- The merchant refiner HollyFrontier announced that it was installing a renewable diesel production unit at one of its refineries last December.
- This week the company further announced plans to convert its Cheyenne Refinery to renewable diesel production by 2022, almost doubling its total planned production capacity.
- Three distinct developments since December's announcement contributed to management's decision to expand its investments in renewable diesel even at a time of low petroleum prices.
- HollyFrontier's decision is highly rational under the circumstances.
Last December merchant refiner HollyFrontier (HFC) became the latest member of its sector to announce its intention to begin producing renewable diesel. At the time the company intended to build a 8,000 bpd (123 million gallon per year) renewable diesel unit [RDU] at its 100,000 bpd Navajo Refinery in Artesia New Mexico. This week the company announced an expansion of that investment via the planned conversion of its existing Cheyenne Refinery to a second RDU with an additional 6,000 bpd (90 MGY) of capacity. HollyFrontier expects to invest up to $750 million in renewable fuels, which is a substantial amount for a company with a market capitalization of $5 billion. With an expected internal rate of return of 20-30%, though, management views these investments as being worth the risk.
The Cheyenne Refinery conversion is expected to cost HollyFrontier up to $175 million. Many investors will undoubtedly be surprised that the company has decided to move forward with such a substantial investment so soon after announcing a similar project at the Navajo Refinery, especially given its share price performance in 2020 to date (see figure). The prevailing operating conditions are certainly not conducive to novel projects of this type. That said, three major developments have occurred since last December's announcement that explain why HollyFrontier is not just moving forward with its investment in renewable diesel, but actively increasing it.
The U.S. Congress, just a few weeks after HollyFrontier's Navajo Refinery announcement, passed a retroactive reinstatement and extension of the federal biomass-based diesel blenders' credit [BTC]. This credit grants a refundable tax credit of $1 for every gallon of biodiesel or renewable diesel that is blended with petrodiesel. Whereas the BTC has been frequently allowed to expire over the last decade before ultimately being reinstated, Congress opted to provide some certainty the latest time around by extending it through 2022, albeit at a reduced value in the later years. HollyFrontier's Cheyenne conversion is expected to come online in Q1 2022, allowing it to capture the tax credit for at least multiple quarters.
Second, in February of this year HollyFrontier lost an important case in federal court regarding its biofuel blending obligations under the revised Renewable Fuel Standard [RFS2]. The company's Cheyenne Refinery had received small refinery exemptions in the past that waived its blending requirement under the mandate. The federal court ruled that these exemptions had been improperly awarded by the federal government to HollyFrontier, however, and the Trump administration, which had made these exemptions an important hallmark of its biofuels policy, ultimately opted not to appeal.
It is no coincidence that the same refinery that lost its blending obligation exemption is the one that HollyFrontier is converting to renewable diesel production. The company explicitly referenced this loss in its announcement of the planned conversion:
The conversion to renewable diesel production will result in HollyFrontier ceasing petroleum refining and reducing the workforce at the Cheyenne Refinery. This decision was primarily based on the expectation that future free cash flow generation in Cheyenne would be challenged due to lower gross margins resulting from the economic impact of the COVID-19 pandemic and compressed crude differentials resulting from dislocations in the crude oil market, coupled with forecasted uncompetitive operating and maintenance costs and the anticipated loss of the Environmental Protection Agency’s small refinery exemption.
The Cheyenne Refinery's small scale and location have worked against its refining margins in the past. Rather than sell the refinery, though, HollyFrontier expects to make it very profitable via the conversion to a new, eco-friendly product slate. The stated IRR of 20-30% is notable not just because of how much higher it is than that generated by the refinery's current operations, but also because it is squarely centered around the 25% hurdle rate that advanced biofuel producers have long been required to demonstrate by financiers.
Some investors may be skeptical that a 20-30% IRR can be achieved via renewable diesel production, particularly at a time of unusually low petroleum prices. This reaction is unreasonable based on the results reported by the Darling Ingredients (DAR) and Valero Energy (VLO) joint venture Diamond Green Diesel, however. The JV, which is the largest U.S. producer of renewable diesel, reported a Q1 2020 EBITDA margin of $2.66/gallon, up from an already impressive $1.86/gallon in the prior-year period. While not the same metric as IRR, a sense of the rapid payback period can be obtained by comparing this reported margin against the company's expected capital investment of less than $2/gallon installed capacity at the Cheyenne Refinery.
The BTC alone does not explain these strong margins for renewable diesel production, which raises the third development. Subsidies for renewable diesel under the federal RFS2 and the California/Oregon Low Carbon Fuel Standard [LCFS] have both increased in 2020 to date, the former by a substantial amount (see figures). Renewable diesel receives additional subsidies worth a combined $2-$2.50/gallon from these two programs. When added to the BTC, the impact of these policies is to make renewable diesel very profitable even at a time when ULSD is quite low. Rather than having its location be a liability, then, the Cheyenne Refinery's proximity to California and Oregon will be an asset post-conversion.
Source: EcoEngineers (2020).
Source: LCFS Data Dashboard (2020).
HollyFrontier will be a major, if not the largest, producer of U.S. renewable diesel when its two RDUs become operational. Much can change in the interim, of course, but the company's management clearly believes that any future changes will only benefit renewable diesel production. In this regard the company is joined by other refining executives, including the CEO of CVR Energy (CVI) who gave the following justification for that company's own investment in renewable diesel:
I talked about this renewable diesel. What's driving that is the low carbon fuel standard that California and Oregon have embraced. I think most of the industry out there feel that that is probably going to overtake the United States at some point and be the norm in some form or fashion. It may not come in that way, but what that tends to mean is drifting away from the fossil fuel molecule.
HollyFrontier can be expected to oppose any future efforts to weaken renewable diesel's incentives now that it is a stakeholder, much as those automakers that have invested in electric vehicle development have opposed efforts by the Trump administration to roll back the Obama administration's heightened fuel efficiency standards. Much has changed just in the last six months, and HollyFrontier has responded by doubling down on its initial renewable diesel investment.
To put the earnings potential of HollyFrontier's renewable diesel investments in perspective, an EBITDA margin of $1-$2/gallon would result in an EBITDA gain of $200-$400 million annually. By comparison, the company reported annual EBITDA of $1.7 billion in 2019. The investments will not be a complete game-changer, therefore, but they can be expected to expand the company's earnings by 10-20%. The fact that HollyFrontier's share price has fallen by more than 30% since the first investment was announced, albeit for very different reasons, suggests that either the company is overstating its case, or investors are underestimating the investments' EBITDA-generating potential. The latter seems to be the more likely of the two options given developments in the renewable diesel sector.
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