Andeavor Wins A Hardship Waiver From The EPA

Summary

• The share price of refiner Andeavor jumped to a 2-month high following news that some of its refineries have been granted "hardship exemptions" from the national biofuels mandate.
• Subsequent media reports have stated that up to 25 refineries in the U.S. are expected to also be granted hardship waivers from their biofuel blending obligations.
• Blending credit prices collapsed to a 31-month low on the news despite the fact that the exemption has historically just shifted the obligation to non-exempted refineries.
• Yesterday's news that the White House is reviving collapsed mediation talks between biofuel producers and refiners suggests that the EPA's decision on Andeavor is a negotiating tactic.

The share price of refiner Andeavor (NYSE:ANDV) moved to a 2-month high this week (see figure) after Reuters reported that the U.S. Environmental Protection Agency [EPA] had released the company from needing to comply with some of the country's biofuel blending mandate. The move by the EPA is not entirely unprecedented, and the waiver only applies to the smallest three of the company's ten refineries, but the granting of the exemption on "hardship" grounds to a company that reported a net income of $1.5 billion last year has given rise to expectations that additional exemptions for other refineries will be forthcoming.

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Background

The revised Renewable Fuel Standard [RFS2] requires U.S. refiners to blend predetermined volumes of biofuels, primarily corn ethanol, with refined fuels prior to retail. Every gallon of qualifying ethanol that is blended generates a Renewable Identification Number [RIN] that is then either submitted to the EPA to demonstrate partial compliance with the mandate or, if sufficient RINs have already been submitted, sold to other refiners.

Many merchant refiners sold or spun-off their blending capacity during the logistics MLP creation spree at the beginning of the decade and have found themselves purchasing large volumes of RINs on the market to make up for the lack of RIN-generating activities. While this strategy had little impact when the price of the largest D6 category of RINs traded for mere pennies prior to 2013, it has increasingly made headlines as RINs have traded well above that level in every subsequent year.

Andeavor, which was formed after the company's previous iteration, Tesoro, purchased fellow merchant refiner Western Refining in 2016, has been no exception. As Tesoro the company reported total RIN expenditures of $125 million in 2014.

This amount surged to $366 million last year as additional refining capacity was acquired and its blending obligation increased (each refiner's individual blending obligation is in part a function of its market share), causing the company to record one of the largest annual expenditures among merchant refiners behind only Valero (VLO). While some expenditure increase was to be expected given the increase in Andeavor's refining capacity over the same period, the former has outpaced the latter.

A wave of exemptions?

Another major change in 2017 was the presence of a sympathetic ear in the form of current EPA administrator and noted RFS2 opponent Scott Pruitt. (The EPA oversees the implementation of the biofuels mandate.) Mr. Pruitt spent the second half of 2017 examining mechanisms for reducing refiners' RIN expenditures following the failure of former Trump administration adviser (and refinery owner) Carl Icahn to do the same earlier in the year.

The granting of the hardship waiver indicates that Mr. Pruitt has finally identified a strategy for doing so. This notion is further supported by yesterday's news from Platts that an additional 25 refineries will be receiving similar hardship exemptions. Likely awardees include other merchant refiners that reported large RIN expenditures in 2017 such as CVR Energy (CVI), Delek US Holdings (DK), PBF Energy (PBF), and Valero.

The positive impact for Andeavor is already being felt beyond the immediate scope of the company's three refineries that have been granted the exemption thus far. D6 RIN prices have been exceptionally volatile in 2018 to date in response to competing headlines about the prospects of various efforts to "reform" the mandate by national politicians (see figure). A 47% price rebound in late March was more than offset this week as the D6 RIN price fell to a 31-month low on the news of the mass exemptions for other refineries. Andeavor's expected RIN expenditure amount for 2018 has fallen in tandem.

Taken at face value, the EPA's decision to issue a hardship exemption to small refineries owned by Andeavor and other refiners is unusual for two reasons. First, the exemptions only apply to specific refineries' required blending volumes, not to the mandate as a whole. In other words, the exemptions simply shift the RIN obligations of the small refineries in question to the larger, non-exempted refiners.

As University of Illinois economics professor Scott Irwin was quick to point out on Twitter, there is no legal precedent for using the small refinery exemption to reduce the overall blending mandate volumes (which, in any case, have already been established for 2018).

So, Mr. Irwin asks, why are the larger, non-exempted refiners not pushing back against the exemption? After all, even with the mass exemptions for small refiners, legal precedent requires non-exempted refiners to just submit more RINs to the EPA than they would otherwise need to in response.

The second unusual aspect of the EPA's decision is its use during a time of robust refining margins. The devastation that Hurricane Harvey caused to the Gulf Coast in late August of last year prompted refining margins to surge, ultimately resulting in bumper earnings across the refining sector. Andeavor, for example, reported a net income of $1.5 billion and its second-strongest diluted EPS result in the last five years for 2017.

Merchant refiners, which have been the most vocal opponents of the RFS2 due to their collective lack of blending capacity (larger integrated firms are believed to in some cases generate surplus RINs that are sold into the market), saw their share prices rally strongly between August 2017 and January of this year on the back of the rising margins (see figure).

The smaller Icahn-owned CVR Refining (CVRR) even reinstated its dividend at a double-digit forward yield after several quarters of no payments due to the improving operating environment. Given that the exemption is intended to be used when the mandate causes "disproportionate economic hardship" to a small refinery, it is unprecedented to see it used in this manner.

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Unprecedented, perhaps, but not necessarily surprising given the political forces that are at work behind these sharp RIN price movements, which also provide a likely explanation for the lack of pushback from non-exempted refineries. President Donald Trump famously pledged his full support for ethanol blending under the mandate on the 2016 election campaign trail but then found his administration being pushed in the opposite direction by administration officials such as Mr. Icahn and Mr. Pruitt.

Mr. Trump has subsequently attempted to play the role of mediator between advocates for refineries, as represented by Mr. Pruitt and various Gulf Coast GOP senators, and those for biofuel producers, as represented by various Corn Belt GOP senators. Those talks appeared to have collapsed in early March as the mandate's opponents realized that they did not have the necessary level of political support to push a long-term compromise through Congress. Government officials told the media yesterday, however, that a new round of talks has been scheduled for next week.

My major takeaway from this week's developments is that the EPA's exemptions have been timed to bring the mandate's supporters back to the negotiating table. While the mandate's opponents cannot make permanent changes to the mandate without the involvement of Congress (as reaffirmed by a federal appellate court last summer), they can use executive branch powers to cause a great deal of temporary turmoil and uncertainty to it (as signaled by extremely volatile RIN prices) and thereby put pressure on the mandate's supporters.

The fact that D6 RINs are trading at 31-month lows (the prices of RINs for more advanced biofuels such as biodiesel are also trading at multi-year lows) indicates that the market believes that there is merit to this strategy. Whether it has enough merit to overcome the famed "Grassley Veto" (named for Iowa's senior senator and ardent supporter of the mandate Charles Grassley) remains to be seen. In the meantime, however, Andeavor's shareholders are not complaining about the company's reduced RIN expenditure expectations.

Analyst’s Disclosure: I/we 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.