The Pandemic Isn't Slowing The Darling-Valero JV Diamond Green Diesel
Summary
- Darling Ingredients and Valero Energy operate the joint venture Diamond Green Diesel, which is one of the world's largest producers of renewable diesel.
- The COVID-19 pandemic and turmoil in the energy markets has prompted questions about the ability of DGD to continue its planned expansion of production capacity.
- Valero's recent Q1 showed the first results for DGD since the pandemic began.
- This article discusses why the pandemic is unlikely to have a negative impact on DGD's expansion plans.
Food processor Darling Ingredients (NYSE:DAR) and refined products producer Valero Energy (NYSE:VLO) operate a renewable diesel joint venture under the name Diamond Green Diesel [DGD]. DGD currently operates a renewable diesel production facility with 276 million gallons of annual capacity in Norco, LA. This facility is one of the world's largest production facilities for biomass-based diesel [BBD], which is a category that includes both biodiesel and renewable diesel.
Renewable diesel is produced by reacting lipid feedstocks (e.g., waste animal fats, used cooking oil, etc.) with hydrogen via a hydroprocessing step that is very similar to that employed in petroleum refineries. While the resulting fuel is properly categorized as a biofuel due to its immediate biomass feedstock origins, it qualifies for the same ASTM D975 spec that petroleum-derived diesel fuel meets. Renewable diesel's performance characteristics are therefore very similar to those of ULSD, with an important distinction being that its emissions of both localized pollutants such as particulate matter and life cycle greenhouse gas emissions are the lower of the two fuels by a large margin.
These beneficial characteristics of renewable diesel have caused policymakers to quickly embrace it as an ecofriendly version of petrodiesel. U.S. renewable diesel production has increased rapidly from virtually nothing in 2009 to almost 400 million gallons per year [MGY] in 2018 in response to the implementation of favorable policies such as the U.S. revised Renewable Fuel Standard and California's Low Carbon Fuel Standard [LCFS]. The Darling-Valero JV has been the country's largest renewable diesel producer during that time period.
DGD is in the process of greatly expanding its renewable diesel capacity while also adding a smaller amount of renewable naphtha capacity. The first expansion phase, which has already been finished, saw DGD's capacity expand from 160 MGY to 275 MGY. The second expansion phase, which is expected to be completed next year, will see the Norco facility's capacity increased further to 675 MGY. DGD is also in an "advanced engineering review" for a third expansion phase that would see a new 400 MGY renewable diesel facility built in Port Arthur, TX, with an estimated completion date of 2024. The success of all three phases would see DGD become one of the world's largest producers of any biomass-based diesel, whether biodiesel or renewable diesel.
The recent collapse of refined fuels demand in response to the COVID-19 pandemic and rollout of lockdown orders across the U.S. has raised questions about whether the DGD expansion plans will remain in place. A similar expansion of U.S. advanced biofuel capacity (albeit in the form of ethanol rather than renewable diesel) that was underway in early 2008 dissipated in response to the Great Recession, for example. The COVID-19 pandemic has been unique among economic downturns in terms of its impacts on refined fuels demand, however. Diesel fuel demand has remained mostly steady, especially compared to demand for gasoline and jet fuel. As the Q1 earnings report that Valero released last week illustrated, the pandemic is unlikely to reduce the financial rationale for the DGD expansion.
DGD has historically reported an average EBITDA of $1.26/gallon of renewable diesel sold, inclusive of the beneficial impact of the $1/gallon Blenders' Tax Credit [BTC] that was recently extended by Congress through 2023. This production margin, which is the equivalent of a refining margin of $53/bbl, has enabled DGD to fund its $1.1 billion expansion entirely through its internal cash generation. That fact has also made the expansion sensitive to any reduction to margins caused by, for instance, the COVID-19 pandemic.
As Valero reported in its recent Q1 report, however, there are no signs that renewable diesel production margins have been negatively affected by the implementation of widespread lockdown orders; if anything, the opposite is true. Valero reported operating income by DGD in Q1 of $198 million, up from $121 million YoY. Renewable diesel gallons sold only increased by 10% over the same period, though, meaning that substantial margin expansion occurred even as production capacity also increased. Q1 2020 EBITDA margin was $2.66/gallon compared to $1.86/gallon in Q1 2019. This margin expansion has prompted Valero to state that DGD will achieve an average EBITDA margin of $1.26/gallon in the future even before accounting for the impact of the BTC.
Two factors explain Q1's substantial margin expansion, and both of them can be expected to persist regardless of how the COVID-19 pandemic develops in the coming quarters. The first factor is that the price of diesel fuel has declined but not collapsed (see figure). Valero reported an average NYMEX ULSD price in Q1 of $1.55/gallon, down 20% YoY. Diesel fuel demand has held up relatively well in the U.S. given the country's reliance on gasoline for personal transportation and diesel fuel for freight transport, the latter being an activity that has been less affected by lockdown orders than the former. More importantly, the biomass-based diesel price premium relative to ULSD expanded in the latest quarter as the BTC's extension spurred demand for blending, mitigating the impact of the lower ULSD price to an extent.
The impact of this price decline was largely offset by the second factor, the beneficial contribution of California's (and now also Oregon's) LCFS. The LCFS uses a marketplace carbon price to incentivize the blending of low-carbon fuels with petroleum-derived fuels. This carbon price has increased strongly in recent years as the LCFS's carbon reduction targets have been strengthened. In Q1 2020, assuming a carbon intensity score of 25 gCO2e/MJ for DGD's renewable diesel, the LCFS contributed a subsidy of $1.88/gallon of renewable diesel, up from $1.80/gallon in Q1 2019. Operating expenses were also down 8% over the same period.
The value of LCFS credits will remain high in the coming years following the recent increase of the LCFS's carbon intensity reduction target to 20% by 2030 (see figure). This will increasingly push out the higher-CI fuels such as corn ethanol that have historically contributed the largest volumes under the LCFS while continuing to provide a large subsidy to lower-CI fuels such as renewable diesel.
Source: CARB (2020).
There are a number of longer-term issues that the DGD expansion will potentially encounter given the ongoing expansion of total U.S. renewable diesel capacity, such as potential feedstock availability constraints. These will not be encountered for some time, though, given that lipid prices in the U.S. are near decade lows (see figure). In the meantime, the financial rationale for the DGD expansion remains largely unaffected by the COVID-19 pandemic. Investors can expect DGD to play an increasing role in the earnings of Darling Ingredients and Valero Energy moving forward as a result.
This article was written by
Analyst’s Disclosure: I am/we are long VLO. 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.
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