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Refiners: Acquire Renewable Energy Group To Turn RIN Lemons Into Lemonade

Summary

Refiners face a regulatory gauntlet, and RINs have become their highest operating expense.

Refiners that make ethanol can be trapped - knee deep in a river of RINs and dying of thirst.

Unlike ethanol producers, biodiesel producers have an ability to separate and control RINs.

REGI creates enough RINs to satisfy the obligation of many refiners.

The company is currently trading at less than 50% of its replacement value.

Introduction

The petroleum industry is faced with a gauntlet of compliance that grows more burdensome every year. It shouldn't surprise us when we see the petroleum industry fight regulation - it is a learned behavior from years of harsh treatment. If we were forced to walk a mile in their sandals, we would understand. Meanwhile, we enjoy the freedom of driving our cars 15,000 miles a year while we pay less for gasoline than we pay for milk.

Gauntlet (defined) - a form of punishment when someone is forced to run between two rows of people who are armed with sticks which they use to strike out at the runner

The pinnacle of a refiner's regulatory burden is found in the Renewable Fuel Standard ("RFS"). To the refining industry, the RFS is burdensome in its scope, its reach, its complexity, its deficiencies in fraud protection, and perhaps most painful, its financial costs. We won't outline the RFS in detail here, because it is quite complicated (and boring) and we don't want to lose our audience. There are plenty of sources (including the EPA) which provide a good overview of the RFS and how Renewable Identification Numbers ("RINs") work to satisfy regulatory compliance.

Please don't misunderstand, we fully support the RFS vision to promote growth in renewable fuel consumption. The RFS regulation has improved in many ways over the years, and we anticipate that the EPA will continue to tweak the system to make it more transparent, fair and effective. Moreover, we have spent the last decade launching, promoting and growing a renewable fuel business. We believe that renewable fuels are good for the environment, the economy, and for energy security. We also believe that the RFS - whether modified or not - is here to stay. Jeff Stevens, CEO of Western Refining (NYSE:WNR), agrees. In his most recent quarterly update, he said, "we've come to the conclusion that [the RFS] is probably here to stay for a while... so we've continued to focus on retail and wholesale assets essentially controlling the RIN and the RIN expense..."

Some refiners have taken steps to expand blending operations to cover their RIN obligation, but that approach is not always practical or possible for others. Other refiners have decided to fight the RFS tooth and nail, and we anticipate that this battle will continue. Quoting the GEICO commercial - "it's what they do." Nevertheless, it is pragmatic for refiners to take steps that enable it to survive and thrive with or without a modified RFS. The RFS has given the refiners a lot of lemons. The time has come to make lemonade.

Valero's Ethanol Trap

By owning and operating numerous ethanol plants, Valero (NYSE:VLO) is unique from many other refiners. One might think that ethanol plant ownership helps VLO to more easily satisfy its RIN obligations, but that is not the case. Unless a refiner connects significant blending operations to its ethanol production, it might find itself knee deep in a river of ethanol RINs and dying of thirst. Allow us to describe the general flow of ethanol and RINs using VLO as an example.

A VLO plant produces ethanol and the ethanol gallons are sold with RINs, eventually arriving at a blending terminal. The terminal separates the RIN (an electronic number) from the ethanol when it is blended with gasoline. The blending terminal now controls the RIN as a financial asset, which it sells to the highest bidder. Here is the issue in a nutshell: VLO loses control of the ethanol RIN when the ethanol is sold. The blender captures the lion's share of the RIN value simply by controlling the blending infrastructure.

This is a reason why VLO is leading the fight to modify some of the RFS rules. Even though VLO generates considerable RINs through ethanol production, it does not have enough physical infrastructure to blend all of it. As a result, VLO continues to sell ethanol with RINs, and then must cover its obligation by purchasing paper RINs from the market. In today's market, VLO might lose $0.90 per gallon of ethanol because of this disconnect. Not surprisingly, refiners are divided on RFS reform based upon whether or not they control blending operations. Due to competing interests on a complicated topic, this issue is not likely to be resolved quickly.

For other refiners, like CVR Refining (NYSE:CVRR), an expansion into blending infrastructure is impractical. Refiners like this have only one option: purchase RINs from blenders, brokers, and Wall Street aggregators. CVRR and others allege that the RIN market can be rigged, and say that independent...


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