This Biodiesel Stock Is on Sale

Shares of biodiesel producer Renewable Energy Group (REGI) have been sinking since the Environmental Protection Agency announced its intentions for renewable fuel mandates for 2014 (link opens PDF). What's the reason? Well, the amount of biomass-based diesel required to be blended into the nation's fuel supply has steadily risen by about 200 million gallons per year since the creation of the current Renewable Fuel Standard, or RFS2, in 2007. The EPA proposed freezing mandates at 2013 levels, or 1.28 billion gallons, through the end of 2015. While every other fuel category had its mandated volume reduced, investors didn't take kindly to the possible removal of a key growth catalyst for REG.

Freezing the biomass-based diesel mandate is bad news for all producers. However, shares of REG have dipped much lower than those of the next largest publicly traded peer, Darling International (DAR 4.94%), which recently began producing fuel with Valero (VLO 0.08%) as part of the Diamond Green Diesel joint venture.

REGI data by YCharts

Why the seemingly unequal treatment? Is it possible this dip is a buying opportunity? I think a solid case can be made for adding shares to your portfolio.

Take note
Why did REG pullback more than its peer? Darling is a viable business with or without Diamond Green Diesel. It simply made sense for the rendering (processing of cooking oils and animal fats) leader to partner with the world's largest independent refiner to produce fuel. REG is a little more beholden to EPA mandates because it solely produces fuels and heating oils, although the market is overlooking the fact that it, too, is viable in the current environment (more below). 

It's important to note the differences between biodiesel and biomass-based diesel. Although they are often collectively referred to as biodiesel, the EPA categorizes them separately. Both companies produce biomass-based diesel fuels that are grouped into the "advanced biofuel" category. To qualify for the EPA's "advanced biofuel" category, a fuel must reduce lifetime greenhouse gas emissions by 50% compared to petroleum-based fuel. This category is pegged at 2.2 billion gallons for 2014, although it includes the 1.28 billion gallons of biomass-based diesel.

By comparison, biodiesel that does not reduce emissions by 50% qualifies for the EPA's "renewable fuel" category along with corn ethanol, which are both first-generation biofuels. The category is pegged at 15.21 billion gallons for 2014, although corn ethanol will contribute a great majority of that total. The major difference stems from which feedstock is used during production. Additionally, advanced biofuels qualify for more valuable credits than first-generation fuels.

Darling and Valero's renewable diesel offers more value than an advanced biofuel, and actually satisfies the ASTM D975 standard -- making it interchangeable with petroleum-based diesel fuel. Nonetheless, the renewable diesel will be used as a blendstock for Valero's petroleum-based diesel. It's also worth noting that REG has done an incredible job improving the efficiency and flexibility of its biorefineries this year. However, the market is still worried about what the proposed policies mean for REG's growth plans for the next few years.

Growth frozen?
Freezing biomass-based diesel requirements through 2015 may force management to freeze plans to finish constructing four biorefineries -- representing an annual capacity of 150 million gallons (mmgy) -- that have had their construction halted at various times since 2008. Two factors contributed to the decisions to halt construction: market conditions and financing.

The company's growing cash pile seemed to be hinting that construction could once again resume for some of the biorefineries, but market conditions may have just trumped that for the short term. There's still the possibility that process improvements, which improve the economics of each biorefinery, will allow REG to complete construction in the current market. Unfortunately, shares are focusing on short term conditions. 

Take the long-term view
If the EPA refuses to revise biomass-based diesel volumes upward for next year, it still isn't the end of the world. REG has room to grow with or without increasing volume mandates, and will continue to exceed $1 billion in annual sales. Consider how the company grew in the third quarter of 2013 compared to the same period of 2012:

Source: REG

It would be great to add the 150 mmgy of capacity sooner rather than later, but let's not forget that REG's eight biorefineries in operation have an annual capacity of 257 mmgy, which make it the nation's largest biodiesel producer. Those same facilities were profitable this year, when biomass-based diesel was pegged to 1.28 billion gallons. Why should anything change when the market is pegged to the same volume in 2014? Am I crazy for thinking it's crazy to value a profitable company with more than $1 billion in annual sales at just over $400 million? Sometimes, I wish I had a megaphone to yell at Wall Street.

The biggest reason to be optimistic about a resurgence in REG's share price is the expectation that biomass-based diesel volumes will be revised upwards before 2014 mandates are finalized. There's no reason to reduce volumes for any type of diesel fuel blendstock when the biggest concern for the nation's fuel supply is the Blend Wall related to gasoline fuel blendstocks. Even if diesel consumption continues to fall, the country's overall blending ratio of 1.16% is nowhere near the theoretical limit of 7% for diesel-based fuels. REG President and CEO Daniel Oh voiced his frustrations with, and his intentions to respond to, the proposed mandates before they are finalized. Investors will have to wait until early next year before learning of his success.

Foolish bottom line 
There's no doubting that REG just got riskier, but I think it's highly likely that the EPA raises biomass-based mandates for 2014, and inevitable that required volumes are raised for 2015. Be aware that REG shares will continue to be volatile given the focus on short-term conditions, which has generally been the case since its IPO several years ago. However, the company remains on firm financial footing, and is profitable with current volume obligations. There's simply no reason to think the viability of current operations will change in 2014.