Last week saw an interesting development in the ongoing policy debate between ethanol producers and merchant refiners when President Donald Trump told reporters that he might be willing to remove a federal restriction on the use of so-called E15 (ethanol blended with gasoline at a 15 vol% level) during the summer. As Reuters reports:
'We’re going to be going probably, probably to 15 and we’re going to be going to a 12-month period,' Trump told reporters during a White House meeting. 'We’re going to work out something during the transition period, which is not easy, very complicated.'
The share prices of ethanol producers jumped on the news, led by the recently-suffering Pacific Ethanol (PEIX). The prices of Green Plains, Inc. (GPRE), REX American Resources (REX), and diversified ag company Archer Daniels Midland (ADM) also climbed, albeit by not as much. The news was a welcome change of pace for investors given that the industry's production outlook has deteriorated substantially in 2018 to date in response to America's expanding trade war with China, continued wet and cold weather across much of the Corn Belt even as planting season begins, and policy uncertainty regarding the future of the revised Renewable Fuel Standard [RFS2] biofuels mandate.
Mr. Trump's announcement was unexpected given that a decision to allow the blending of E15 year-round had previously been offered to ethanol producers as part of a broader negotiation on the RFS2 rather than as a standalone policy decision. The earlier news that the Trump administration has put the effort to find a compromise "on ice" for the next few months had led to an expectation that the E15 proposal had also been shelved. The fact that it has not explains why Mr. Trump's comments caused ethanol producers' share prices to move higher.
Earlier this decade, the U.S. Environmental Protection Agency [EPA], which both regulates vehicle tailpipe emissions and administers the blending mandate, began allowing E15 ethanol blends after making a determination that vehicles manufactured after 2001 could consume it without problem. (Before that decision E10 had been the maximum blend allowed in non-flex fuel vehicles.) The EPA limited E15's use during the summer driving season due to concerns over the potential for smog formation during hotter days, however, to the chagrin of ethanol producers.
Those producers have lobbied the EPA to allow the use of E15 year-round for the last several years without success. The Trump administration, which is caught between mutually-incompatible campaign pledges to maximize ethanol blending while alleviating the burden that the RFS2 imposes on petroleum refiners, saw E15 as an important bargaining chip. This led to a proposal last month to allow year-round E15 blending in exchange for the imposition of a cap on Renewable Identification Number [RIN] prices, which are the compliance credits that merchant refiners purchase in large volumes to demonstrate their compliance with the mandate. The ethanol industry's advocates rejected the proposal, however, and the waiver of E15 consumption restrictions fell by the wayside until last week.
The immediate reaction in the media was that the ethanol industry's gain was the merchant refining sector's loss. The share prices of merchant refiners that have incurred some of the largest reported RIN expenditures in the past such as Andeavor (ANDV), CVR Refining (CVRR), Delek US Holdings (DK), Marathon Petroleum (MPC), and PBF Energy (PBF) did move lower at first after Mr. Trump made his comments. In all cases, the share prices recovered most or even all (plus some more) of their gains, though, even as the share prices of ethanol producers also moved higher.
There are a couple of possible explanations for this market discrepancy. The first is that while the removal of restrictions on E15 availability is a net positive for ethanol producers inasmuch as it results in higher ethanol demand, it could also be positive (albeit to a lesser extent) for merchant refiners. It is true that the move could, in theory at least, be detrimental to the size of merchant refiners' market. Ethanol displaces gasoline consumption and roughly 15 billion gallons of ethanol is consumed in the U.S. annually (compared to approximately 144 billion gallons of gasoline). The vast majority of this ethanol is consumed as E10, so increasing the blend to E15 could cause ethanol consumption to increase (and gasoline consumption to decrease) by another 7.5 billion gallons per year.
The actual impact of any waiver of its E15 restrictions by the EPA would almost certainly be very muted in comparison. The actual adoption of E15 in the seven years since its use was first approved by the EPA has been quite low: in early 2016, there existed more than 10x the number of stations offering E85 as there were offering E15 despite the fact that the former (unlike the latter) can only be used in specially-modified vehicles. Last January actually saw a push to increase the permitted blend in unmodified vehicles to E30 because E15 adoption has been too slow to result in ethanol demand growth. So while ethanol share prices have moved higher due to the potential for demand growth if Mr. Trump moves forward with the E15 waiver, it is unlikely that refiners would experience much of a dent to gasoline demand in response.
The second possible explanation is that increasing the volume of ethanol that can legally be blended with gasoline for use in unmodified vehicles would increase the availability of RINs. Each RIN is created when a corresponding gallon of biofuel is produced, but it remains attached to that gallon until the biofuel is blended with a refined fuel for retail. This separated RIN is what merchant refiners have been buying in very large quantities over the last several years. RIN prices moved sharply higher in early 2013 when the EPA set the mandated volume of biofuel blending at a level that was greater than 10 vol% of gasoline consumption for the first time (see figure), leading to concerns that high RIN prices were a sign of a RIN shortage resulting from the mandated supply of ethanol being set at a point that was higher than U.S. drivers were willing and able to consume. Put another way, if blenders were unable to sell some of the E10 that they produced, then they would charge a premium for the resulting separated RINs to cover their losses. Merchant refiners would in turn have to purchase these RINs at any price in order to meet their share of the national mandate.
Source: EcoEngineers (2018).
If removing the restrictions on E15 consumption during the summer driving season results in increased E15 availability and sales, then the supply of RINs can be expected to increase as well, relieving pressure on the RIN price since annual demand is fixed by statute. Sure enough, the weighted RIN price across all four RIN categories declined by 10% after Mr. Trump raised the possibility of year-round E15 availability.
It remains to be seen if the Trump administration will actually take the steps necessary to make E15 available all year without requiring a concession from ethanol producers on the RFS2 in exchange. My guess is that Mr. Trump realizes that ethanol producers are likely to feel disproportionately negative impacts from the tariffs on U.S. goods (including ethanol) that China's government is proposing to implement and that the E15 waiver is intended to smooth the industry's ruffled feathers. Investors should not read too much into the consequences of a waiver on either ethanol producers or merchant refiners, however, for the reasons outlined above.
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.