Renewable fuel markets and uncertainty often go hand in hand, but the economic fallout of the last month definitely adds a creative twist to the relationship.
The novel coronavirus pandemic and an economic spat between Saudi Arabia and Russia have combined to cut crude oil prices by more than half since the beginning of the year. On multiple continents, local, regional, and national efforts to contain the SARS-CoV-2 virus have led to steep reductions in liquid fuels consumption.
It's still too soon to know exactly how the unfolding situation will affect specific industries, but sharply lower crude oil prices will surely hurt biomass-based diesel producers like Renewable Energy Group (REGI). The positive news is that the company began 2020 with a strong balance sheet. Can that protect the business and the small-cap stock during these uncertain times?
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Yet another increase in uncertainty
There's a heavy dose of irony accompanying the current reality. Investors were just beginning to prepare for a more certain future for Renewable Energy Group.
The federal biodiesel mixture excise tax credit (BTC) was allowed to expire on the last day of 2017. It provided a $1 per gallon subsidy to the first entity that mixed biomass-based diesel and petroleum-based diesel. The expiration meant no one in the industry has benefited from the subsidy for a single drop of production since the first day of 2018.
It hurt financially, especially when the cost of inputs rose last year, but companies kept chugging along. The perseverance paid off: In December 2019, Congress decided to retroactively reinstate the BTC and extend it through the end of 2022. The move allowed Renewable Energy Group to record a net cash benefit of nearly $500 million for biomass-based diesel production from the last two years and plan for a rare stretch of relative stability for the next three years.
Put another way, the resuscitation of the BTC meant the biomass-based diesel industry could temporarily ditch uncertainty. Renewable Energy Group had plans to significantly expand production of renewable diesel (a premium fuel compared to biodiesel), continuing expanding its nationwide distribution network, and potentially repurchase up to $100 million in common stock. Meanwhile, escalating clean-air rules in California and new regulations pertaining to underground storage of biomass-based diesel in the state were expected to create opportunities for significant sales volume growth.
Then March 2020 happened, tossing the industry back into the grip of uncertainty. What happens now?
Image source: Getty Images.
Can a strong balance sheet help Renewable Energy Group weather the storm?
To be blunt, sharply lower crude oil prices are going to cause significant pain for the biomass-based diesel industry. Renewable Energy Group has actually conducted analyses to gauge its exposure to various market risks. The projections suggest investors should brace for impact.
According to the company's estimate, a 10% reduction in biomass-based diesel selling prices last year would have reduced full-year 2019 gross profit by $255.6 million, or 48%. For perspective, selling prices for West Texas Intermediate (WTI) crude oil have fallen roughly 61% since the end of 2019. Of course, commodity markets don't exist in a vacuum. Some of the expected hardship from lower selling prices will be offset by realizing sharply lower purchasing prices for inputs, but it figures to be a difficult year.
Lockdowns issued in efforts to control the novel coronavirus pandemic are sure to take a bite out of demand for transportation fuels, but demand for diesel fuels (think trucking, buses, and the like) shouldn't collapse nearly as much as demand for gasoline (think everyday individuals driving cars to work). That suggests sales volumes will deteriorate less dramatically than selling prices, but the latter will still be the determining factor for the health of operations.
Long story short: There are a lot of moving parts right now. It's difficult to gauge how Renewable Energy Group will fare this year given the new uncertainty, although a strong balance sheet will certainly help (a lot).
If management forgoes share buybacks (likely a wise decision in the current environment), then the business could weather sharp operating losses for at least a couple of years. Then again, the reinstated BTC should offset some of the pain from lower selling prices and preserve cash, but how much benefit it will provide cannot be known.
The biggest question is how -- or whether -- the new uncertainty affects the company's ability to invest in its long-term future: namely, an expansion of its national distribution network and renewable diesel production capacity. The next official update from management is sure to have some pretty awful financial numbers and guidance, but investors that focus on the long-term viability of the business will be the first to realize whether shares are trading at a bargain or flashing red warning signs.
