Cold weather states are beginning to focus on improving their air quality by clamping down on heating oil emissions. It may sound like a small splash in the ocean of potential air quality targets, but several northern states rely on heating oil for more than half of all residential heating requirements. This winter Massachusetts, New Jersey, and Vermont will require low sulfur diesel oils and limit the sulfur content in heating oil to 500 parts per million before transitioning to ultra-low sulfur diesel, or ULSD, with just 15 ppm, by 2018. New York has required ULSD for heating oil since 2012, while Vermont will play catch-up to its Northeastern peers by 2018. More states will surely follow.
It may not sound that enticing, but the Northeast consumed approximately 360,000 barrels of heating oil per day in 2011, the last year data are available. Of course, opportunistic investors will realize that the value created by low sulfur requirements for heating oil extends far beyond the heating oil market. The Energy Information Administration predicts the new heating oil requirements will grow ULSD consumption 20% by smoothing out seasonal demand concerns. That will create favorable growth conditions for both petroleum refineries churning out ULSD and biodiesel and renewable diesel producers such as Renewable Energy Group (NASDAQ:REGI) and Diamond Green Diesel, a joint venture between Darling Ingredients (NYSE:DAR) and Valero Energy (NYSE:VLO).
A growing value opportunity for biofuels
For biodiesel and renewable diesel producers and their shareholders, the value of selling into heating oil markets or hedging with heating oil swaps is greater than the sum of the parts. It allows Renewable Energy Group and Darling Ingredients to smooth out their seasonal businesses. First generation biodiesel sales are often greatly reduced during winter months due to the biofuel's tendency to solidify into a wax (not the desired state of matter for vehicle fuel) at low temperatures. While the chemical structure of biodiesel allows crystallization to occur at lower temperatures, all diesel fuels actually contain high cetane waxes that solidify in colder temperatures -- requiring diesel fuels to be winterized (additional blending costs) to survive as liquids. As a result, biodiesel sales slow and renewable diesel margins shrink in colder months.
Renewable Energy Group and Darling Ingredients are well aware of these factors and have taken steps to reduce their exposure to each. The nation's largest biodiesel producer created REG Energy Services to sell heating oil, ULSD, and BioHeat blended heating oil products -- which reduce emissions by as much as 89% compared to traditional heating oil -- in the Northeast. The new low sulfur requirements will increase the value of these opportunities.
Meanwhile, Diamond Green Diesel wields a production facility designed to produce 136 million gallons of renewable diesel per year. While chemically similar to petroleum diesel, renewable diesel boasts a higher cetane number than ULSD. That doesn't change the fact that costs for blended diesel fuels increase during winter months. Those shrinking margins force Darling Ingredients to hedge against seasonality with heating oil swaps and options contracts, which could become more valuable with the new low sulfur requirements. It also opens the door for Diamond Green Diesel to sell into heating oil markets with blended oils.
Valero Energy, the other half of Diamond Green Diesel, could also take advantage of the ULSD heating oil mandate as a traditional refiner. While the company spun off its retail business in 2013, it continues to flex its refining might in both the gasoline and diesel markets. Three of the company's 16 refineries are capable of producing ULSD, which could be easily utilized to expand production of heating oils -- a business that generates over $300 million per year in sales for the retail business.
Foolish bottom line
Unfortunately, the new requirements for heating oil will arrive just as Northeastern states are converting to natural gas for heating. That will likely result in the continuance of a declining consumption curve for heating oil, although the consequences of natural gas remain unknown. After all, a lack of infrastructure made natural gas a painfully volatile and expensive fuel in the Northeast last winter. However, even if the overall market for heating oil shrinks, biofuels such as biodiesel and renewable diesel will continue to increase their stakes by leveraging their ultra-low sulfur content. Are biofuels really the next big thing in heating oil? Well, perhaps it's the other way around.