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"Syntroleum's Dynamic Fuels Plant Should Run Baby Run, Margins Are Very Solid"

|Includes: Syntroleum Corporation (SYNM), TSN

Syntroleum (NASDAQ:SYNM) is a synthetic fuels firm that has a portfolio of patents, processes and part ownership of a synthetic fuels plant. Their main asset is a 50% ownership in a joint venture with Tyson (NYSE:TSN) called Dynamic Fuels. The plant has a nameplate capacity of 75 million gallons per year, but has been unable to reach consistent production over the last 2 years. When they do produce however Dynamic Fuels supplies an impressive list of customers including the US Navy, Norfolk Southern (NYSE:NS), Mansfield Oil and many major car rental companies. Mazda (OTCPK:MZDAF) recently used their fuel in the grueling Rolex 24 race at Daytona, after which they claimed that they get more horsepower out of the Dynamic Fuel than they do with regular diesel fuel. It also has a lower exhaust temperature implying a more efficient fuel, and possibly higher MPG. The problem hasn't been the SYNM process, it has been mechanical, supply and margin problems. The Dynamic Fuels Plant stopped production in Q4 2012 for the installation of some badly needed feedstock processing equipment but chose not to resume production because of the poor economic environment. They released an 8-k on December 13th explaining the situation and the challenging economic environment. At that time there was no $1 tax credit and break-even margins at best, so the firm made the right decision to shutter operations.

However, that was then and this is now, and SYNM has yet to release an 8-k announcing the resumption of production. This is unfortunate because the poor economics of Q4 2012 have reversed and now offer SYNM a fantastic opportunity to make a substantial margin...if they can and do produce.

The Dynamic Fuels plant produces a "blended" product that is 83% Ultra Low Sulfur Diesel (ULSD), 12% Naphtha and 5% Liquid Petroleum Gas (NYSE:LPG). Currently I show $3.11 for ULSD or Heating Oil (Gulf Coast), $2.49 for Naphtha (I estimate that price using the price of Gulf Coast gasoline) and $0.84 for LPG (I use the price of propane). That results in a "blended" rate of $2.85/gallon. (Note, Dynamic Fuels produces a "drop-in" ULSD, they do not produce biodiesel)

Dynamic Fuels also get additional subsidies per gallon. They get 1.7x the value of a D4 RIN per gallon of ULSD. A RIN is a Renewable Identification Number and is part of the EPA's Renewable Fuels Standards 2 (RFS2). A D4 RIN currently goes for $0.53, so $0.75 gets added to the "blended rate." They also get 1.7x the value of a D5 RIN for their Naphtha. D5 RINs currently trade at $0.50, adding another $0.10 to the "blended" rate. Finally there is a $1.00 tax credit per gallon of ULSD, which adds $0.85 to the "blended" rate. It is possible that Syntroleum may be able to get RINs for their LPG, and the tax credit for their Naphtha, adding another $0.07 to $0.10 to the margin, but as of right now I'm showing a "RIN and tax credit adjusted" "blended rate" of $4.53/gallon.

Dynamic Fuels uses 7.6 lbs of yellow grease per "blended" gallon. Yellow grease currently trades at $0.35/lb, for a total cost of $2.66/gallon. Add to that $0.30/gallon for delivery and $0.15/gallon for hydrogen and you get $3.11/gallon of variable costs. Subtract that from the $4.53/gallon adjusted "blended" rate and you get a gross margin of $1.41. No, that is not a typo, that is $1.41/gallon gross margin. Subtract another $0.45 for operating costs (OPEX) and you get a net margin of $0.96. That too is not a typo. Dynamic Fuels, if they were/are producing at full capacity right now, and hitting the company specified OPEX, they should be making $0.96 to $1.01 on every gallon of "blended" fuel they produce. (Note, SYNM claims an OPEX of $0.55, which includes the $0.15.gallon hydrogen. I count hydrogen as a variable input, so my entire cost per gallon is actually $0.05 higher than what SYNM claims, thus the range of $0.05). Those margins put the break-even production level around 30%, so even at an impaired 50% they would be making money.

The Dynamic Fuels plant can produce 6.25 million gallons/month, so with a $1.00 net margin, Dynamic Fuels could be making $6.25 million per month in net profits. Prior to the Q4 2012 shut down the plant had "production for a period of 52 consecutive days representing one of our best performance periods to-date." They were on the verge of finally reaching a profitable level of production, and that was before they installed two new processing units. One would have to imagine that Dynamic Fuels could be producing if they wanted too, and yet no announcement regarding the resumption of production. Dynamic Fuels also got a $23 million tax credit windfall at the end of 2012 (see previously linked 8-k), so they have or will have plenty of cash that would allow them to take some risks. If management is choosing not to produce with a net margin close to $1.00/gallon, one has to wonder what it would take. Are they waiting for it to reach $2.00? The Dynamic Fuels plant certainly produced in the past with much lower margins, so what is management waiting for?

They could be waiting to see how the markets settle out after the tax credit passed at the end of the year. There is a dynamic between the tax credit, RINs, RFS2 quota and feedstock. In my opinion those fears are completely unfounded for a number of reasons:

  1. The main feedstock for biodiesel is soy oil. Currently I show soy methyl ester (SME) biodiesel having a negative net margin. That is a reason for RIN prices to go higher, not lower.
  2. Biodiesel plants that use yellow grease use more lbs per gallon than Dynamic Fuels, and produce a lower quality Fatty Acid Methyl Ester (OTCPK:FAME) biodiesel that sells at a discount to ULSD. I'm showing margins barely above break-even for this process. That is a reason for feedstock prices to go lower, not higher.
  3. There is a new feedstock available, inedible corn oil. This new supply should help keep feedstock prices low, especially considering margins for using corn oil in FAME are also very low.
  4. Dynamic Fuels is a "blender" so they get to keep 100% of the $1.00 tax credit ($0.85 blended) to themselves. Most biodiesel producers aren't "blenders" so they only get to keep about $0.50 of the tax credit. That gives Dynamic Fuels a $0.35/gallon competitive advantage over biodiesel. That is a reason to produce, not sit idle.
  5. Dynamic Fuels also gets RINs for their Naphtha, adding another $0.10 to their margin that biodiesel doesn't get. That too is a reason to produce, not sit idle.
  6. It is early in the year when RIN prices are highest because the RFS2 quota is far from being met, and demand for yellow grease is the lowest (FAME has jelling problems in winter and can clog fuel lines). This is simply the best and most profitable time of the year for Dynamic Fuels to be producing. That is a reason to produce, not sit idle.
  7. ULSD trades similar to heating oil, and being winter, heating oil is supportive of a higher ULSD price. That is a reason to produce, not sit idle.
  8. Dynamic Fuels knows with 100% certainty what current margins are, they have no idea what future margins will be, and never will. Dynamic Fuels should not be passing up solid profits now because of a fear that the markets may turn against them like they did late last year. Go with what you know, and make changes if the markets change. They shouldn't be sitting idle passing up profits because margins MIGHT narrow in the future, especially considering they just got a $23 million gift from the tax payers.
  9. The tax credit will expire at the end of the year, providing an incentive for biodiesel plants to over-produce this year to capture as many credits as possible, just like they did the last time it expired. That will likely result in the 2013 RFS2 quota being surpassed by a sizable amount and early in the year. Just like 2012, this will drive down RIN prices late in the year. The window to produce at a profit may be short this year, and the early part of the year should have the highest margins.
  10. To meet the RFS2 quota, much of the biodiesel will have to be made from high cost soy oil. Dynamic Fuels uses the lowest cost feedstock, produces a superior product and has multiple competitive cost advantages. The regulatory system is designed to ensure that the RSF2 quota is met. In order to meet this quota the least efficient process, SME, must survive. If the least efficient process can survive, the most efficient low cost process should thrive. Dynamic Fuels is a low cost efficient producer, and should thrive as long as SME survives. SME should survive as long as the RFS2 stays in place, and I doubt that is going to change at least for the next 4 years.

In conclusion, Dynamic Fuels' should be producing. If the reason they stopped producing is as they claimed, economics, that reason no longer holds. The economics of this industry have made a dramatic improvement since the end of last year. The tax credit passed, RIN prices have rebounded, feedstock prices have remained stable and most importantly, margins have widened dramatically, and are now highly profitable. Now is the time for Dynamic Fuels to "run baby run." For the investor interested in SYNM, it is important to understand the mechanics and fundamentals of the plant and alternative energy industry. The Dynamic Fuels plant has been edging ever closer to reaching profitability and consistent production, and was almost there late last year, and that was before they installed some new equipment. If the Dynamic Fuels plant can finally run at full capacity, and if they were to do so now when margins are high, it would go a long way to making SYNM a profitable commercially viable firm. Right now SYNM is a speculative stock being priced based upon an unproven, unprofitable and unreliable plant. Once the plant proves itself, and starts generating positive cash flows, Wall Street will value it based upon those cash flows. The Dynamic Fuels plant has a 75 million gallon capacity, SYNM owns 1/2 of those gallons. Current margins are near $1.00, and SYNM trades below $0.50 with about 100 million shares outstanding. You don't need to have a Ph.D in finance from Wharton to see the potential, and that is valuing SYNM on just 1/2 of one plant. SYNM and TSN have plans for 4 or 5 more. Dynamic Fuels was so close to crossing the finish line late last year before it and the market stumbled. Now isn't the time to take a seat in the stands, it is time to get up, brush off, get back in the race and "run baby run," the finish line looks to be within your reach.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I am long SYNM.