Mixed Signals For The Ethanol Sector's Outlook

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Includes: GPRE, PEIX, REX
by: Tristan R. Brown
Summary

The EPA made multiple announcements last week that affect U.S. ethanol producers and the ethanol sector's operating outlook.

First, the EPA released final numbers for the biofuel blending that must occur in 2019 that were slightly higher than the preliminary numbers that it released earlier this year.

Second, the EPA announced that it will not reallocate to other refiners the volumes that were exempted as part of the "hardship waivers" that it allocated to small refineries.

Finally, the Trump administration announced that it has frozen the waiver allocation process for 2019 while it reviews its selection criteria.

Last week was a "good news-bad news" situation for the U.S. ethanol sector as the U.S. Environmental Protection Agency [EPA], which oversees the country's biofuels blending mandate, sent mixed signals to producers about their sector's operating outlook. On Friday the EPA finalized the 2019 blending volumes that it had initially proposed earlier this year. The total volume of biofuel that must be blended was slightly higher at 19.92 billion gallons than the EPA's earlier proposed volume of 19.88 billion gallons. This shift higher was due to an almost 40 million gallon increase to the cellulosic biofuel mandate, something that surprised seasoned industry observers who have grown used to seeing the cellulosic biofuel volume steadily revised lower. The vast majority of cellulosic biofuel production in recent years has taken the form of renewable natural gas rather than ethanol, though, so the ethanol sector is unlikely to benefit from the increase.

The good news for U.S. biofuel producers is that the finalized document does lock in the 630 million gallon increase to the advanced biofuels mandate that the EPA's earlier proposal called for (see table). This 15% YoY increase will, in the event that U.S. drivers begin adopting E15 following the Trump administration's earlier decision to permit the blend to be sold year-round (sales has previously been limited to eight months of the year), help to ensure that sufficient ethanol volumes are available to meet that new demand. The impact on U.S. ethanol producers will again be limited, though, due to the fact that they predominantly produce ethanol from corn starch, and this fuel is explicitly excluded from participating in the advanced biofuels mandate. The volume under the mandate that most U.S. ethanol producers can contribute to will remain flat in 2019 at 15 billion gallons (i.e., the difference between the total renewable fuel volume and the advanced biofuels volume due to the nested nature of the mandate).

Source: EPA (2018).

The bad news for U.S. ethanol producers is that the EPA also announced that it will not be "reallocating" the volumes in 2017 and 2018 that were excluded from the mandate as part of the "hardship waivers" that the regulator distributed to refiners in large numbers under former administrator Scott Pruitt. The waivers allowed individual refineries to ignore the biofuel volumes that they would normally be required to blend with their refined fuels under the mandate. In theory these exempted volumes are to be effectively redistributed to those refineries not receiving waivers so that the annual blending volumes remain unchanged. In practice, though, the EPA's announcement that no reallocation will occur means that every gallon that has been waived is then permanently missing under that year's mandate. In other words, if 20 billion gallons are to be blended under the mandate and the EPA grants waivers to refineries that are collectively responsible for blending 1 billion gallons of that total, then the de facto total blending volume is reduced to 19 billion gallons for that year.

Researchers at the University of Illinois Urbana-Champaign have calculated that a continuation of the EPA's recent waiver policy in 2019 will cause the total volume of biofuels blended under the mandate to be effectively 1.6 billion gallons lower than the nominal volumes shown in the table above. Most of this, 1.2 billion gallons, will come out of corn ethanol's share of the total mandate. This means that guaranteed demand for corn ethanol in 2019 under the mandate will be 13.8 billion gallons rather than the purported 15 billion gallons. The EPA's distribution of waivers for 2017 and 2018 also reduced corn ethanol's guaranteed demand by more than 1 billion gallons, which does much to explain (along with China's tariffs on U.S. ethanol) why the U.S. ethanol glut has persisted over the last several months. The EPA's refusal to reallocate the waived gallons means that the glut is unlikely to dissipate in the short term.

Whether or not the glut persists through 2019 will depend on how widely the EPA distributes the hardship waivers moving forward. The agency came under sharp criticism from the Midwest's Congressional delegation for distributing hardship waivers at a time when U.S. refiners were recording large profits on high margins since this created a very low hurdle for qualifying in the future on financial distress grounds. The EPA's response has been, according to Reuters reporter Jarrett Renshaw, to place a hold on 2019 waivers while it reviews its selection criteria:

This is not, of course, the same as returning to the pre-Trump administration requirement of a showing of actual hardship by the refineries receiving waivers. It is the best news that U.S. ethanol producers have received on the topic in several quarters, however. Renewable Identification Number [RIN] credits, which are used by refiners to demonstrate their compliance with the mandate, have shown glimmers of life over the last week, and the price of the largest D6 category rose by 50% in a matter of days (see figure). The prices of the three largest categories still remain well below their levels of one year ago, though, and they have a very large amount of ground to make up before they will be able to drive demand for ethanol.

Source: EcoEngineers (2018).

The share prices of independent ethanol producers Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), and REX American Resources (REX) likewise experienced modest bumps last week although they, too, have lost ground in 2018 to date (see figure). Investors in those companies will want to pay careful attention to the Trump administration's review of the criteria that it utilizes in distributing hardship waivers in 2019, as the number of waivers that are distributed next year will do much to determine if and when the sector's production margins finally rebound.

Chart GPRE data by YCharts

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.