President Trump has developed a compromise between biofuels producers and refiners regarding the small refinery exemptions that have been allocated in large numbers under his administration.
The news that the White House was meeting with both sides to develop such a compromise sparked a major rally in the share prices of U.S. biofuel producers.
The compromise would cause biofuel blending volumes for the last three years to be retroactively increased via the reallocation of the hardship waivers for those years to large refineries.
The compromise is likely to face stiff opposition from refinery owners, and its implementation is not yet assured.
President Donald Trump's recent series of meetings with representatives from the biofuels production and refining sectors has yielded a tentative White House compromise. According to Transport Topics:
[t]he blueprint discussed in a meeting at the White House calls for the administration to make up for three years' worth of waived biofuel quotas tied to the Environmental Protection Agency's decision to exempt some oil refineries from annual blending requirements. That comes on top of other concessions that administration officials had already developed with the aim of encouraging greater U.S. demand for ethanol made from corn.
The "other concessions" refer to the Trump administration's earlier proposal to increase the volumes of biofuels that must be blended with refined fuels next year under the U.S. Renewable Fuel Standard [RFS2] blending mandate by one billion gallons. As I explained last week, that proposal was unlikely to have a substantial positive impact on U.S. biofuels producers, let alone to the degree needed to offset the damage that has been done to those same producers by the Trump administration's earlier policy decisions, and it was quickly dismissed by the biofuels sector as inadequate. Investors have been much more optimistic about the negotiations that resulted in the latest proposal, on the other hand, and the share prices of biofuels producers such as The Andersons (ANDE), FutureFuel (FF), Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), Renewable Energy Group (REGI), and REX American Resources (REX) have handily outperformed the S&P 500 index in September to date, especially over the last week (see figure).
The new compromise, which the White House hopes to finalize in meetings with refinery representatives, would have a much larger impact on both the biofuels and refining sectors if implemented, albeit in very different ways. To understand why, it is necessary to understand how recent SRE allocations have negatively affected biofuel producers. The Trump administration's Environmental Protection Agency [EPA], which oversees the implementation of the RFS2, greatly expanded the retroactive allocation of small refinery exemptions [SRE], or so-called "hardship waivers", to small U.S. refineries (see figure). The RFS2 requires refineries to blend specific volumes of biofuels with refined fuels annually, and this requirement is partially or wholly waived by the SREs that are distributed. The waivers that have been distributed in recent years have effectively reduced biofuel demand under the RFS2 by roughly 10% at a time when relatively low gasoline and diesel fuel prices have already created a persistent low-margin biofuel production environment.
Small refinery exemptions granted per year, 2013-2018. Source: EPA (2019).
What has made the impact of the waivers on biofuels producers especially punishing has been the EPA's past unwillingness, despite a legal obligation to do so, to reallocate the exempted volumes to the rest of the U.S. refining sector. In other words, the legislation that created the RFS2 requires the blending volumes for those refineries not receiving SREs to be increased by an amount equal to the exempted volumes in a given year so that the total blending volume remains unchanged. The approximately 1,800 million gallons of biofuels that recipients of SREs did not have to blend in 2017 should have instead been blended by other refineries, for example. The Trump administration's EPA has instead opted to effectively reduce the total blending volume by an amount equal to the volume covered by annual SRE allocations, reducing national demand for participating biofuels.
The reports that the Trump administration's new compromise would reallocate three years' worth of SRE volumes means that the White House is proposing to retroactively enforce federal law, presumably for the years 2016, 2017, and 2018 (while Mr. Trump was not inaugurated until 2017, the retroactive nature of SRE allocations meant that his administration made allocation decisions for 2016). While this might seem disingenuous from a legal perspective, from a financial perspective, it is a critical distinction. By one estimate the lack of SRE reallocations has reduced biofuels demand under the RFS2 by more than 4 billion gallons from a 58 billion gallon combined nominal volume during those years:
Two major uncertainties still exist. The first is whether or not the proposed compromise will even be accepted by refiners. Merchant refiners with small refineries such as CVR Energy (CVI) and Delek US Holdings (DK) would not directly be affected by the reallocation since any SREs received between 2016 and 2018 would still be valid. Refiners that were unlikely to have received SREs such as BP (BP), Marathon Petroleum (MPC), PBF Energy (PBF), and Valero (VLO) in those years, on the other hand, would see higher retroactive blending costs as the SRE volumes for the same years were reallocated to them in proportion to their overall market shares. The Trump administration's proposal, which was reportedly formulated by Mr. Trump, a representative of integrated biofuels producer Archer-Daniels-Midland (ADM), and U.S. senators from Corn Belt states, is certain to encounter strong opposition from owners of large refineries as a result.
Second, reporting on the compromise suggests that it would be retroactive in nature, leaving open the question as to whether any waived volumes would be reallocated in future years. Mr. Trump will be in office during the SRE allocation process for at least one and possibly five more years, making future reallocations an important question. It has historically taken the federal courts up to four years (or longer) to decide legal questions arising from the RFS2's implementation, so biofuel producers cannot necessarily count on court-ordered enforcement of the reallocation requirement anytime soon.
The coming week will be an important one for investors in long-suffering biofuel producers. The adoption of Mr. Trump's proposed compromise would have a very beneficial impact on U.S. biofuel producers, although the amount of the impact would depend on the final details. The White House will likely face an uphill battle when it tries to convince the U.S. refining sector to agree to the proposal, however, making its implementation uncertain at this stage.
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.