December 21, 2016 | By John Campbell

While the petroleum industry remains divided over the question of moving the point of obligation for compliance with the Renewable Fuels Standard (RFS) from petroleum refiners and importers to blenders, the U.S. EPA has made it’s reluctance to change the program crystal clear. The agency’s strongly-worded November proposal to deny all point-of-obligation changes, however, only temporarily quiets the program’s critics, who are bound to revive the debate.

Small refiners who do not have downstream assets argue that they are being held up by big refiners who have blending and retail assets. Some independent refiners who generate their own renewable identification numbers (RINs) through ownership of biofuel plants have expressed support for moving the point of obligation. Large refiners have said “no.” Due to the vast difference of opinion within the petroleum industry, it is highly unlikely that the U.S. EPA will make a change. In its petition denial, the agency said altering the program could make the system more complex, cause marketplace confusion, and deter investment. But that does not mean the problem of some refiners being forced to buy high-priced RINS will go away.

Although it might reduce undesirable trading practices, moving the point of obligation would not change RIN supply and demand fundamentals. There may be a better way to improve the ride: EPA should reconsider allowing biofuel producers to separate the RIN from the physical gallon. While this is not a plan currently endorsed by ethanol producers, it’s a plan they might want to consider.

RINs: Your Ticket to Ride

To get a handle on these issues that go round and round like a carousel, it is helpful to understand why we have RINs in the first place. When Congress created the first RFS in 2005, some feared there could be logistical issues if the government required that every gallon be blended with a specific percentage of biofuel. Others feared that crop variables might lead to a shortfall of corn and cause a squeeze. So, legislators and regulators came up with safeguards and off-ramps for the EPA administrator to use if needed.

One of these safeguards was the creation of credits, now known as RINs. The RINs allowed for inter-year and year-to-year banking and trading of credits to account for different fuel needs and infrastructure throughout the United States. It meant that biofuels could be used where it made the most sense and allowed a marketplace to develop in the buying and selling of RINs.

The EPA says the RIN market is working as it was designed to, incentivizing the production, distribution and use of renewable fuels. Still, the program remains mired in controversy for three principal reasons: time, transparency and trading.

Time: Waiting in Line Takes Too Long

Although RINs have a limited two-year life span, EPA has had difficulty making yearly RFS decisions and has sometimes made decisions many months late. As a result, EPA has moved the compliance deadlines accordingly. The significance of this is that the market does not know which renewable fuel bucket refiners will fill with which RINs. For example, compliance data for 2014 is not yet available This means that the market can only guess about the supply and demand for RINs and that there is a long time to trade RINs before compliance deadlines. This often leads to speculative trading.

Transparency: Blindfolded Until the Music Stops

The market knows within about 30 days when a RIN is created. The market does not know its final resting place until the obligated party deadline. This could be two years later or more. In the meantime, a RIN could be on a fast and furious ownership run, trading hands several times before an obligated party drops it into one of many RFS compliance buckets. During this volatile period of ownership, nobody knows who owns what. This is because once the blender is allowed to separate the RIN from the physical gallon, it becomes blindfolded musical chairs until the music stops and everybody tries to take a seat (RIN compliance deadline). This tends to favor business people who have a trading desk and a big balance sheet.

Trading: Who Gets to Grab the Brass Ring?

Trading was envisioned by Congress and regulators, but the RIN system was never intended to become an unregulated and unsupervised speculative ride. The view was that nobody would be interested in this obscure piece of digital data and that trading would occur primarily between obligated parties. For many years, RIN values were just pennies, mostly reflecting transportation differentials between regions. Today the RIN values are much higher, so the cost of compliance got a lot pricier.

So far, much of the debate has been about who wins and who loses as RIN values rise and fall. In the futures market for other commodities, winners and losers must equal out to net zero. Similarly, a holder of RINs may just as easily lose if the price goes down from where they were purchased, but we really don’t know who is winning or losing other than by digging through the financial reports of publicly traded players.

One thing for sure is that all this booty is not going to the biofuel producer. You can look at the margins for publicly traded biofuel companies and see that the vast majority of RIN value is carved up among the players downstream from the biofuel producer. Some say that injured refiners should just buy biofuel producers if they have a problem with RINS. That is like telling a biofuel producer to buy a refiner if they don’t like the price of fuel. It is not that easy, even though about one-third of the biofuel industry is already owned by petroleum companies.

Fine-tuning the Ride

Assuming the point of obligation stays the same, there are other alternatives that might improve the situation:

1. EPA must make its decisions on time. This will: A) Give the market less time to speculate about what EPA might do, and B) Put the compliance deadlines back on track—less time to trade RINs. EPA might even consider forcing the obligated party to do an initial compliance report on a monthly basis so everyone can see how each obligated party intends to comply rather than waiting 14 or more months to find out.

2. Increase transparency. Each time a RIN trades, the new owner needs to be identified immediately. These trades are already on automated data systems through an EPA clearinghouse, so making the data available should not pose a huge problem. This information exists but EPA has not published it since 2013. EPA could also develop and publish a cumulative, real-time balance sheet for RINs.

3. Limit trading. Other traded agricultural commodities have position limits, daily price movement limits, and the status of the ownership is known (commercials versus noncommercials, for example). While not exactly comparable, RINs trading could be limited to those with a nexus to the industry and the status of ownership (obligated party versus nonobligated party) could be made known immediately. There could be other practical ideas to reduce the speculative aspect of trading.

The End of the Line

Rather than changing the point of obligation, EPA should reevaluate allowing biofuel producers to separate the RIN from the physical gallon. Under current rules only the blender can separate the RIN. Decoupling RINS at the point of manufacture would not solve many of the problems noted here, but small refiners could at least deal directly with biofuel producers, rather than having to buy from their petroleum competitor or a speculative holder.

We may not be able to stop the merry-go-round of RIN compliance, but we can set it at a better pace, and keep the big kids from jumping the line.

Author: John Campbell
Managing Director, Ocean Park Advisors
310-670-2093
jcampbell@oceanpk.com

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