 million. After REGI pays off its GOZone bonds (which it said it would this quarter), we estimate that it will have $220 million in long-term debt obligations. By the end of 2016, we forecast that REGI will grow its cash and equivalents to roughly $140 million. As a result, our end of 2016 forecast for Enterprise Value is $420 million ($340 million equity + $220 million debt - $140 million cash) - assuming current share prices.

This results in an REGI EV/EBITDA ratio equal to 3.8 ($420 million/$110 million). In addition, this results in REGI being valued at only $0.93/gal of production capacity ($420 million/452 million gals). This is well below the $2.0/gal required to replace its biodiesel production fleet (and the $2.0/gal does not include any of REGI's investments in distribution, or in its partially completed plants). Therefore, REGI is currently trading at much less than half of its asset replacement value. This is the least expensive that REGI has ever been on the $/gal enterprise value metric.

With REGI priced at less than 50% of its replacement value, it would be a less expensive for a refiner to acquire a stake in REGI than to build new biodiesel facilities. REGI's low valuation metrics suggest that the market does not assign much, if any, value for REGI's Life Sciences group, which has an interesting joint R&D program with Exxon Mobil (XOM), along with expected commercial sales of its first product before the end of 2016. If REGI were to spin off its Life Sciences group, it would save roughly $15mm in cash expenses, which would bring the trailing EBITDA forecast to $125 million, and its EV/EBITDA ratio to only 3.4.

Refiner Perspective

CVRR recently informed the public that it expects to pay nearly $230 million for its 2016 RIN compliance, its highest operating expense category. At the end of the year, what will CVRR have to show for this expense? Wouldn't it be better to invest the $230 million into an acquisition that produces RINs indefinitely? What might be CVRR's RIN expense for 2017 and beyond? Should it leave that up to the speculators?

REGI's current market capitalization is $340 million; therefore, a controlling interest could be acquired for $170 million. REGI has the potential to control 960 million RINs, roughly 3X the estimated RIN obligation of DK, CVRR, ALJ, and WNR. Might it be preferable for these refiners to be "long" RINs, rather than "short" RINs?

Lastly, a petroleum refiner might obtain intangible and promotional value from acquiring a biodiesel producer. This intangible value might be maximized if the acquiring executives could say the phrase "anthropic climate change" with a straight face.

REGI Technical Update

REGI continues to trade in a downtrend that began in 2013, the last time it had healthy gross margins (as it does today). The stock has traded for the last few days near its 200-day moving average and a short-term support line. The most recent NASDAQ report shows that 24.6% of REGI's shares have been sold short. Who knows, maybe we will see another "mother of all short squeezes" soon.

Source: Trading View

Summary

Refiners have a sour taste in their mouth from being force-fed the RFS and other burdensome regulations. Some refiners have acquired ethanol production facilities, only to discover that the RFS rules leave them knee deep in a river of RINs and dying of thirst. Other refiners have built and/or acquired blending infrastructure to reduce compliance costs and/or benefit from the RFS rules. Other refiners have taken the approach of fighting the law while continuing to pay increasing RIN compliance costs.

Unlike ethanol producers, biodiesel producers have an ability to separate and control the RINs that they create. An acquisition of REGI is a refiner's best opportunity to acquire significant U.S. biodiesel and RIN production capacity. In doing so, petroleum refiners can create a physical hedge for RINs, and insulate themselves from RIN price speculation and volatility.

REGI's stock is trading at levels that do not recognize its potential or even its replacement value. A controlling stake in REGI would cost $170 million, with potential to control 960 million RINs indefinitely. Meanwhile, a refiner such as CVRR is paying $230 million in 2016 RIN expense for its 290 million RIN obligation. An intrepid refiner might view an REGI acquisition as a unique opportunity to make lemonade from lemons.

For more information, please contact us at [e-mail].

Analyst’s Disclosure: I am/we are long REGI. 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.

Comments

[gpaone2000]

goat21, typically I would agree, however at their market cap you get the whole kit and caboodle.

[goat21]

Oil refiners tend to by biofuel facilities and not companies.

[7519671]

A brilliant, brilliant, brilliant untangling of a Gordian knot.

[Viking Analytics]

I am truly humbled. Soli deo gloria.

[Viking Analytics]

Excellent article here by OPIS shows how the RIN battle pits refiner vs. refiner: http://bit.ly/2c3qlew. The RFS rules will not be resolved quickly, and that's why the refiners who are short really should make contingency plans.

Let's assume that REGI can find a way to separate and control 50% of its annual 960 million RINs over a 5-year horizon. That would result in 960 * 50% * 5 = 2.4 Billion RINs. Current REGI market cap is just under $350 million, so a controlling interest would cost $175 million. That would mean a control stake - if REGI simply breaks even for five years - would be the equivalent of paying $0.07/RIN ($175 million / 2,400 million). We estimate that CVRR will pay $0.79/RIN in 2016 ($230 million / 290 million). In other words, and acquisition of REGI would enable CVRR to reduce its RIN costs by more than 10X.

With a continuing glut of crude oil, resulting in the lowest petroleum crack spreads that we have seen in years, the refiners need all of the margin that they can find.

REGI was up 2% on 2X average volume yesterday (August 30th), while the oil market sold off 3.5% and S&P declined.

[Tongariro Capital]

Nice article. Well written. Thanks

[BigtimeSTAN]

Also, refiners could effectively manage this problem by buying up these credits when they are cheap and holding them rather than purchasing them on a as need basis. The cost of RIN go through cycles just like prices in any commodity environment - It's not to say that it is uncontrollable to manage these costs throughout different market environments.

[BigtimeSTAN]

REGI doesn't exactly have the greatest history of managing their capital and their debt load has increased a good amount over the past several quarters - is it worth buying and assuming their debt where they already have trouble managing their own capital and creating a steady reliable stream of cash flow from operations?? If you buy it solely on the idea of getting RIN credits, you're not making the right decision for long-term business. There are other ways to get around this other than buying a low quality business that really would not be so accretive to their business if say there were changes in the regulatory environment - not worth the risk

[gpaone2000]

I've long thought the same as the author, however I could not articulate this as well as he has.
With a democratic wh (most likely) I don't see the RIN's and BTC going anywhere fast, in fact there may be more. To bet against an outright dissolution is foolhardy. If your long at a reasonable price I would hang in there for awhile. The authors case is quite compelling.

[Viking Analytics]

Thanks for the feedback! It is a complicated topic, and am glad that you took the time to read more than just the headline. I have worked in biofuels for a decade, and even so, these ideas took some time to formulate. Yes, a refiner that chooses to fight for dissolution without contingency planning reminds me of the definition of insanity: "doing the same things and expecting different results."

[darnoc111]

Seems like the government has made a rigged system (crony capitalism), that when you get down to the bottom line the consumer will lose since indirectly since they will have to pay for these RINs.

[Viking Analytics]

I completely agree that we unfortunately have a system of crony capitalism, and wish that it weren't so. Unfortunately for the refiners and their shareholders, they are uniquely bearing the cost of the RINs at the moment, not the consumer.

[datapoint]

Yes. It will be a huge win-win for the Big Oil to spend $800m (about $20 a share) to buy REGI for great PR and RIN benefits.

[Viking Analytics]

$170 million for a controlling interest of 960 million annual RIN potential does seem like a better use of cash than $230 million for a one-time 290 million RIN obligation, doesn't it? Even if REGI stock price doubles (resulting in $340 million for a controlling interest), it seems quite compelling. Thanks for the feedback.

[Zetetic Alpha]

Only makes sense if acquiring company thinks that RINs/blenders tax credit are here to stay as a long-term policy. REGI stock overachieving is dependent on subsidies that are only granted grudgingly by congress. If we had a five-year comprehensive EPA plan for renewables then the industry could be smarter about capital allocation.

Think XON is most likely candidate for a takeout apart from RINs -- if they were to act soon they could get REGI at a considerable book discount and it would be peanuts for them - carefully managed PR benefit alone would be worth the purchase price and the deal would be quickly cash positive.

[Viking Analytics]

ZA - I agree that there is policy risk; however, I would see an acquiring refiner as having less policy risk than a non-strategic investor. As it is now, they would be removing current policy risk on RINs. I don't see the tax extenders bill as "grudgingly granted by congress." Since it always has special loopholes for everyone on both sides of the aisle, it is always a crowd pleaser. I am not approving the system of special interest lobbyists controlling legislation, but it is what it is. Again, my message is for a refiner to make "lemonade out of lemons."

I assume that you meant XOM, since XON is a biotech company that, among other things, is creating genetically-engineered frankenstein mosquitos to kill zika virus carrying mosquitos. What could possibly go wrong?? An interesting thing about XON is that it is working with DAR on ways to create proteins out of rendered byproducts using the black soldier fly. XON has a market cap of $3 Billion, with negative cash flow. Maybe it could issue more fiat shares to acquire REG Life Sciences in a spin off.

XOM is running this commercial over and over on CNBC that touts all of the good things they are doing in the world, including "algae into biofuels." I believe XOM's R&D commitment to algae biofuels is greater than REG's market cap. Algal lipids are being produced now at commercial scale by others, with a commercial price near $500 per gallon (250X more than the price of diesel). Those are the "healthy omega 3 fats" that you can get in Horizon organic milk. It will never be profitable to turn algal oil into biofuels, but I don't expect anyone to stop talking about it. Unlike algal biofuels, XOM could get real accretive cashflow from an acquisition of REGI, but maybe they think they have all the positive spin PR that they need.

[Zetetic Alpha]

Yes, XOM, thank you for being gracious on that slip.

That was sloppy of me. The Mobile merger happened a while ago....

[Viking Analytics]

It turned out to be a relevant malaprop. No worries!

[robgra]

RIN system needs to be abolished.

[lalex]

Agreed. Author makes a case for someone to acquire REGI, while they are long in it. Just get rid of the overburden process, which was intended to conserve oil/gas....we're awash in it now.

[Viking Analytics]

Whatever one's opinion on environmental and RFS policy, the fact is that some form of the RFS is most likely here to stay. WNR (a refiner/blender) and CVRR (refiner only) agree on this. The refiners - for better or for worse - are stuck with the obligation. I am just proposing a solution for one of them to turn a difficult situation into something favorable. The "system needs to be abolished" strategy has not yet worked.