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Are Regulations Causing Higher Gas Prices?

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Eight hundred million dollars.

That's how much money Valero (NYSE: VLO  ) estimates it will cost to comply with the United States' Renewable Fuel Standard through the purchase of Renewable Identification Numbers, or RINs. It's a pretty hefty bill no matter how you spin it, and those charges can only lead to one thing: higher gas prices.

Let's look at this renewable fuel credit phenomenon and see why it's having such an effect on refiners' bottom lines and your gasoline bill. 

From RINsanity to higher gas prices
When RINs were created in 2005, they were intended to reduce our reliance on foreign oil with a domestic energy source. In a way, they did their job rather brilliantly. The RIN credit enabled ethanol producers to earn an extra premium on their product that helped to cover the costs of development. Within six years, the production of ethanol shot up 257% and was helping to displace just over 9% of our fuel needs. As the production of ethanol increased, the price of RINs remained steady. Then this happened:

The massive run-up back in March was frightening, and it hasn't gotten much better since. Spot prices for D6 RINs -- corn ethanol -- hit an all-time high of $1.48 last week. For refiners to meet the requirements for the Renewable Fuel Standard, they have to buy these RIN credits, sometimes from the secondary markets completely independent of the purchase of the ethanol itself. This is one of the reasons Valero has given that $800 million figure for losses attributable to RINs, and Marathon Petroleum (NYSE: MPC  ) has already given warning that RINs will have a significant impact on its earnings release in August. 

Since RINs are having such an impact on company earnings, it's probably likely that the companies haven't been pricing RINs into their gasoline. That means we haven't seen a major uptick in gasoline prices -- yet. But it's awfully hard to imagine that refiners will remain so altruistic, so eventually these higher RIN costs will get passed down to the consumer. 

How much? Let's do a little back-of-the-napkin math. Ethanol today comprises of 10% of all motor fuel, and for each gallon of ethanol there is a single RIN credit. Before now, we would have barely noticed these costs because RINs were relatively cheap -- about $0.01 per gallon. But if you use that same math with current RIN prices and assume refiners were to fully pass on the price of a RIN to the consumer, it would add about $0.15 to each gallon of fuel. This is probably not what the architects of the Renewable Fuel Standard program had in mind.

Refiners' reaction
In a way, Valero has quite possibly the best case to make of anyone out there when it comes to the interaction of refiners and ethanol. Not only is the company a major oil refiner in the United States, but it's also America's No. 3 ethanol producer and is responsible for making just over 8% of the nation's corn ethanol supply. To paraphrase Valero CEO Bill Klesse, ethanol is a viable source of fuel that has some promise, but RINs are creating more problems than needed and need to be redone. 

Long-term, Valero has the potential to be hurt less by the current RIN issue than many others. Currently, a hit of $800 million would cut out about 15% of the company's operating cash flow. But one of the major advantages that Valero shares with other independent refiners, such as Marathon Petroleum and Phillips 66, is that they have a large capacity to export petroleum to premium markets that don't require ethanol blending and, thus, RIN credits. If RIN prices were to continue on their current track, it wouldn't be a stretch to see these refiners and several of the integrated majors push for more petroleum product exports to avoid these costs. 

The ones that are in much more trouble are those that lack access to the export markets. We're looking at you, HollyFrontier (NYSE: HFC  )  and CVR Refining. HollyFontier estimates that RINs could hit the company's operational cash flow by about 9% based on its 2012 performance. That's not as much as Valero right now, but it doesn't take into account the other troubles that could lie ahead for these refiners. These two companies have all of their refining capacity in the mid-continent region of the United States. So not only can they not deflect some of their products to export markets easily to avoid RIN costs, but they're also more likely to suffer as the spread between Brent and West Texas Intermediate has gotten narrower throughout the past quarter.

The RIN/WTI spread double-whammy could be a tough to pill to swallow for the smaller refiners out there such as Holly Frontier and CVR Refining.

What a Fool believes
The problems for the refiner business come not from the use of ethanol. On the contrary, there are several companies that support the product and are hopeful that biofuels from cellulose can make it to the market. The larger issue today lies with the way the current Renewable Fuel Standard credits are structured. Since consumer habits for fuel consumption have changed, so, too, should the incentive structure and target levels for biofuel production.

The boom in oil and gas in the United States has completely disrupted the way we think of the oil and gas industry, and you, the long-term investor, should get to know what these changes mean for the future of the industry. To help, The Motley Fool is offering a comprehensive look at three energy companies set to soar during this transformation in the energy industry in a special report called "3 Stocks for the American Energy Bonanza." By simply clicking here, we'll give you free access to this report. 


Read/Post Comments (6) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 04, 2013, at 11:07 AM, tim101506 wrote:

    It's funny how gas was so cheap up until Cheneys "secret" trip to Saudi Arabia, and just as soon as he got back the prices skyrocketed! And this was a while before Obama took office!

  • Report this Comment On August 04, 2013, at 11:17 AM, GT6 wrote:

    If we have learned anything over the last 10 years, it's that the only thing that affects gas prices is their ability to get away with it. Profits are off the chart and yet prices still rise, so it has nothing to do with cost or regulation. If they think we will pay, they will up the ante. When the economy crashed and no one had money, the price came down. Now that things are returning to normal, the price is jumping again and it will keep climbing until demand drops off.

  • Report this Comment On August 04, 2013, at 2:09 PM, howardlangeveld wrote:

    Is this a plot RINs or CO2 in the atmosphere? It would be good if these excessive profits were instead shifted to a Carbon Tax that would promote renewable resources and energy efficiency.

  • Report this Comment On August 04, 2013, at 5:33 PM, scott4402 wrote:

    No matter what, the extraction of oil from under the sea floor, needs to be figured out of the equasion, because it might soon be drastically be reduced as a potential large supplier of oil. If the extraction of large quantities is shown to be increasing the rate and volume in which thermal energy is being transferred from the hotter planet surface into the colder ocean waters.

  • Report this Comment On August 05, 2013, at 2:21 PM, Johny205 wrote:

    Ethanol is a scam to begin with. It costs as much energy to produce ethanol as the energy you get from it. A year or two ago corn was $8 a bushel and they keep making ethanol with it? Many herds of cattle got liquidated because ranchers couldn't afford to feed them $8 corn. The price of tillable farm land has gone up over 100% in the last 5 years, with land in the Iowa area selling for more than $12,000 per acre. If 30% of our corn wasn't going into our gas tanks land and meat would be cheaper. Ethanol is also crappy for your engine.

  • Report this Comment On August 05, 2013, at 3:09 PM, nazekim wrote:

    Regulation and speculation are causing the gas prices to rise. For example, it's sort of like the rise and fall of gold based on commodity speculation. When reports of a drop in inflation and a rise in interest rates occur, there is less upward pressure on the rate of inflation and less demand for gold. Bottom line-when there is choice, the market is less vulnerable to commodity speculation.

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