A Narrowing RIN Price Spread Is Bullish For The Darling Ingredients-Valero JV

Summary

• The Darling Ingredients-Valero Energy joint venture Diamond Green Diesel is undergoing a major expansion of its renewable diesel production capacity.
• This expansion is occurring even as demand for biomass-based diesel (biodiesel and renewable diesel) is remaining flat under the federal biofuels blending mandate.
• A situation is developing in the ethanol sector that will increase demand for biomass-based diesel under the mandate despite the lack of explicit demand growth.
• The narrowing of the price differential between D4 and D6 RINs will increase demand for biomass-based diesel even as the JV causes existing U.S. renewable diesel production capacity to double.

Last November I wrote an article about the law in California (and now also Oregon) that is driving the expansion of the Darling Ingredients (NYSE:DAR) and Valero Energy (NYSE:VLO) renewable diesel joint venture Diamond Green Diesel [DGD]. That law, the Low Carbon Fuel Standard [LCFS], provides a large subsidy to low-carbon fuels that operates as a function of their carbon intensity, and that subsidy has contributed to the impressive profit margins that have been achieved by DGD. More recently, however, a changing dynamic in the national transportation fuel market is setting up a situation that will further benefit the JV during a critical phase in its expansion.

DGD produces a biofuel that is popularly known as "renewable diesel" via the reaction of lipid feedstocks (e.g., animal processing residues, used cooking oil, distillers' corn oil, etc.) with hydrogen. The resulting biofuel is a hydrocarbon that meets the same D975 technical specification as ULSD despite not being refined from petroleum. DGD has long been the major producer in the U.S. renewable diesel market, and it is in the process of greatly increasing its scale as part of a multi-phase expansion process. The first phase saw DGD's production capacity increase from 160 million gallons per year [MGY] to 275 MGY. The second phase, which is on track for completion in 2021, will see that volume increase still more to 675 MGY. (A third phase is being considered that would add a second facility with a total capacity of 400 MGY.)

The first expansion phase was recently completed without any major problems. The second phase is financially riskier due to the sheer scale of the production volume increase that will occur. U.S. renewable diesel capacity in 2019 totaled only 394 MGY, meaning that the new volume from the second phase alone will exceed all existing U.S. production capacity combined. The danger here is that this rapid increase will result in the oversupply of California's and Oregon's markets, causing production margins to shrink. This is especially true given that U.S. renewable diesel capacity is being heavily invested in by entities besides DGD as well, and U.S. capacity is expected to expand by a total of 2249 MGY over the next five years as a result.

The good news for DGD is that a situation is developing in the U.S. ethanol sector that will boost national demand for renewable diesel (and biomass-based diesel in general). Multiple legal defeats have left the Trump administration, which implements the federal revised Renewable Fuel Standard [RFS2] biofuels blending mandate, with no recourse but to mandate the blending of the volumes that Congress established when it created the mandate in 2007. The large majority of the biofuel that is currently consumed takes the form of ethanol that has been blended with gasoline at 10 vol% ("E10"). Most U.S. fueling infrastructure can only handle a maximum blend of 10 vol%, yet the volumes established by Congress will require a higher percentage than that to be achieved.

Barring major growth in E15, blenders are casting about for other biofuels that comply with the federal mandate but do not face the same blend restrictions as ethanol. Many of them have settled on renewable diesel, which faces no such blending constraints, as a satisfactory alternative. The main disadvantage of biomass-based diesel in this capacity is that it is approximately $1/gallon more expensive on an energy-equivalent basis than ethanol, and this premium discourages its use in place of ethanol. The LCFS only offsets the impact of the cost premium in the two state markets in which it applies. Barring an appropriate incentive at the federal level, then, renewable diesel is not as attractive an alternative as it would otherwise be.

One of the main ways in which the federal government implicitly offsets this cost premium is through the $1/gallon blenders tax credit [BTC] for biomass-based diesel. This mostly, but not entirely, reduces the effect of the price premium on blenders' decision-making process. The RFS2 has at times complemented the effect of the BTC by incentivizing the use of biomass-based diesel to meet ethanol's share of the mandate, and it is likely to do so again in the near future.

Such a substitution effect is possible due to the nested nature of the mandate's biofuels categories. The broadest is the D6, or Total Renewable Fuel, category that encompasses the entire mandate. Nested within this is the D5, or Advanced Biofuels, category, and nested within that are the D4, or Biomass-based Diesel, and D3/D7, or Cellulosic Biofuels, categories. The required carbon intensity reduction thresholds for each category increase with each nesting, rising from 20% for D6 to 50% for D4 and D5 and 60% for D3 and D7. This means that any biofuel that meets one category's requirements can also meet a less-stringent category's requirements, but the opposite is not true. In other words, biomass-based diesel (D4) can instead contribute to the D6 category, but corn ethanol (the primary contributor to the D6 category) cannot contribute to the D4 category.

As a general rule, the production cost of a biofuel is inversely correlated to its carbon intensity, with lower-carbon fuels being more costly to produce than higher-carbon fuels. The RFS2's subsidies, which are known as "Renewable Identification Numbers" [RIN], apply to each category individually and are priced accordingly, with D4 RINs usually being more expensive than D6 RINs (see figure) to reflect the higher cost of producing biomass-based diesel compared to corn ethanol.

Source: EcoEngineers (2020).

There have been exceptions to this pattern, though, particularly during those years in which the White House has required the blending mandate to breach the 10 vol% ethanol blend wall. During these periods blenders have resorted to using biomass-based diesel, mostly biodiesel but also renewable diesel, to substitute for ethanol by generating the less-valuable D6 RINs. Since biomass-based diesel is no longer directly competing with ethanol in this situation, however, the D6 RIN price has increased to the point of converging with the D4 RIN price (see figure). The D4 RIN price premium over D6 RIN prices was especially low in 2013-14 and 2015-2016 following rapid increases to the latter.

Source: EcoEngineers (2020).

Not coincidentally, these periods of RIN price convergence were marked by a sharp increase in the number of D6 RINs being generated by biomass-based diesel (see figure). Practically this meant that biomass-based diesel that could not contribute to the D4 mandate, either due to that category's saturation or an inability to meet its 50% carbon intensity reduction threshold, was able to receive almost the same subsidy under the RFS2 by contributing to the D6 category instead. That volume practically disappeared after the Trump administration took steps in early 2017 to reduce mandated ethanol blending to the blend wall volume, and the period from 2017-2019 was characterized by a much larger average D4 RIN price premium in response.

Source: EPA (2020).

As noted above, the Trump administration is no longer able to reduce mandated ethanol blending, and the ethanol blend wall is likely to be encountered again in 2021 as a result. Not surprisingly, the D4/D6 RIN price differential has narrowed rapidly since the beginning of 2020 (see figure). I expect the prices to once again converge as 2021 approaches. From the perspective of DGD, such a convergence will increase demand for biomass-based diesel that is currently limited under the RFS2 to 2,430 million gallons, the same volume as for 2020. While the explicit D4 category mandate is not changing, in other words, a convergence will still enable national biomass-based diesel demand to increase. The fact that DGD has another 400 MGY of capacity coming online in 2021 makes this a fortuitous development, and one that will support the JV's production margins so long as it persists.

Source: EcoEngineers (2020).

Analyst’s 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.