The oil refining business is as tough as it has ever been. Cutthroat competition, stiff regulation and high operating expenses translates into some of the narrowest profit margins in the energy sector.
And, in the last few years, refiners have been struggling with a glut of product inventories, namely gasoline and distillate. The amount of refined fuels held in storage in the U.S. remains stubbornly high, resulting in low profitability and forcing some of the operators to announce production cuts, postpone capital spending and retrench employees.
Of late, the game has become even tougher with RIN obligations – involving a soaring cost – having a considerable amount of financial impact on the refiners.
What Are RINs?
It all started in 2005 when the Congress passed the 'Energy Policy Act' to reduce America's dependence on imports, lower greenhouse gas emissions and enhance the country's energy security. The legislation, among other provisions, created a Renewable Fuel Standard (or RFS) requiring the mixing of renewable fuels (like corn ethanol or other biofuels) into gasoline and diesel.
The U.S. Environmental Protection Agency (or EPA) calls for a blending target known as the Renewable Volume Obligation (or RVO). For example, in 2010, EPA proposed that 12.9 billion gallons of ethanol and other biofuels be blended into gasoline and diesel. By 2017, the amount had jumped to 18.8 billion gallons and the proposed RVO requirement for 2018 is 19.2 billion gallons.
Apart from its efforts to force the use of ethanol in the domestic gasoline mix – the percentage of which has gone up from around 3% in 2005 to roughly 10% now – the Congress instructed the EPA to develop a system of electronically tracking numbers that could allow the agency to check whether the assigned blending requirements were being met by the concerned parties.
These 38-character tracking numbers or tradable certificates (sometimes referred to as ‘credits’) are known as RINs (Renewable Identification Numbers). Each physical gallon of renewable fuel produced/imported is assigned a RIN that follows the fuel’s journey to a blender. Post blending, RINs are separated from the blended gallons of petroleum-based fuels, and they are used as proof by obligated parties that they have complied with the federal program.
Lack of Transparency Leads to Widespread Abuse
Interestingly, the so-called RFS point-of-obligation are not the actual parties engaged in blending gasoline with ethanol or other biofuels, but refineries and gasoline-diesel importers. That means, all oil refiners – big and small – are required to shoulder the burden for mixing ethanol into gasoline, even if they do not possess the blending terminals to do so.
As a result, the program puts the large integrated energy conglomerates – having terminal, distribution and retail infrastructures – and biofuel producers at an advantage as their operations are equipped to process ethanol. On the other hand, the facilities of independent refiners can process just petroleum products and not ethanol. This means that the refiners have to either buy or build special ethanol blending terminals or purchase RINs to comply with the RFS.
A Multibillion-Dollar Burden on Refiners
For most of the smaller players, investing in a new ethanol blending and distribution infrastructure is not financially viable. So, the only option for them is to buy RIN credits that they require to meet the RFS standard. Most independent refiners have to purchase them from integrated majors and biofuel producers who sell their excess credits. In other words, the refiners are being penalized for unable to process ethanol.
Originally sold for a few cents a gallon under EPA supervision, the ethanol RIN price soared to $1.50 per gallon in 2013 as an unregulated trading market emerged. Subsequently, it fell below 25 cents only to top $1-a-gallon recently. This translates into an additional operating cost of $3–4/barrel of crude processed for refiners.
For the likes of Valero Energy Corp. (VLO - Free Report) – the world’s biggest independent refiner – this amounted to an annual spending of $749 million in 2016, up significantly from $440 million in 2015. In fact, as a percentage, RINs accounted for more than a fifth of Valero’s last year’s operating income – a substantially high amount. Similarly, the credits cost smaller rival PBF Energy Inc. (PBF - Free Report) as much as $347.5 million last year as against just $126.4 million in 2015.
Already reeling under an environment of depressed profit margins – reflected by the Oil and Gas - Refining and Marketing industry’s rank of 232 (bottom 9%) – the additional cost of RINs have put most refiners under pressure. With refiners having to buy RINs just to stay in business, most of them have seen their profits and share prices slump.
In particular, investors are advised to sell or avoid companies like HollyFrontier Corp. (HFC - Free Report) , PBF Energy, Phillips 66 (PSX - Free Report) and Tesoro Corp. all of which carry a lowly Zacks Rank #4 (Sell) or Zacks Rank #5 (Strong Sell).
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