HollyFrontier became the latest refiner to announce a large investment in renewable diesel production capacity earlier this month.
The company intends to build a 8,000 bpd renewable diesel unit at its Navajo Refinery in New Mexico with operations beginning by Q1 2022.
The company's decision is being driven by a combination of state and federal climate policies.
This article examines the rationale behind HollyFrontier's investment decision.
Merchant refiner HollyFrontier (HFC) just became the latest of a growing line of merchant refiners to enter the renewable diesel sector. The company announced earlier this month that it plans to construct a 125 million gallon per year [mgy] (or 8,000 bpd) renewable diesel unit at its 100,000 bpd Navajo Refinery in Artesia, New Mexico. The announcement was paired with the news that HollyFrontier is increasing its dividend and authorizing a new $1 billion share buyback program, which suggests that all three initiatives are directly linked to management's desire to put to use the large cash reserve that it has built up since 2017 (see figure).
This news might leave some investors asking why two obviously shareholder-friendly initiatives such as a dividend increase and new buyback program are being paired with a $350 million investment in biofuels at a time when U.S. biofuels producers are being squeezed by the combination of low fuel prices and a dismal federal policy environment. The market's response has certainly been muted to the news as HollyFrontier's subsequent share price has underperformed the broader sector (see figure).
To understand why HollyFrontier is investing in the renewable diesel unit it is necessary to consider the specific details of the investment. It is no coincidence that, of the company's multiple refineries, the unit is to be constructed in New Mexico. The Navajo facility has access to the PADD 3 region's abundant lipid feedstocks, including vegetable oil and animal processing residues, but is also close to southern California with rail access to that state's major refined fuels terminals. While the federal policy environment under the Trump administration has been very unfavorable to biofuels producers, that of California (and more recently also Oregon) has done much to drive the recent expansion of U.S. renewable diesel production.
Specifically, California's Low Carbon Fuel Standard [LCFS] mandates the blending of qualifying low-carbon fuels into its overall fuel supply. The state incents a sufficient supply of these alternative fuels to the state market by providing them a subsidy that is a function of the LCFS's prevailing carbon price and the alternative fuel's unique carbon footprint relative to a refined fuels baseline. The carbon price has increased by more than 700% over the last three years (see figure), to the point that every gallon of qualifying renewable diesel that is sold in the state now receives a subsidy of up to $2, depending on the feedstock used in its production, in addition to the market value of its energy content.
Source: CARB (2019).
This situation is translating into substantial profits for existing renewable diesel producers. Diamond Green Diesel, which is a large Louisiana renewable diesel producer that operates as a JV between Darling Ingredients (DAR) and Valero Energy (VLO), recently reported that it had generated an adjusted EBITDA of $1.35 per gallon of renewable diesel sold (and $1.26 per gallon of renewable diesel produced) in the first three quarters of 2019. This result is especially impressive in a year in which the spot price of Gulf Coast ULSD has only briefly exceeded $2/gallon (see figure). Moreover, the federal tax credit for renewable diesel has been non-existent since the start of 2018 and federal Renewable Identification Numbers [RIN] under the revised Renewable Fuel Standard [RFS2] have averaged only $0.78/diesel gallon-equivalent YTD.
This is not to say that the RFS2 did not factor into HollyFrontier's investment decision. It did, but in a manner that highlights growing uncertainty among merchant refiners regarding national politics. The RFS2 requires refiners to achieve annual biofuels blending quotas with their refined fuels or, failing that, to purchase a sufficient volume of RINs to demonstrate compliance. HollyFrontier's RIN expenses have been quite large in the past. In 2016, for example, which was the last year before the Trump administration took steps to weaken the mandate, the refiner spent $242 million on RINs. While HollyFrontier's planned renewable diesel unit will not be of a sufficient capacity to generate annual RIN volumes equal to its annual RIN obligations, the company does expect it to generate profits that will offset its RIN costs, stating in its announcement that "This investment will provide HollyFrontier the opportunity to meet the demand for low-carbon fuels while covering the cost of our annual RIN purchase obligation under current market conditions."
One way of interpreting this statement is that HollyFrontier is preparing for the possibility (if not the eventuality) that President Donald Trump will not be elected to a second term next year, and that his Democratic successor in such a scenario will rollback the Trump administration's efforts to weaken the RFS2. The refiner's planned renewable diesel unit could cover even its 2016 RIN cost amount, let alone the lower amounts of subsequent years, by generating EBITDA of $1.94/gallon of renewable diesel. While this would be a stretch under prevailing market conditions, it could be assumed that higher RIN prices and the possible reinstatement of the renewable diesel tax credit under such a political scenario would make up most of the difference.
Investors should be aware of two cautionary notes regarding HollyFrontier's announced renewable diesel investment. First, while lipid feedstocks are incredibly cheap at present, this does not mean that they will remain so when the production unit is expected to become operational in Q1 2022. The company's announcement explicitly referenced the use of soybean oil ("and other renewable feedstocks"), the price of which is currently near all-time lows in real terms (see figure). The price of soybean oil strongly influences the prices of other lipids, and a return to the lipid prices of 2012 would diminish the financial returns of the renewable diesel production unit.
Second, the LCFS's subsidy value is as high as it currently is largely because renewable diesel, along with biodiesel, have been the main low-carbon fuels to contribute to California's mandate over the last decade (in terms of carbon credits generated). Brazilian sugarcane ethanol and electric vehicles were expected to be the major contributors when the policy was implemented a decade ago but neither have come close to meeting expectations. Any large increase in the future supply of low-carbon fuels would cause the subsidy value to decline, however, in which case the renewable diesel unit's proximity to California would lose some of its appeal. I don't expect such a subsidy value outcome given the growing competition between California and New York to rapidly decarbonize their transportation sectors, but it is something for investors to be aware of.
HollyFrontier is joining peers such as Valero, Marathon Petroleum (MPC), and Phillips 66 (PSX) with its planned entry into the renewable diesel sector. From HollyFrontier's perspective, the investment is attractive due to its potential ability to utilize Californian climate policy to offset the expenses that it incurs under federal climate policy. While the process economics could change between now and 2022, prevailing market conditions make the investment an especially attractive way for HollyFrontier to utilize its large cash reserve.
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.