EPA Tosses Refiners a Major Biofuels Win

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Despite being able to feast on dirt cheap mid-continent crude oil and huge profit margins, the refining or downstream sector of the energy industry is facing a huge problem … and not it’s the dwindling WTI-Brent spread. In this case, we’re talking about something a bit more “corny.”

That would be the ethanol and biofuel mandates stemming from the Energy Policy Act of 2007.

This bill spells out the amounts of ethanol that refiners are required to blend into gasoline and costs for complying with the piece of legislation are skyrocketing — up from just pennies per gallon to more than a dollar. All in all, that’s putting a squeeze on the oil refiner’s profits.

However, the sector recently got some good news in the way of a pending Environmental Protection Agency decision to overturn or alter the rules governing just how much ethanol refiners will need to blend next year. If that ruling goes off without a hitch, investors could be treated with significant gains in the refining stocks once again.

Hitting the “Wall”

According to the Energy Policy Act, refiners are required to blend 13.8 billion gallons of corn-based ethanol and 2.75 billion gallons of advanced biofuels into our gasoline supplies this year. Those numbers rise to 14.4 billion gallons of corn-derived ethanol in 2014 and 15 billion in 2015. These requirements have been the rallying cry for investors in biofuel producers like Pacific Ethanol (PEIX).

However, there is a slight problem with those amounts, and it’s called the “blending wall.”

Unfortunately for the ethanol faithful, for whatever the reason, American’s just aren’t driving as many miles. That has significantly reduced the amount of gasoline demanded by our citizens. So in order to comply with the mandated amounts of ethanol, refiners will be forced to sell fuel blends exceeding 10% ethanol, export more gasoline to places like Brazil or purchase Renewable Identification Number credits to offset the amount of renewable fuel they did not mix with their gasoline.

The problem is that, in concentrations of more than 10%, ethanol can cause engines to corrode and break apart faster. Additionally, emissions control systems can fail if the blend is too high. Some older cars can’t handle gasoline/ethanol blends of more than 15% at all.

So most refiners have voiced that they will either go with exporting the fuel or buying credits. Both choices will result in higher costs for consumers down the line … which will offset gasoline demand and start the cycle all over again.

But, the EPA might just be throwing the downstream sector a bone on this one.

In a leaked document to news agencies Bloomberg and Reuters, the department has stated that the blend wall as an “important reality.” In acknowledgement of the phenomenon, the EPA is potentially drafting new rules that will cut the amount mandated corn-based ethanol and advanced biofuels down to just 13 billion and 2.21 gallons, respectively.

The agency is also looking at drastically dropping the Energy Policy Act’s requirement for cellulosic fuels — those produced from scrap wood or corn husks — to just 23 million gallons. That’s down from 1.75 billion gallons, as the technology hasn’t been up to snuff.

All in all, the fact that the EPA is considering changing the rules for ethanol is huge win for the refiners.

The EPA only issues a set amount of credits, and then they trade on the open market. Refiners have been scrambling to secure RINs as the blend wall is fast approaching. The costs of these credits for not complying with the Energy Policy Act have surged — from just 1.5 cents to more than $1.10 since 2012.

So far, the costs of these credits have only just begun to hurt earnings at some of the major downstream players like Western Refining (WNR). However, hitting and surpassing the blend wall could severely impact the sector’s chances.

Two Ways to Play

Given that the EPA is considering scaling down our nation’s biofuel and ethanol efforts, investors once again have the green light to buy refiners.

Profit margins for many of these firms should pop if the plan is implemented and the downstream players won’t have to purchase some many RIN credits. For example, smaller refiner Alon USA Partners (ALDW) estimated RIN costs are around $20 million, while refining kingpin and my personal favorite Valero (VLO) is in the $800 million range.

That’s some pretty substantial coin that could trickle back down to shareholders. In Alon’s case, analysts estimate that expense removal could add an additional 24 cents to its distribution this year. And given the recent widening WTI-Brent crack spread, investors in the sector could be handsomely reward. Buying the sector and stocks like Marathon Petroleum (MPC) make a lot of sense.

On the flipside, if you’re a more aggressive investor, shorting several of the ethanol and advanced biofuel names — Pacific, BioFuel Energy (BIOF), Gevo (GEVO), KiOR (KIOR) etc. — might prove to be especially fruitful. If the EPA is successful at lowering the standards, much of these firms could have a hard time getting there products into market.

Considering that many aren’t profitable, this could mean another round of bankruptcies in the future. But for the refiners, it looks like smooth sailing.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

Aaron Levitt is an investment journalist living in Ohio. With nearly two decades of experience, his work appears in several high-profile publications in both print and on the web. Also likes a good Reuben sandwich. Follow his picks and pans on Twitter at @AaronLevitt.


Article printed from InvestorPlace Media, https://investorplace.com/2013/10/refiners-just-scored-major-win/.

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