The Engineering Reasons Behind Merchant Refiners' Renewable Diesel Boom

Summary

• U.S. renewable diesel production capacity is currently experiencing growth of almost an order of magnitude in just a few years.
• Merchant refiners are playing a critical role in the expansion.
• This article examines three important engineering/technical factors that have caused merchant refiners to invest in renewable diesel rather than other biofuels.

Last month I discussed the policy reasons for U.S. merchant refiners' heavy investments of late in renewable diesel production capacity. That expansion, which is being largely driven by merchant refiners such as CVR Energy (CVI), HollyFrontier (HFC), Marathon Petroleum (MPC), Phillips 66 (PSX), and Valero Energy (VLO), will see total U.S. capacity increase by almost an order of magnitude through 2023 (see figure). Even giant Exxon Mobil (XOM) has been getting involved, albeit from the feedstock side, with its continued joint venture to produce microalgal lipids at scale. Multiple investors have asked me about the engineering reasons, though. Specifically, why are merchant refiners investing in renewable diesel rather than more established pathways such as corn ethanol or biodiesel? After all, those latter two fuels have been much larger contributors to the two policies, the U.S. revised Renewable Fuel Standard [RFS2] and the California/Oregon Low Carbon Fuel Standard [LCFS], that are driving refiners' investments.

Source: Author calculations (2020).

Three engineering/technical factors explain merchant refiners' single-minded focus on renewable diesel production. When considering them, it is important to keep in mind that "renewable diesel" refers to the lipid-derived hydrocarbon fuel that meets the same ASTM D975 spec as does ULSD, even in unblended form. (Some sources alternatively call it hydrotreated vegetable oil [HVO] or hydroprocessed esters and fatty acids [HEFA] diesel, but the three labels generally apply to the same fuel that is produced from a variety of feedstocks such as used cooking oil, animal processing residue, and distillers' corn oil.) Renewable diesel is distinct from the two other primary forms of biobased diesel fuel that are on the market, "cellulosic diesel" and "biodiesel." Cellulosic diesel is a hydrocarbon, but one that is derived from lignocellulosic rather than lipid feedstocks. Its production is limited due to the challenges of working with lignocellulose. Biodiesel, which is the most-produced biofuel in the U.S. besides ethanol, is not a hydrocarbon, but rather a fatty acid methyl ester [FAME] fuel that has similar technical performance to ULSD when blended with ULSD at up to 20 vol%.

Renewable diesel's lack of a "blend wall" makes it preferable to merchant refiners compared to biodiesel and especially ethanol. While U.S. biodiesel consumption remains well below 20 vol% of ULSD consumption, it could in theory encounter a blend wall were a rapid increase in production to occur. Ethanol consumption has repeatedly encountered its own 10 vol% blend wall in the U.S. since 2013, and efforts to increase this limit have fallen far short of what has been needed.

Renewable diesel, by contrast, encounters no such blend wall; maximum renewable diesel consumption within existing infrastructure constraints is limited only by the size of the ULSD market. There are artificial limitations on blends in some states due to restrictive pump labeling laws that require consumers to be informed of the exact renewable diesel blend percentage, but this constraint can be avoided if a refiner owns wholesale or retail capacity that allow for blending downstream of the refinery.

This fuel composition factor directly contributes to the second factor: a lack of blending infrastructure. Ethanol is not carried in refined fuels pipelines due to its miscibility with water; the same characteristic that allows mixed drinks to exist (otherwise the alcohol and water in adult beverages would phase separate in the same manner as oil and water) also enables ethanol blends to bring water into pipelines. Biodiesel has been greatly limited in refined fuels pipelines until very recently over concerns that it could contaminate subsequent batches of other fuels with FAME via trailback, causing jet fuel to go off-spec. In 2015 the ASTM increased the amount of FAME that can be contained in on-spec jet fuel following rigorous safety testing, but many large pipelines still limit biodiesel blends due to concerns over the precision of FAME content measurements.

All ethanol and most biodiesel blending therefore occurs downstream of the refinery at wholesale terminals or retail locations. While this has the advantage of making it easier to comply with restrictive pump labeling laws, it makes also makes it difficult for merchant refiners to comply with blend mandates via their own blending activities. Merchant refiners are generally characterized by the small size of their wholesale/retail segments relative to their refining segments, and the master limited partnership boom of 2011-2012 compounded the problem as many merchant refiners to spun off their blending assets into logistics MLPs. This lack of control over the last stages of the ULSD supply chain has caused merchant refiners to resort to purchases of credits, often at high cost, in order to comply with blending mandates.

Renewable diesel does not face the same transportation constraint due to its comparative lack of restrictions to pipeline access. Major refined fuels pipelines such as the Colonial Pipeline allow renewable diesel blends in excess of 5 vol% so long as the blend rate is specifically disclosed; the Explorer and Plantation lines have similar, if less-permissive, policies. The aforementioned pump labeling laws can still cause constraints in some states, although pipeline operators are beginning to manage the problem by collecting detailed data on blends as they enter the lines. Whereas many refiners cannot move ethanol and, to a lesser extent, biodiesel through the refined fuels pipelines that they rely upon to move their product to market, renewable diesel blends are increasingly acceptable.

The third and final factor is that most merchant refiners already have access to much of the equipment that is needed to produce renewable diesel. Ethanol and biodiesel production is completely unrelated to petroleum refining: ethanol is produced via a biochemical process, fermentation, while biodiesel is produced by reacting lipid feedstocks with methanol at close-to-ambient temperatures. Renewable diesel, on the other hand, is produced by reacting lipid feedstocks with hydrogen. This "hydrotreating" (or "hydroprocessing") is, of course, already employed by refiners on petroleum products for the purposes of contaminant removal and molecule cracking. Refineries often have hydrogen production capacity on-site for the same reason.

The close relationship between renewable diesel production and conventional petroleum refining can be seen in the capacity addition announcements recently made by CVR Refining and HollyFrontier. CVR Refining announced that it is exploring the production of renewable diesel by "utilizing excess hydrogen capacity of both refineries and converting selected existing desulfurization units to renewable diesel production." HollyFrontier recently stated that it is taking its own renewable diesel plans to the next level by converting an entire refinery to renewable diesel production; Marathon Petroleum is engaged in a similar conversion. The growth in both refiner hydrocracking and hydrogen production capacity over the last decade (see figure) has allowed merchant refiners to make such partial or full conversions with lower capex than would be possible when constructing a greenfield renewable diesel facility.

Source: EIA (2020).

Even those refiners that have opted to build greenfield facilities, such as the Valero-Darling Ingredients (DAR) JV Diamond Green Diesel, have been able to leverage their immense hydroprocessing expertise. Renewable diesel production is able to utilize this advantage in a manner that would not be accessible to merchant refiners were they to instead produce biodiesel or ethanol.

These three engineering/technical factors are important for investors to be aware of as they follow merchant refiners' renewable diesel investment boom. They provide important context with regard to which refiners are likely to generate the level of profitability from their capacity additions that has been reported by the Darling-Valero JV. Policy is important and will generate headlines, especially when subsidy values are high, but these technical factors will determine which refiners are best-positioned to convert those incentives into shareholder value.

Author note: Much of the information presented in this article is from a free comprehensive report on biomass-based diesel that was recently published by the Fuels Institute. Investors who are interested in a more detailed discussion of the engineering/technical factors described here are encouraged to read Section 3 of that report.

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.