Shares of Renewable Energy Group (REGI) have been surprisingly resilient throughout the ongoing market correction. While the S&P 500 has dropped 7% since the beginning of 2020 and the price of crude oil has tumbled 23% in that span, shares of the renewable-fuels manufacturer are hovering at a break-even return.
Perhaps that's not too surprising. Renewable Energy Group, which is valued at $1 billion, is expected to receive a roughly $500 million windfall from the federal government after an important tax credit was retroactively reinstated. The subsidy was also extended through the end of 2022.
Despite the newfound certainty of the subsidy and the the financial flexibility that brings, investors will be eager to learn the company's strategy for expanding its renewable diesel footprint. Here's why it's the most important thing to watch when Renewable Energy Group reports fourth-quarter 2019 operating results on March 5.
What's that windfall about?
In mid-December, Congress struck a budget deal that extended several existing tax credits for low- and zero-carbon technologies. Among them was the federal biodiesel excise tax credit (BTC), which had been allowed to expire on the last day of 2017. The budget deal retroactively reinstated the BTC to the first day of 2018, and extended it through the last day of 2022.
The tax credit provides a $1-per-gallon subsidy to the first entity that blends biomass-based diesel fuel with petroleum fuels; that's usually the producer of the renewable fuel. Although Renewable Energy Group couldn't collect the subsidy in the last two years, the company estimated it would have received $450 million in tax credits from production volumes in the seven quarters ended September 2019.
The business now gets to collect that bounty in early 2020. In fact, the total windfall is likely to be valued at roughly $500 million when fourth-quarter 2019 production volumes are included. What's more, the extension of the tax credit means the company should collect at least $250 million per year from 2020 through 2022. That would create an additional $750 million in revenue in the next three years -- and the tally doesn't include production increases.
On the one hand, Renewable Energy Group reported an operating loss of $104 million in the first nine months of last year. The reinstatement of the BTC should make the business comfortably profitable again.
On the other hand, the steep operating loss in the absence of the BTC suggests the business is a little too dependent on federal subsidies. That's what makes an expansion of the company's renewable diesel footprint so important.
What's the renewable diesel strategy?
Biodiesel and renewable diesel are both biomass-based diesel fuels. Both are produced from animal fats, greases, inedible food oils, and other renewable feedstocks. Both are covered by the BTC and other state and federal tax credit programs. But there are important differences between the two.
Biodiesel is a first-generation renewable fuel. It has a chemical structure that limits blending potential with petroleum-based diesel and limits use in colder climates. It's typically produced in smaller facilities, which results in higher per-unit costs of production.
Renewable diesel is a next-generation renewable fuel. It has a chemical structure similar to that of petroleum-based diesel, which allows near seamless integration with existing transportation infrastructure. In fact, renewable diesel doesn't even have to be blended with petroleum-based diesel fuel to be used. The renewable fuel typically sells at a premium to biodiesel and can earn higher per-gallon tax credits (although not for the BTC) due to its favorable characteristics. It's also produced in larger facilities, which results in lower per-unit costs of production.
Put another way, renewable diesel is an inherently higher-margin fuel than biodiesel. Case in point: Renewable Energy Group generated over half of its total adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) in 2018 from its lone renewable diesel facility. It had an effective production capacity of about 90 million gallons per year (MMgy) in 2018, or about 20% of the company's total production footprint.
Renewable Energy Group needs to take advantage of its newfound financial flexibility and invest heavily in renewable diesel. That way, if the BTC isn't extended beyond 2022, then the company might be profitable without federal subsidies.
The near-term expansion effort has gotten off to a rocky start. Renewable Energy Group and Phillips 66 were exploring a joint venture to build and own a 250 MMgy renewable diesel facility in Washington state. It would have been located adjacent to a Phillips 66 petroleum refinery, allowing for improved economics compared to a greenfield project. But the duo decided not to pursue the joint venture.
That was a gut punch for investors, but there's no need to panic. Renewable Energy Group has previously studied the potential to invest in a large-scale expansion of its existing renewable diesel facility. It purchased land adjacent to the facility and conducted engineering work, but didn't have the funding to do much more. Now that funding isn't an issue, investors might expect to learn more details when the company reports full-year 2019 operating results.
The biomass-based diesel producer has also suggested it was exploring other renewable diesel projects, although management didn't go into details. Partnering with a refiner still makes economic sense, especially since the company owns proprietary technology for producing renewable diesel.
All eyes will be on renewable diesel
Renewable Energy Group is about to receive a significant windfall from the retroactive reinstatement of the BTC. Meanwhile, the tax credit's extension through the end of 2022 provides a rare level of economic certainty for the small-cap stock.
However, three years isn't that much time, and there's no guarantee the federal subsidy will be extended beyond 2022. While increasing investments in logistical services and renewable heating fuels could help to insulate the business from the inherent uncertainty of low-margin biodiesel, renewable diesel appears to be the most visible way to reduce the company's dependence on subsidies.