The U.S. Environmental Protection Agency's [EPA] long-awaited proposed Renewable Volume Obligations [RVO] were released this week and, despite a number of leaks in the run-up, the announcement still managed to surprise. The overall blending volumes were in-line with those that were released last month, with the major exception of the biomass-based diesel category. As I have discussed in previous articles, though, the nominal volumes are just that: nominal. The more important item to watch was the EPA's decision on "reallocation," and the agency's proposal was very decisive on that topic.
Reallocation is important because of the EPA's habit under Administrator Scott Pruitt of handing out a large volume of so-called "hardship waivers" to refiners. Normally, refiners are required to blend specific volumes of biofuels with their refined products prior to retail every year. In the absence of such blending, these refiners must meet their obligation by instead purchasing Renewable Identification Numbers [RIN], as the biofuel mandate's tradable blending credits are known. Recipients of the waivers have their annual obligation partially or entirely reduced for a given year.
While the EPA has had the ability to distribute hardship waivers since the mandate was created, under Mr. Pruitt's leadership, the agency awarded an unprecedented number of them. More controversially, many of the recipient refineries received the "hardship" waivers even as they reported very large quarterly profits in 2017 and 2018. While this practice prompted outrage from ethanol producers and Corn Belt politicians, it was not entirely unexpected. Mr. Pruitt had been personally vetted by refinery owner and then-Trump administration official Carl Icahn for the top EPA spot and, following the breakdown of a President Trump-mediated compromise between refiners and biofuel producers, Mr. Pruitt had few options left for reducing refiners' blending obligations.
On their own, the waivers only reduce the recipient refiner's blending obligation but leave the national blending volume unchanged. This is because Congress, when it created the mandate, intended for it to be a "market forcing" mechanism that would cause fossil fuels to be displaced by biofuels for the purposes of energy and environmental security. (The creating legislation was even named the "Energy Independence and Security Act", and it was the first to tie explicit carbon footprint reduction thresholds to biofuels consumption.) According to conventional legal wisdom, then, the expectation has been that while some individual refiners would have their blending requirements reduced by the waivers, the reduction would be offset by a corresponding increase for all of the refiners not receiving waivers so that the total volume remained unaffected by the waivers.
Mr. Pruitt apparently does not feel beholden to this conventional wisdom. In calculating the percentage of total fossil transportation fuels that must be displaced by biofuels in 2019, the EPA included no increase to the total volume to offset the total volume that has been waived (see last two rows in below figure). This means that every gallon that is waived by the EPA for an individual refinery causes the total blending volume to be reduced by an equal amount.
Source: EPA (2018).
The EPA did not stop there, however. In the past, the agency has followed the standard regulatory rulemaking process of releasing proposed blending volumes at the end of Q2 followed by a public comment period of several weeks, after which it spends several more weeks synthesizing the responses before releasing final blending volumes in Q4. As Professor Scott Irwin of the University of Illinois Urbana-Champaign pointed out, the EPA has decided that it will not invite any comments relating to either its new waiver approach or its decision not to reallocate waived volumes.
Or, to quote Professor Irwin, "Why not just give ag the bird and say, 'We will see you in court, chumps.'"
The response of RIN prices to the EPA's arbitrary reduction of RIN demand was relatively muted, if only because the expectation had already prompted them to fall by roughly 70% since last November on an average weighted basis (see figure). Even then, though, last week's modest rebound was quickly stopped as the weighted RIN price fell by 15% this week. Lower RIN prices benefit those refiners that have incurred the highest RIN expenditures in previous quarters, including Valero (VLO), Marathon Petroleum (MPC), HollyFrontier (HFC), PBF Energy (PBF), CVR Refining (CVRR), and Tesoro (TSO). Put another way, the 70% reduction to the weighted average RIN price since those firms released their 2018 RIN expenditure projections means a corresponding reduction to their expenditure expectations.
Source: EcoEngineers (2018).
The share prices of some big biofuel producer names, on the other hand, turned lower in response to the news, including Pacific Ethanol (PEIX), Green Plains, Inc. (GPRE), Renewable Energy Group (REGI), REX American Resources (REX), and The Andersons (ANDE) (see figure). The Trump administration has had mixed impacts on the sector in recent months. On the one hand, the trade war that the White House has launched against some of America's main trading partners has prompted lower soybean and corn prices on reduced trading volumes, which reduces producers' operating costs. On the other hand, it has also reduced biofuel export volumes. Growing uncertainty over the future of the blending mandate under the Trump administration has also greatly weakened the backstop that RINs provide to biofuel demand, however, hurting producers' outlook at the same time.
The EPA's move quickly prompted a backlash not only from producers but also from within the White House itself. Secretary of Agriculture Sonny Perdue released a very critical statement that took aim at both the waivers and at the way in which the EPA has proposed to reduce the blending mandate.
Mr. Perdue's response is especially interesting given that both he and Mr. Pruitt serve at the pleasure of President Trump at a time when the White House is beginning to think about the upcoming midterm elections. Equally interesting, albeit for very different reasons, has been the response of Senator Chuck Grassley (R-IA), who said earlier in the spring that he would call for Mr. Pruitt's resignation if the EPA took the course that it set this week. Mr. Grassley's Twitter feed has been silent on the issue, which suggests that negotiations are taking place behind the scenes.
While biofuels producers have reason to be pleased with the fact that the White House's official stance on the EPA waivers is far from unanimous, it also means that the uncertainty that has prevailed since Mr. Trump's election victory is likely to continue for the foreseeable future. The fact that this week's EPA proposal directly contravenes Congressional intent as confirmed by a federal appellate court less than a year ago means that lawsuits are on the way. The last time the biofuels producers took the EPA to court on similar grounds, though, they had to wait four years for a ruling. A similar wait for resolution at this point will do the biofuels sector no favors.
Disclosure: I am/we are long FF. 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.