Shares of refiners have been on a tear, up some 20% to 30% for the year, on favorable input costs from burgeoning U.S. crude oil production. However, in the five-day trading period beginning in March, shares of Valero Energy, the second-largest U.S. refiner, fell nearly 10% with most other refiners down about 5%. Just prior to this sell-off the price of environmental credits, officially known as Renewable Identification Numbers (RINs), spiked approximately 15 fold—from 7¢ per gallon at the start of the month to $1.06 per gallon only 11 days later.

Refining companies must purchase RINs to comply with Congressionally-mandated renewable fuels standards (RFS), so their sell-off is explainable. But what’s behind the striking price action in the up-till-now obscure RINs and what are the broader implications for other aspects of the energy value chain?

Every year the amount of renewable fuel—including ethanol and advanced biofuel—required to be blended into the U.S. gasoline pool increases. Based on the percentage of their throughput, refiners have individual RFS quotas or amounts of ethanol that they need to blend with gasoline.

Meeting quotas

To attain the quotas, they purchase ethanol from third parties and blend it with gasoline in their own terminals. They also purchase RINs, unique serial numbers attached to each gallon of ethanol produced in or imported to the U.S. When the ethanol to which the RIN is attached is blended with gasoline by a third party, the refiner will either submit the numerical tag to the government for compliance reporting or will trade it on a secondary market if the company has already reached its target. Excess RINs were generated by industry participants in most years prior to 2013, but all refiners have to purchase RINs at some point because, for a variety of reasons, it is impossible to hit the yearly RFS targets by blending at their own terminals alone.

In 2013, the mandated amount of ethanol to be blended into gasoline is 13.8 billion gallons and 2014 will see that figure rise to 14.4 billion. However, the most recent indications in the market are that more than 95% of gasoline gallons sold in the U.S. are blended with 10% ethanol already, a threshold beyond which threatens vehicular safety, as auto manufacturers will not extend an engine’s warranty if the fuel employed contains too much ethanol.

In other words, the 2013 mandate for ethanol blending, which has obviously not yet been met as we are only at the end of the first quarter of the year, is higher than what the infrastructure can support. Even though the required volume of ethanol that must be blended into the gasoline pool continues to ascend each year, the maximum amount of ethanol that feasibly can be blended is falling because the gasoline pool itself is shrinking as consumption declines and because blending can occur only up to the 10% threshold.

Outdated projections

The mandated volumes are based on projected gasoline consumption. When the RFS was created in 2007, it was thought that demand for the transportation fuel would steadily rise. However, rising automaker corporate average fuel economy standards, increased vehicle efficiency and demographic and economic changes have combined to reduce demand. Going forward, the only way for the RFS mandate to be met is via the purchase of RIN credits. But, because RIN numbers can only be converted into RIN credits when they are blended into gasoline, the supply of tradable RIN credits is itself capped.

Analysts at Citigroup project that RINs stockpiles will not fall to zero until late 2014, but the situation is one where demand for RINs will necessarily rise while supply necessarily cannot rise. The sell-off in refining stocks is thus more understandable, though the precise impact on earnings capacity remains elusive for a variety of factors. The most significant is that petroleum exports are not subject to blending requirements, meaning that refiners can increase the amount of fuel that they sell aboard and decrease what they sell in the U.S. market in order to reduce their RFS mandates. On a related note, they could offset higher RIN costs by increasing the price at the pump—effectively both options spell higher retail fuel prices.

A third possibility for refiners is expanded engagement with midstream companies, such as Magellan Midstream Partners LP, Buckeye Partners LP, Kinder Morgan, among others, who provide ethanol blending and transportation services, or they could expand their own midstream product terminal assets to support self-blending. This could help refiners to mitigate their RIN exposure, though any additional blending is also subject to the 10% threshold. As blended ethanol cannot be transported via pipeline due to its corrosive nature, this provides yet another opportunity for trucking providers.

As long as the 10% threshold is in place, this problem will not be solved by increasing ethanol production or expanding blending infrastructure. Ultimately, it may take gasoline supply shortages in the U.S. and/or surging pump prices as RINs costs are passed along to consumers, for the RFS policy to be reformed.

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