The share prices of U.S. independent biofuel producers have followed up on one of their worst 4-month stretches in recent years by rallying mightily over the last two weeks. The shares of ethanol producers Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), REX American Resources (REX) and biomass-based diesel producer Renewable Energy Group (REGI) have handily outperformed the S&P 500 since August 28 by as much as 44 percentage points (see figure).
The cause of this rebound was President Donald Trump's August 29 announcement made on Twitter that his administration is preparing a "giant package" to boost the ethanol sector. According to Mr. Trump, this package will simultaneously avoid having any negative impacts on merchant refiners (i.e., the "small refineries" mentioned in the announcement) despite the fact that merchant refiners have been especially loud opponents of the U.S. Renewable Fuel Standard blending mandate over the last several years:
The share prices of independent and merchant refiners such as CVR Energy (CVI), Delek US Holdings (DK), HollyFrontier (HFC), Marathon Petroleum (MPC), PBF Energy (PBF), and Valero (VLO) have also outperformed the broader S&P 500 index since August 28, seemingly lending credence to Mr. Trump's statement that his administration's ethanol support program will be "great for all" - i.e., both ethanol producers and merchant refiners (see figure). (Gasoline prices have remained almost unchanged over the same period, so the sudden increase in the share prices of both biofuel producers and merchant refiners cannot be attributed to a sudden change in the underlying commodity price environment.) Mr. Trump's statement that "I was able to save the small refineries from certain closing" seemingly refers to his administration's August 9 decision to again award a large number of small refinery exemptions to refiners, thereby effectively reducing the mandated blending volumes for the most recent year by over 1.4 billion gallons.
It would be quite bullish for both sectors if the White House is able to simultaneously boost the operating environments of both merchant refiners and biofuel producers, as Mr. Trump has suggested. The arrival of Hurricane Dorian along the Eastern seaboard has delayed the full release of the biofuel package that Mr. Trump announced. The information that has been made available strongly suggests, however, that investors are overly optimistic about its impact on ethanol companies' operating environment. There are two reasons for believing that the actual plan will fall well short of these investors' expectations.
First, consider the scale of the volumes that are being proposed for inclusion in the announced package. Reuters reported last Friday that its centerpiece will be an increase to the 2020 mandated biofuel blending volume of 1 billion gallons. While that sounds like a big number, it actually is relatively modest within the context of the mandate. In July, the EPA proposed to require that 20 billion gallons of biofuel be blended with refined fuels in 2020, an increase of just over 100 million gallons from 2019's requirement. The 1 billion gallon increase would be divided across the mandate's four categories, including advanced biofuels, the latter of which is comprised mostly of biomass-based diesel rather than ethanol (although biomass-based diesel producers have been particularly hard-hit by the Trump administration's earlier weakening of the mandate).
Second, a 1 billion gallon increase in 2020 doesn't even begin to offset the reduction to the mandated blending volumes that have resulted from the Trump administration's increased small refinery exemption awards for a single year, let alone since President Trump took office. Professor Scott Irwin at the University of Illinois Urbana-Champaign, whose Twitter feed should be required reading for anyone investing in the U.S. renewable fuels sector, has calculated that the mandated blending volumes for 2017 and 2018 were reduced by 1.8 billion gallons and 1.4 billion gallons, respectively, due to the exemption allocations (compared to approximately 500 million gallons in 2015 under the Obama administration). Exemption awards under the Trump administration have reduced the blending mandate by a total of over 4 billion gallons. In other words, Mr. Trump's proposed 1 billion gallon "spike" would only offset 25% of the total reduction to the mandate that has occurred on his watch.
Third, the contention that the boost would benefit the corn ethanol sector, which is responsible for the vast majority of the fuel ethanol that is blended under the mandate, is questionable. The Energy Independence and Security Act (EISA) of 2007, which created the mandate, explicitly limits corn ethanol's mandated blending volume to no more than 15 billion gallons per year. This limit was reached in 2015. The 1 billion gallon increase would have no effect on actual corn ethanol blending volumes so long as the small refinery exemptions remained in place since the 15 billion gallon cap refers to the nominal blending volume before the exemptions are accounted for rather than the actual blending volume that occurs after accounting for them. (This is not true for the biomass-based diesel volume, which I will cover in a separate article.)
The corn ethanol sector is unlikely to benefit from Mr. Trump's proposed increase to the mandate blending volume for 2020. Something that Mr. Trump could do that would benefit that sector, however, would be to follow the legal requirements of the EISA of 2007 by reallocating the exempted blending volumes from the qualifying small refineries to non-qualifying large refineries. This would have the advantage of supporting those small refineries that are struggling financially while reinforcing the blending mandate. That said, the Trump administration's Environmental Protection Agency [EPA], which administers the mandate, refused to reallocate the exempted volumes under its previous head Scott Pruitt, and his successor Andrew Wheeler has maintained this policy despite its questionable legality. Refiners have also made it clear that they would strongly oppose any reallocation, with the CEO of the American Fuel and Petrochemical Manufacturers recently telling Reuters that any reallocation would be "bad policy and unlawful."
The rally in ethanol producers' share prices that has occurred over the last two weeks should be interpreted as a sign of how desperate the sector's operating environment has become rather than as an indication that the Trump administration's plan will save the sector. Corn ethanol producers in particular (i.e., most ethanol producers) will only benefit from either a reversal of the increased small refinery exemption allocations, a move that the Trump administration seemingly closed the door on in early August, or by the reallocation of the waived volumes. Neither mechanism has been included in the details of Mr. Trump's ethanol package that have been released to date. The headline blending volume increase will have very little impact on the ethanol sector without the inclusion of one or both of these mechanisms. The sector's challenging operating environment looks set to continue as a result.
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.