RIN Credits, Ethanol Blending and the 800-pound Gorilla

Renewable energy credit prices are on the rise as ethanol blend economics remain poor and the year-end reporting date looms. EPM talks with Clayton McMartin, president of Clean Fuels Clearinghouse, about renewable identification number credits, industry consolidation, and the oil industry's 800-pound gorilla, Valero Energy Corp., which can no longer be ignored.
By Ron Kotrba | March 05, 2009
The 800-pound gorilla in the room finally announced itself in early February. For months, speculators have been trying to figure out which ethanol companies will buy out which ethanol plants during this period of crushing economic recession and potential ethanol industry consolidation. Aside from food companies, what other industry made record profits in 2008 and could logically purchase distressed ethanol production facilities? The oil refiners—they who are obligated to blend ethanol into their supplies as mandated under the federal renewable fuels standard (RFS). On Friday, Feb. 6, VeraSun Energy Corp. "took out the trash"—that's public relations lingo for releasing bad news on a Friday, with the understanding that there will be little coverage of it until at least Monday. The same day, VeraSun issued a press release titled, "VeraSun Energy Obtains ‘Stalking Horse' Bid From Valero for Five Facilities; Files Motion Seeking Authority to Sell Substantially All Assets by March."

According to Bill Day, corporate spokesman for Valero Energy Corp., the oil refiner's 2008 overall production averaged 1.19 million barrels per day of "gasoline and related blend stocks" equaling roughly 18.2 billion gallons a year. The U.S. EPA has declared that this year's RFS is 11.1 billion gallons, which equals 10.21 percent volume ethanol blend requirement for each of the obligated parties. Assuming Valero's 2009 gasoline production projections are similar to its 2008 production its share of the 10.21 percent would come to about 1.9 billion gallons of ethanol blending in 2009.

Valero could purchase renewable identification number (RIN) credits to satisfy its obligation. If the oil refiner were to only purchase RINs to satisfy its RFS obligation and blended zero ethanol into its supplies—an unrealistic scenario but interesting to entertain, nevertheless—figuring a historically high RIN credit price of 15 cents per credit, the oil refiner could pay $285 million in RIN credit accumulations to satisfy its obligation for 2009. Instead, Valero proposes to pay $280 million for capital assets that, year after year, will continue to help it internally meet obligations under the RFS. It is also interesting to note that the five VeraSun plants in question have a cumulative nameplate capacity of 560 MMgy, which could satisfy between a quarter and a third of Valero's ethanol blending obligations for 2009. The five ethanol plants at $280 million with a 560 MMgy cumulative production capacity could amount to the oil company paying only 50 cents per installed gallon of production capacity.

The RFS, RINs and Ethanol Industry Consolidation
There are some important things to remember about the RFS before getting into RINs, or the government's mechanism to keep track of how much renewable fuel is being blended into U.S. fuel supplies for domestic consumption to meet the RFS, and the state of U.S. ethanol production. First, the RFS is a floor, not a ceiling—it's the minimum volume obligated parties must blend into U.S. gasoline supplies. During spells of weak economics, however, that floor may act as a ceiling. Second, there is a distinction between U.S. installed capacity, actual U.S. production and consumption by obligated parties to satisfy the federal mandate.

Installed capacity will always be greater than or, at best, equal to actual production. As far as the RFS is concerned, consumption by obligated parties to satisfy the mandate includes consumption of domestic product produced, plus net imports of ethanol, or the delta between exports and imports, plus the change in ethanol stocks at the end of a given period. According to data gathered by BBI International's Staff Writer and Plant List Manager Bryan Sims, 32 U.S. ethanol plants representing 2.02 billion gallons of annual production capacity are currently idled. This phenomenon, coupled with poor ethanol blend margins—meaning the price of ethanol and the price of gasoline are so close that any economical benefit blenders would see by blending the cheaper ethanol have been minimized—along with the 2008 year-end reporting deadline approaching quickly on Feb. 28, 2009, have together caused RIN prices to skyrocket.


Totals from January 2008 to October 2008 Figures in millions of gallons
SOURCE: ENERGY INFORMATION ADMINISTRATION

"The price of RINs is going up because it's more favorable to the obligated parties to place RINs in order to satisfy their obligations directly as opposed to the RINs they would get through blending," says Clayton McMartin, president of Clean Fuels Clearinghouse and the renewable fuels registry, RINSTAR. In late January, RIN prices hit 16 cents per credit, up from just a couple of cents at the beginning of the year. "There are some people who are coming to the game late, and are just now starting to understand what their obligations are under the regulations," McMartin continues. "Consequently, they're out there scrambling trying to find RINs, but there is less ethanol being put into the marketplace right now so, as a result, the RINs that are out there are fetching a higher price." Some of the latecomers buying up RINs in January and February 2009 are doing so to apply them to their 2008 obligations. But obligated parties can also carry a deficit forward for one year without penalty. With 32 ethanol plants idled, and some that are producing under capacity, stocks or inventories are lower. Until inventories are back up, McMartin doesn't see RIN prices dropping.

But with 10.5 billion gallons of installed production capacity still in operation (likely producing well under nameplate capacity), and with 2.02 billion gallons of installed production capacity idled, without even considering capacity under construction there is fear that the industry is overbuilt versus the mandate. McMartin, with years of experience in the oil business, says consolidation is coming to the ethanol industry. "The first 14 years of my career—and I've been at this for 20 some years—was spent in the refining industry, and when I started, the oil refining industry had twice as many refineries as it has today," he says. "And today those refineries produce more product than what was produced by twice as many refineries years ago. The ethanol industry has now entered into a period when consolidation is coming—it's overbuilt." From the perspective of the obligated parties that must blend ethanol or buy RINs, an overbuilt ethanol industry is desirable because ethanol and RIN prices would remain low. For ethanol producers, however, consolidation would mean stronger ethanol prices and a healthier industry long term.

"When you're in a consolidation period, which is what the ethanol industry is now in, you've got hardware on the ground and ultimately it will be utilized, but it won't be used by the same people who are on the title today," McMartin says. "They're going to recapitalize and we're already seeing some of that." He says the phenomenon of major oil companies purchasing distressed renewable fuel assets is inevitable. "This is classic consolidation and it will change the complexion of the renewable fuel industry forever," he tells EPM. "Refiners—and especially Valero—have been in this mode for the past 25 years. Check out the history of Valero—they are the poster child of mergers, acquisitions and consolidation. They are in the energy business. And when you can buy assets for 10 cents on the dollar, it just makes sense."

Finagling RINs: Not Just an Accounting Function
The quickest way to improve blend economics would be to raise the cost of crude oil, but hoping for higher crude oil prices seems counterintuitive. "Isn't the objective of the RFS for us to replace crude oil in the United States with renewable fuels?" McMartin poses. "That's happening today but it's not being reported." He says two major factors are driving down the cost of crude oil. "One is we're approaching having renewables constitute 10 percent of our motor fuels use," he says. "And the other, of course, is the downturn in the economy; but the downturn in the economy just accelerated what was intended to happen from the RFS." Displacing petroleum means less of a demand for crude oil, so how is more crude oil put into the marketplace? By lowering the price. "So oil is going to go down, and it will continue to go down so long as renewable fuels use goes up," he says. "If you're a renewable fuel producer you do one of two things. You learn to compete at a lower margin—and like I said, the ethanol industry is going through a consolidation period now—or you somehow figure out how to monetize the asset that you're generating. And that asset that you as an ethanol producer are generating is the renewable fuel credit known as a RIN. Most producers just haven't recognized that."

The RIN-Master as McMartin is sometimes referred to, says he is seeing an active market for RINs forming right now. "I'm talking about RINs with fuel and RINs without fuel," he says. "We're starting to see premiums placed in the marketplace on fuel with RINs versus fuel without RINs."

For each gallon of ethanol produced domestically or imported into the United States, a RIN is generated. "EPA wanted to ensure the RIN moved through the supply chain and then, when it got to the end just at the point before the consumer took it and put it in for consumption, the RIN becomes a tradable credit known as a separated RIN," he says. Assigned RINs are different in that they follow the fuel all the way from the point of production through the supply chain to consumption; for assigned RINs, the credit is not moved independently from the fuel.

"What's not very well understood is that fuel can move without RINs, so a gallon of ethanol can move with zero RINs and up to 2.5 RINs," he says. "So if I have a customer who wants to take two RINs and is willing to pay me more for them than the customer who I end up selling zero RINs to, I keep my RINs moving to the individual in the marketplace who's willing to pay me more for them. That's what producers should give real serious consideration to doing—but they don't. Because they move them one for one, they produce them and they move them."

The general manager for Commonwealth Agri-Energy in Hopkinsville, Ky., Mick Henderson, tells EPM, "We feel that RINs are always bought with the ethanol," he says. "Even the smallest jobbers have figured out the value of RINs. If they did consider the idea [of moving ethanol with or without RINs], they would undoubtedly bid the ethanol down to a price that would negate the sales value separate anyway. Therefore we don't see any positive impact for our business, RINs or without." McMartin says a lot of ethanol plants look at RINs this way, a point of view he says is shortsighted. "You can lead a horse to water but you can't make it drink," he says. "If an ethanol producer is going to take control of their product in the marketplace, then this is where they would do it."

The ability to move from zero to 2.5 RINs per gallon of ethanol gives producers latitude in commercial consideration, which EPA intended all along. "As long as the RIN moves through the system, EPA doesn't care how it goes," McMartin says. "They want it to go where economics drive it."

Valero's director of regulatory compliance, John Braeutigam, tells EPM that, while he can't talk about the VeraSun deal or Valero's business strategy, he says that he doesn't view the RFS or RINs as necessary evils. "We're just following requirements set out in regulations," Braeutigam says. EPM asked him how a refinery would maximize its ownership of ethanol production facilities. "If a company is just an ethanol producer, then there are limited circumstances where they can sell ethanol without RINs," he says. "Refiners or importers can separate RINs from fuel, and rack blenders can also separate. If an oil refiner had more ethanol plants than they needed and generated more RINs than they needed as an obligated refiner, they would have to sell the rest."

McMartin speculates as to how Valero might best utilize in-house ethanol production. "It depends on a lot of things, such as how it handles the entity—will it be part of Valero or a separate wholly owned company," he says. "Also it depends on other ethanol supplied to Valero, since there are limitations under the regulations as to what an obligated party can do with its own production. In the end though, Valero will maximize the assets within the confines of the regulations. You can bet your last dollar that Valero will have ethanol for sale both with and without RINs."

With 32 ethanol plants idled and some producing under capacity, McMartin says ethanol stocks are being reduced and, until inventories are replenished, he doesn't expect RIN prices to let up.

Ron Kotrba is an Ethanol Producer Magazine senior writer. Reach him at rkotrba@bbiinternational.com or (701) 738-4942.