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The Renewable Fuel Standard: A Thorn in Refiners' Side

Lately, independent refiners have been struggling. Feedstocks benchmarked against West Texas Intermediate have cost more, as takeaway capacity from Cushing, Okla. -- the storage hub of WTI crude oil -- became more efficient. This development ate into profit margins. However, it seems that the Renewable Fuel Standard (opens a PDF) set by the Environmental Protection Agency has proved to be another thorn that U.S. refiners must deal with.

Logo used in the United States for E85 fuel. Source: Wikimedia Commons.

What is it all about?
To Fools who aren't yet aware of what this regulation is all about, it's a program that essentially requires higher production of ethanol and other biofuels in the United States to meet a certain level each year. The EPA aims to achieve "significant reductions of greenhouse gas emissions from the use of renewable fuels". According to the 2013 standards, or RFS2, a total of 16.55 billion gallons -- or an estimated 9.74% of all motor fuels market in the country -- must be renewable fuel.

To ensure compliance, the EPA requires refiners and blenders to buy a proportionate amount of renewable fuel from producers at market price, depending on the amount of fossil fuel these refiners sell each year. That way, the total mandated gallons of renewable fuels are expected to make way into the market.

How is it enforced?
The EPA has a mechanism that keeps track of fuel ethanol and other renewables sold in the market. For each gallon of ethanol these refiners buy, a uniquely identifiable Renewable Identification Number, or RIN, is generated. At the end of the year, each refiner has to possess the assigned number of RINs that must be deposited with the EPA. According to RFS2, one gallon of ethanol corresponds to one RIN, while one gallon of biodiesel bought generates 1.5 RINs.

The problem is, individual refiners may not really have as much need for ethanol or other biofuels as have been mandated for purchase. So there's another way out: These RINs can be stripped from the biofuels and sold separately in the open market. So refiners don't necessarily have to buy the physical commodity but may simply buy the RINs from the open market. Of course, the price of one RIN is still the same as the price of one gallon of ethanol.

The problem
At 9.74% of the motor fuel market for 2013, the total renewable fuel in the market is currently within the 10% "blendwall" limits. The blendwall is the maximum proportion of ethanol most drivers are willing to accept in gasoline. That's why individual obligations for refiners may exceed requirements. While refiners do require ethanol for blending the E10 variant of gasoline (which contains 10% ethanol), there could be a definite mismatch between demand and regulatory requirement. In other words, this year refiners had to buy RINs in the open market just to satisfy the mandatory quota. HollyFrontier (NYSE: HFC  ) reports that as of June, it has been "purchasing RINs in order to meet approximately half of our renewable fuel requirements."

Additionally, RINs have been costlier this year. Corn ethanol (and hence RIN) prices shot up this year to around $1.10 per gallon, from less than $0.10 per gallon in 2012. This is exactly where buying fuel ethanol or its corresponding RINs haw turned out to be a headache for these refiners.

The players so far
This year, Valero Energy (NYSE: VLO  ) has so far spent $267 million on RINs, of which $137 was spent in the second quarter. This is a $78 million increase in RIN expenditure over last year's second quarter. Marathon Petroleum (NYSE: MPC  ) spent $65 million in the second quarter and $107 so far this year to purchase RINs. Phillips 66 (NYSE: PSX  ) , on the other hand, has so far remain tight-lipped on the actual numbers. But analysts have hinted that the value could be pretty large, and could be as large as Valero's.

So are these numbers large? Yes. These figures shaved off a considerable percentage off the operating income of these refiners. However, things look even bleaker next year, unless there is a change in the regulatory framework. According to the EPA, next year's total mandated renewable fuel volumes stand at 18.15 billion gallons -- up from 16.55 billion gallons this year. This could mean disaster, as the only recourse might be for E15/E85 gasoline to hit the market. Drivers have so far been reluctant to use this blend, as it could void auto warranties. In other words, breaching the 10% "blend wall" could spell trouble for refiners.

The energy space, however, isn't just restricted to refiners. Record oil and natural gas production is revolutionizing the United States' energy position. Finding the right plays while historic amounts of capital expenditures are flooding the industry will pad your investment nest egg. For this reason, The Motley Fool is offering a comprehensive look at three energy companies set to soar during this transformation in the energy industry. To find out which three companies are spreading their wings, check out the special free report, "3 Stocks for the American Energy Bonanza." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free. 

Read/Post Comments (3) | Recommend This Article (2)

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 14, 2013, at 10:23 PM, agsb2 wrote:

    Renewable fuel should be a thorn because there is no such thing because it goes against the law of Thermodynamics.

  • Report this Comment On August 14, 2013, at 11:42 PM, fpl1954 wrote:

    Yes, we definitely need to switch to renewable fuel. OK, that's the easy part, saying it. Doing it isn't quite as simple. In fact, we are switching, maybe not as fast as we can, but pretty close.

  • Report this Comment On August 19, 2013, at 8:17 AM, 15PlusPercent wrote:

    Of course ethanol has 34% less energy than gaoline leading to 15% lower gas mileage in your car, risks ruining your engine (typically not warranted for pre-2010 cars), and taxpayer subsidies go to the alcohol companies resulting in consumers paying up to $4/gal at the pump.

    Using our scarce global food supply for transportation fuel while the US has a glut of light crude and gaoline does not seem to fit any definition of renewables. Forcing 10-15% of inferior fuel into motor gasoline results in product exports to comply with regulation, and of course higher gasoline costs for consumers.

    I fully understand why Congress has squelched any attempt to disclose their personal interests and equity positions - who wouldn't want to get rich via insider trading with no threat of jail time.

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