Buying Ethanol Put Options to Profit from a Fall in Ethanol Prices

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High-Price Ethanol Credits Add to Refiners’ Woes

SUGAR LAND, Tex. — The oil-refining business has always been a tough way to make money.

Stiff competition, heavy regulation and high operating costs make for some of the lowest profit margins in the petroleum industry. And in the last year, profits have been even harder to come by because of the global fuel glut that has translated into bargain-basement prices for the gasoline and diesel that refiners produce.

But lately, the game has been tougher still for people like Jack Lipinski, chief executive of CVR Energy, an independent operator of two refineries in Oklahoma and Kansas. The problem involves a soaring cost that is outside of his control.

This year, on top of everything else, CVR Energy will have to spend as much as $235 million on credits for renewable fuels. That is nearly double what the company spent last year on the credits, and it exceeds the company’s total labor, maintenance and energy costs.

Mr. Lipinski blames the federal program that requires CVR to buy the credits, but he also suspects a role by unknown market speculators who may be driving up the costs of the credits.

“I have no way of fixing it,” Mr. Lipinski said in an interview at his headquarters in this Houston suburb. “It’s a black pool of speculation that could cause bankruptcies in our sector.”

The Environmental Protection Agency, which administers the credits, discounts charges of widespread abuse. And the issue may be only a short-term problem, as it was in 2020, when a speculative bubble drove the price of the credits to unsustainable heights before bursting.

But now, the profits and share prices of many independent refiners like CVR, PBF Energy and the HollyFrontier Corporation are slumping.

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Valero of Texas, the world’s biggest independent refiner, has projected that the credits could cost the company as much as $850 million this year, compared with $440 million in 2020.

Small and medium-size refiners process roughly half the nation’s transportation fuels. Unless the price of credits falls significantly, refinery executives warn of a wave of consolidation that could concentrate refining in fewer hands, leading to higher prices for drivers at gasoline and diesel pumps.

The credits are part of a federal program put in place a decade ago by President George W. Bush and Congress. Refiners of gasoline and diesel fuel are required to add a certain amount of renewable fuel — corn ethanol or other biofuels — to each gallon of petroleum-based fuel they refine. The program was meant to trim oil imports, reduce greenhouse gas emissions and help corn farmers.

If a refiner cannot or does not want to add biofuels to its product — which is CVR’s situation — the company is required to buy a per-gallon credit from refiners that do.

These credits originally sold for a few cents a gallon under the system supervised by the E.P.A. But as an unregulated trading market has emerged, the price has swung wildly for the credits, which are known as RINs, for Renewable Identification Numbers.

The ethanol RIN price approached $1.50 a gallon in the 2020 bubble before falling below 25 cents. And it recently spiked at nearly $1 before slipping back somewhat.

Ethanol is broadly unpopular in the oil industry, largely because biofuels compete with petroleum products for market share. And many say the policy to promote ethanol is antiquated after a six-year drilling frenzy in the United States that has resulted in reduced imports and cheap gasoline.

But the industry is divided on the question of who should be responsible for RIN purchases — those who refine gasoline, as is now the case, or those who blend gasoline with ethanol or other biofuels.

So far, the E.P.A. has declined to change the policy. And industry experts see little chance of any change, at least until after the November elections.

The independent refiners say they are penalized by the system, because their operations are equipped to process only petroleum products — not ethanol, which absorbs water and can cause damaging corrosion in pipelines and storage facilities.

The refiners could buy or construct special ethanol blending terminals, but the smaller players say such investments are not financially feasible.

RINs are simply numbered tags created when ethanol or another biofuel is produced. When the biofuel is blended with gasoline or diesel — usually at a terminal near the filling stations where it will be sold — the resulting RINs can be sold to anyone.

If the blender does not sell the credit to a refiner, it can sell it to a hedge fund or a Wall Street bank, which can save the credits or trade them, like commodities contracts. RINs are generally valid for a year, though refiners can retain up to 20 percent of their credits for the next year. Once an RIN has been submitted to the E.P.A., it is out of circulation.

Many refiners loathe the RIN system, but others in the petroleum industry benefit from high RIN prices.

Many big oil companies make money blending ethanol for their gas stations and from trading the credits. RIN sales are also a big profit maker for gasoline station chains like Murphy USA and RaceTrac that also blend ethanol. And higher RIN prices also indirectly help ethanol producers like Cargill and Archer Daniels Midland because they create more demand for fuel blending.

Jack N. Gerard, the top oil lobbyist as head of the American Petroleum Institute, opposes the federal mandates for renewable fuels. But this month, he took sides on the question of who should bear the burden, when he wrote a letter to the E.P.A. urging the agency to maintain the current requirement that puts the onus on refiners.

With any change, he wrote, “compliance plans, investments, and commercial agreements that were premised on the current structure would be disrupted.”

In some years, there is an excess of ethanol and RINs in the market, and the RIN price tumbles. But the high prices lately are evidently the result of investors and blenders stockpiling RINs in the expectation that the E.P.A. will raise the blending requirements in 2020.

The refiners point out that the credits are sold in private transactions that they say lack transparency. They argue that the E.P.A. is not equipped to supervise the market in the way that a financial regulator like the Chicago Mercantile Exchange would be able to.

“RINs should be trading at 20 to 30 cents and not 70 to 80 cents now,” said George J. Damiris, chief executive of HollyFrontier, which operates five refineries. “So any market premium above that cost of production is due to scarcity and speculation.”

E.P.A. officials say that they so far have found no sign of significant market manipulation, but they will continue to be vigilant.

“Industry and academic analysts have pointed out as recently as this summer that higher RIN prices are an expected outcome of rising R.F.S. requirements,” said Christopher Grundler, director of E.P.A.’s Office of Transportation and Air Quality, referring to the renewable fuel standards.

Some analysts say the high RIN prices will create incentives for more ethanol consumption. Several large independent gas station chains that blend biofuels, including RaceTrac, have announced that they will soon begin pumping more fuel with higher concentrations of ethanol to generate more RINs that they can sell.

Most gasoline now sold in the United States is 10 percent ethanol. But there are higher concentrations, like E-15, which is 15 percent ethanol, and even E-85, or 85 percent.

But gasoline containing ethanol is less efficient than gasoline without it. And only about 6 percent of the vehicles in the United States are so-called flex-fuel vehicles designed to run on biofuel concentrations as high as E-85.

The EPA granted a waiver for E-15 gasoline for use in all cars built since 2001, but several auto manufacturers have warned against its use.

Mr. Lipinski, of CVR Energy, expressed skepticism that the ethanol market would take off any time soon under current government policy.

“Nobody’s buying E-85,” he said, shrugging. “Who’s going to pay the same or more for a fuel that gives you 35 percent less gas mileage?”

Ethanol Is Looking Better. Investors Still Need to Tread Carefully.

Ethanol-producer profit margins look poised to move higher.

It may be time for aggressive investors to consider ethanol. Production, inventories and trade policy might align to give the stocks a boost.

Ethanol maker Green Plains (ticker: GPRE) reported earnings Tuesday evening and the stock jumped Wednesday, closing up 11.6% to $14.65 a share. Things are looking up for the confusing, embattled commodity.

“As expected, our third quarter results were attributable to a continued weak ethanol margin environment that began to show improvement in late September,” CEO Todd Becker said in the company’s Tuesday evening news release.

Green Plains lost money in the third quarter. But Becker’s comment about the future boosted shares. Things were better in September. What’s more, Becker said on the company’s Thursday conference call that the industry was exhibiting “production discipline” and product inventories are the lowest in years.

Low production and low inventory is a good setup for higher commodity prices. It sounds as if ethanol-producer profit margins are poised to move higher.

If only it were that simple.

Less-aggressive investors should be warned. Ethanol is confusing and not many people can claim to have traded the sector successfully. Four publicly traded ethanol companies that investors can watch—Green Plains, Pacific Ethanol (PEIX), Andersons (ANDE) and REX American Resources (REX)—are off about 67% from all time highs. The market value of the quartet is less than $2 billion, a fraction of the gasoline-refining industry they sell into. Ethanol-producer stock positions need to be watched carefully.

The confusion comes from all the moving parts that go into the margins. Investors have to track corn prices, gasoline prices and ethanol inventories to get a sense of what companies should be earning.

Corn is the main cost input for U.S.-based ethanol, so corn costs impact profitability. But ethanol prices don’t always track corn prices, because ethanol is sold as a gasoline replacement. There are complicating factors—such as regulation—but low energy prices push down ethanol prices.

And ethanol, of course, is its own commodity. If producers make too much, prices fall. But when inventories are low—as they are now—prices can rise.

All that still isn’t enough to predict ethanol profitability. Sugar matters, too. Brazil produces a lot of ethanol—just like the U.S.—and its industry is based on sugar. Low-price ethanol made from low-priced sugar can impact U.S. producer profits.

The refining industry has historically hated the ethanol industry. Ethanol demand was created—in large part—by the U.S. government. First it was to replace the fuel additive MTBE, which was linked to water pollution. Later, George W. Bush-era federal renewable fuels standards sought to wean America off foreign oil by putting corn in the gas tank. Refiners don’t want to buy ethanol from third-party producers if they don’t have to. That also can make life difficult for the publicly traded ethanol companies.

“Things are looking better for ethanol these days,” IAG agricultural consultant Mark Feight said. He noted the low inventories and said trade detente with China could boost U.S. ethanol exports, further tightening domestic supply and demand. “Then what the industry needs is sugar prices to rise to 15 cents, then the industry could do really well.”

Global sugar prices are about 12.5 cents a pound. Why are sugar prices too low Barron’s asked? “There’s too much of it,” Feight responded. It’s a perfect answer coming from a commodity trader. Big supply drives down prices.

There is a lot to consider. But if Becker is right and low inventories lead to better profits, ethanol stock prices should move higher.

Green Plains shares are up about 14% year to date—most of the gain coming Wednesday—still trailing the comparable 20% gain of the Dow Jones Industrial Average. Green Plains shares remain down about 50% from 2020, when the ethanol margin proxy was higher.

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