If you want an example of a regulation driving up the cost of doing business, look no further than the Environmental Protection Agency's ethanol mandate, which also creates uncertainty for a segment of the refinery industry.
At issue is the rampant volatility of what are called Renewable Identification Numbers. Most merchant and small refiners have to buy these RINs to comply with the Renewable Fuel Standard.
It's a cost that stems directly from the need to comply with a federal program, not to buy or build new assets or expand the use of a product. RINs add to the cost of running a small or merchant refinery for no other reason than to demonstrate compliance with the government's wishes.
In other words, with no Renewable Fuel Standard, there would be no reason to spend the billions of dollars on RIN credits to meet the standard. In many cases, that money would go into capital development or toward reducing costs for consumers, say many of the refiners arguing for a solution. Yet, RINs are one of the most tangible examples of many that show government red tape is hurting bottom lines for businesses.
It is estimated that the standard could drive up costs for the fuel refining business by a total of $15 billion a year.
The cost of buying corn ethanol RINs reached a record high of over $1 billion in the first half of 2016 among the top 10 independent refiners, Reuters reported. By the end of the year, those costs had soared to nearly $2.5 billion, according to corporate filings with the Securities and Exchange Commission. Costs could be much higher by the end of 2017, but the RIN market is tough to track accurately.
The Renewable Fuel Standard was established by energy laws passed in 2005 and 2007. They forced refiners to blend more and more corn ethanol into the nation's gasoline supply. The official rationale for this included energy security — an old shibboleth of evasive policymaking — and cutting greenhouse gas emissions. Many critics, however, see it as just another subsidy program for a special interest group, with spiraling RIN costs just the latest symptom.
The RIN market is unregulated, which means one must sift through corporate filings to figure out how much is being spent and by whom.
In an analysis last year, Turner, Mason & Company, a consulting firm, says it's "difficult to piece together a complete picture of refinery costs from company reports, presentations and filings. Also, each refinery portfolio, and therefore its RIN sensitivity, is different."
The group offered a rule of thumb for examining how much RIN costs have hampered business. They suggested RINs could cost $15 billion per year, but admitted that their number was an "oversimplification," a way "to quickly put a number on RIN costs" by multiplying the entire 2016 renewable fuel obligation under the RFS (just over 18 billion gallons) by the average per gallon RIN cost of $0.82.
There is now new uncertainty in the market driven by big increases in the RFS annual target, which also "results in an increase in RIN cost," the firm stated.
How it works
To understand this fully, one must first be clear how an RIN is generated. Picture a refinery, which takes crude oil, applies heat, water and lots of pressure to get gasoline. That gasoline is then sent into the market where it is blended with ethanol, and thereby generates an RIN for each gallon of ethanol that is blended.
The big companies such BP and Shell are best set up to blend the ethanol, and thereby collect the most RINs. Many merchant companies and small refiners only do the first step of the refining process, which includes turning the crude oil into fuel and sending it into the market. And because they don't have access to the second step of the fuel-to-market process, the blending part, they have to buy RINs from the major oil companies in order to meet the RFS each year.
Refiners such as PBF, CVR and Monroe have been lobbying hard to exempt them and other small refiners by moving the so-called "point of obligation" so as to impose the duty of compliance with the RFS only on those in a position to do the blending.
Brendan Williams, head of government relations for merchant refiner PBF Energy, explained it as a simple case of Coke versus Pepsi, if Pepsi owned a bar. "Say there was a mandate that every glass of soda served to consumers has to contain rum in it," Williams explained. "You can only buy rum and Coke from a bar, right? And Coca-Cola, they may not own [the rum], and they may not own any bars; they just want to sell cola to consumers."
But Pepsi, they own the "cola plus they own the bar. And you get the credit for compliance once the rum actually gets mixed in the glass," Williams said. "So, Pepsi owns the bar. Their bartenders are mixing the drinks. They get all the credits, but they know [Coca-Cola] has to comply. But since [Coke] doesn't have all the resources to get into the massive bar business, they have no choice but to pay their competitor."
EPA did not, at least officially, foresee this market problem and has struggled and failed to address it for the last four years. In fact, it seems to be getting worse, refiners say.
The American Petroleum Institute, representing big integrated companies, sides with the ethanol industry and opposes changing the point of obligation. Merchant refiners say this shows they want to keep the RIN market the way it is because it's a source of revenue for them.
Cost pressures for the world's largest refiner
Other industry consultants see the cost exposure even affecting the world's largest independent oil refiner, San Antonio-based Valero, which had been thought immune to higher RIN costs because it owns big ethanol facilities.
Valero says it spent nearly $750 million in 2016 on RINs, and expects to spend that amount or more in 2017. That's nearly a quarter of a billion dollars more than it spent when credit costs first started to spike in 2013.
"At this level, this is a significant issue for us, so we continue to work aggressively with regulators," said Valero CEO Joe Gorder on an earnings call this year.
An official with the global commodity tracker Genscape pointed out that SEC 10-Q filings for the first quarter of 2017 showed the big refiner was also exposed to higher costs from California's climate rules under state law AB-32, as well as climate rules in Canada, on top of the RIN costs.
"The cost of meeting our obligations under these compliance programs was $146 million and $161 million for the three months ended March 31, 2017, and 2016, respectively. These amounts are reflected in cost of sales," the first quarter SEC filing showed. Its costs appeared to be slightly down from last year, at least for the first quarter of 2017.
Other merchant refiners such as Monroe Energy, obtained by Delta Airlines to produce jet fuel in 2012, are suffering significant cost overruns due to RINs and the RFS.
Delta bought the refinery to hedge the high cost of jet fuel by producing its own supplies. Now, because Monroe has to meet the Renewable Fuel Standard by buying RINs, Delta's goal of reducing the cost of running its airline business has been stymied.
It explained in recent SEC filings that because it deals mainly with supplying jet fuel, which is not even an accepted fuel under the RFS, it must buy an inordinate number of RINs at substantial cost.
The Monroe Trainer Refiner lost $125 million in 2016, compared to profits of $290 million and $96 million in 2015 and 2014 respectively, the Genscape official pointed out from SEC 10-Q filings.
"The refinery's loss in 2016, compared to profits in the preceding two years, was primarily due to high RINs costs and lower distillate costs," the SEC filings from Delta Airlines stated.
"Because the refinery, operated by Monroe, does not blend renewable fuels, it has purchased its entire RINs requirement in the secondary [RIN] market," according to the SEC filing. "We recognized $171 million, $75 million and $111 million of expense related to the RINs requirement in 2016, 2015, 2014, respectively. RINs expense increased during 2016 primarily as a result of a significant increase in the unit cost of RINs from approximately 58 cents per RIN during 2015 to 84 cents per RIN during 2016."
Amid record RIN prices last year, according to refiner reports, the Trump EPA said last week that it will work with the Commodity Futures Trading Commission to begin evaluating "RIN market concerns," including allegations of market manipulation. The EPA discussed the RIN concerns in issuing its proposed 2018 targets for the RFS last Wednesday. "The RIN system was originally designed with an open trading market in order to maximize its liquidity and ensure a robust marketplace for RINs," according to the proposed rulemaking. "However, EPA is interested in further assessing whether and how the current trading structure provides an opportunity for market manipulation."
Despite the agency requiring that the RINs be submitted to demonstrate compliance and allowing for the credits to be traded between companies, the entire RIN system has been notoriously opaque.
Small and merchant refiners, upon whom much of the RIN burden falls, say the credit system is prone to manipulation and unmitigated price spikes for RINs from one year to the next.
The EPA program has also created an unfair disadvantage for independent merchant firms compared with major oil companies, which own nearly every segment of the fuel supply chain. Big companies such as Exxon, BP and Shell have a sizable advantage over their less well-situated refining colleagues who cannot generate their own RINs, forcing them to buy hundreds of millions of dollars worth of these credits from their bigger rivals every year.
PBF Energy, a large merchant company, is trying to change the system. It describes the situation this way in comments to EPA: "PBF and other merchant refiners are forced to buy RINs from their direct competitors or non-obligated blenders, which creates an incentive for these entities to drive up the RIN price by hoarding RINs or limiting biofuel blending."
Both the merchants and smaller refiners have been forced to export their gasoline and diesel to avoid the cost of buying RINs from their dominant rivals. If you sell gasoline and diesel fuel outside the U.S., to Brazil or Europe, for example, the fuel can go to market without complying with the RFS. RINs only apply to the domestic market.
Higher RIN prices have also cut into capital spending and production, which has a knock-on effect on modernization and expansion projects.
Trump adviser's tie-in
CVR Refining's majority shareholder is Carl Icahn, who is an adviser to President Trump. CVR says it saw one of the biggest increases in RIN prices in 2016 since costs first skyrocketed in the beginning of 2013.
Icahn has been accused of using his influence in the Trump administration to change the "point of obligation" under the RFS, which would exempt CVR from having to buy RINs. The EPA was recently sued for all communications between the administration and Icahn on the biofuel change. The watchdog group American Oversight, which is suing EPA for the communications, claims Icahn is trying to influence the agency for his own financial gain.
Meanwhile, CVR has been pointing to its losses due to RINs. The price of an RIN credit hit $1.09 last year, despite the fact that the cost of generating one being only 6-10 cents, according to statements made by CVR Refining's CEO Jack Lipinski in the two most recent quarterly reports to investors.
"As I have said many times before, RINs are an egregious tax on independent, merchant refiners and small fuel retailers," Lipinski said in April. This cost alone has incurred over $670 million in RIN expenses since the RFS program came into force in 2010, according to CVR.
"Not only has the company incurred this expense, but our unitholders have experienced significant market cap losses," Lipinski said. "RINs are sucking the lifeblood out of the merchant refining industry."
On average, the cost of an RIN is 40 cents higher than it should be based on cost, according to Lipinski.
Against the blend wall
Recent swings in RIN prices reflect the same dynamics that sent prices soaring at the beginning of 2013, according to the Energy Information Administration, the Energy Department's statistical and analysis arm.
The EIA, in reporting on what caused the first spike in 2013, says ethanol RINs had historically been between $0.01-$0.05 per gallon. But by March 2013, they reached record highs of around $1 per gallon. The agency, which is independent, says the price spike was a direct result of what industry calls the "blend wall" and other market factors.
The "blend wall" refers to the percent limit on the amount of corn ethanol that can be blended into the gasoline supply to meet the RFS's goal of blending 32 billion gallons of biofuel in the nation's fuel system by 2022. Currently, ethanol is being blended using 10 percent ethanol-to-gasoline fuel blends, or E10.
That means 10 percent is as much ethanol as the fuel supply can currently handle. Higher ethanol fuel blends above E10 are needed to meet the program's goal, requiring a sizable infrastructure investment to achieve.
"This increase in the ethanol RIN price reflects the market's concern that the rising RFS-mandated volumes and the E10 ethanol blend wall will contribute to future significant increases in the cost of blending biofuels to meet the RFS statutory volumes," according to EIA.
The issue demonstrates that without the federal RFS, there would be no mandate to blend ethanol, and therefore no blend wall and no skyrocketing costs of RINs.
Independent refiners point out that higher ethanol fuels required to meet the RFS can't be used in most cars and trucks on the road. In addition, higher ethanol fuels offer lower fuel mileage, forcing drivers to fill up more.
More recent data from 2015 showed the RIN price hovering close to $0.70 per gallon. Data show the RIN price has remained high in the prevailing years, according to EIA.
Lipinski blames the continued high RIN price on "manipulation in the market," which CVR and other refiners want stopped with reform of "this misguided regulation," which most likely means changing the point of obligation.
Lipinski says higher RIN prices prevented his company from making cash distributions to investors in the first quarter of 2017. The withholding of a quarterly cash distribution shows the real-world effect of the ethanol mandate in preventing the company from passing on a benefit to its investors.
CVR continues to press the issue of removing the cost burden of the RFS in its communications to investors, as it sees a complete exemption from the program as the only route to remove what Lipinski calls an unfair tax on business.
"We hope and strongly believe that this pernicious RINs program will be changed in the near future," he said. "However, in the interest of prudent corporate fiscal management, CVR Refining will not distribute cash this quarter."