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Biodiesel Supply, Demand, and RINs Pricing (Oct 25, 2013)
By Scott Irwin,
I begin by reviewing the conceptual model of biodiesel RINs pricing presented in two earlier posts (here and here). The model in Figure 1 assumes that biodiesel demand is perfectly elastic (horizontal) for biodiesel prices equal to (ultra low sulfur) diesel prices. This reflects an assumption that biodiesel and diesel are perfect substitutes and that biodiesel is a small enough part of the diesel market that changes in the biodiesel price do not impact the overall demand for diesel fuel. One could go further and adjust biodiesel prices to reflect the lower energy content of biodiesel (about 12% lower) compared to petroleum diesel.
However, given the low biodiesel blends typically used in the marketplace today, it is doubtful that this lower energy content is priced at the retail level. So, we assume no adjustment is necessary. In the earlier posts, it was also assumed that demand becomes perfectly inelastic (vertical) at an assumed B5 blendwall of 2 billion gallons. This technical limitation was highlighted in the EPA's RFS rulemaking for 2013 (see p. 49815). This turns out to be a quite controversial assumption and has been challenged vigorously by the biodiesel industry. It seems prudent to drop this assumption while awaiting further analysis. Lastly, the model also now accounts for the biodiesel blenders credit that is in place for 2013. The policy effectively shifts the biodiesel demand curve up by the amount of the credit, which is $1 per gallon. At any given quantity of biodiesel, the effective selling price for biodiesel is increased by the amount of the credit.
The model in
implies that the 2013 RFS mandate of 1.28 billion gallons is binding even after consideration of the blenders tax credit. That is, the mandated quantity exceeds the small amount of biodiesel that would be produced in the U.S. absent the RFS mandate and no tax credit (Q1*), as well as the larger amount of biodiesel that would be produced absent the RFS mandate but with a tax credit in place (Q2*). In order to get the higher than equilibrium quantity produced in the first scenario, biodiesel producers must be paid a price that is higher (Pbd) than the breakeven diesel price (Pulsd). From the perspective of a diesel blender, there is a wedge between the price paid to biodiesel producers and the price charged to consumers for the biodiesel in diesel blends. This wedge, or loss, is the diesel price minus the biodiesel price at the mandated quantity. The wedge also equals the "wet" price of a D4 biodiesel RIN. This terminology is used because a gallon of wet biodiesel generates 1.5 ethanol equivalent RINs. In the second scenario, the upward shift in the demand curve due to the blenders tax credit ends up reducing the wet RINs price by exactly the amount of the tax credit. The mandate is still binding at 1.28 billion gallons, but blender losses are reduced by the amount of the tax credit, and hence, the lower RINs price.
highlights the key variables that determine the price of a D4 biodiesel RIN. The D4 price will vary directly with the steepness (slope) and position (intercept) of the biodiesel supply curve. For example, a parallel downward shift in the supply curve will reduce the RINs price accordingly. The market price of diesel shifts the demand curve up and down, and all else constant, will change the RINs price. For example, if the price of diesel declines this will shift the demand curve down and the price of RINs will increase. The blenders tax credit shifts the demand curve upward and the level of the RFS mandate determines the points of intersection with the supply and demand curves.
As noted in this previous post, the model in Figure 1 actually predicts the "intrinsic" value of biodiesel RINs. In options market parlance, this refers to the immediate value of exercising an option. This is equivalent to the loss blenders incur today by blending biodiesel, and it is represented by the blending margin. There is a second component of option value that is also relevant. This value is called "extrinsic," or "time," value and it reflects the value to an option owner of waiting until later to exercise the option when the intrinsic value may be even higher than it is today. Using the options analogy we can think of a RINs price as consisting of two components:
RINs = intrinsic value + time value
I argued in the earlier post that time value had largely been irrelevant in the past since biodiesel prices tended to be much higher than diesel prices, even after adjusting for the blenders' tax credit, so the RIN can be considered "deep-in-the-money." Options of this type tend to have small time values. While this has been true in the past, it may not be the case looking forward due to the tremendous uncertainty about biofuel policy looking forward.
With this background, the first step in the empirical analysis is to check how closely D4 biodiesel RINs prices track blending margins net of the blenders tax credit (when it is in place). The options pricing equation above implies that a D4 RINs should trade for a price no lower than its intrinsic value, which equals the current blending margin for biodiesel. Figure 2 is an updated version of a figure presented in two earlier posts (here and here). It shows the biodiesel blending margin at the wholesale level in Chicago and the D4 RINs price from September 3, 2009 through October 24, 2013. The biodiesel blending margin is normally computed as the price of ultra-low sulfur diesel minus the price of biodiesel plus the $1 biodiesel blenders' tax credit when it is in effect. Here, the margin is multiplied by -1 to facilitate comparison to the market price of D4 RINs. In years when the blenders tax credit is in place (e.g., 2011 and 2013), D4 RINs prices tend to track the blending margin as expected. In years when the blenders tax credit is not in place (e.g., 2010 and 2012), D4 RINs prices tend to be substantially less than the blending margin, which can be explained by traders expecting the retroactive reinstatement of the credit.
For most of 2013, the biodiesel blending margin has either been less than the D4 price or about equal to the D4 price. Periods when the D4 price is above the blending margin are consistent with a positive time value for the RINs "option." Movements in recent weeks are more anomalous, since the blending margin exceeds the D4 price and the blenders tax credit is already in place. Taken literally, this implies it is cheaper to comply with the RFS mandates by purchasing RINs instead of physically blending biodiesel. There have been other brief periods like this since 2009 and the discrepancy currently observed is likely to disappear in the next few weeks.
Up to this point, we have established that D4 RINs prices generally track intrinsic values given by current blending margins. As noted above, there is another interesting dimension to RINs pricing at the present time due to uncertainty with regard to the values of the key variables. The time value of a RIN reflects the possibility that intrinsic value (blending margins) will be even larger at some point in the future. In other words, if I am a trader I may be willing to pay more for a RIN than its current intrinsic value because blending margins may be even larger (bigger loss) at some point in the future. The level of RFS mandates for 2014 represents one of the main sources of uncertainty in this regard.
Figures 3 and 4
present two plausible scenarios for the RFS biodiesel mandate in 2014 and corresponding RINs values. Figure 3 illustrates RINs pricing with a mandate of 1.28 billion gallons in 2014, which is the quantity proposed in recently leaked EPA draft rules for 2014. Also note that the biodiesel supply curve is not the conceptual curve presented in Figure 1, but, rather, it is the estimated supply curve developed in this post last week. The demand curves assume a wholesale diesel price of $2.90 per gallon, about equal to recent values. Under the assumption that the tax credit is extended, the model predicts an equilibrium biodiesel price of $4.60 per gallon and a wet RINs price of $0.70 per gallon ($4.60 - $2.90 + $1), which converts to $0.47 in ethanol equivalents. If the tax credit is not extended, the wet (ethanol equivalent) RINs price would be $1.70 ($1.13). Figure 4 considers a scenario where the EPA does not write down the renewable component of the RFS mandates. In this case there is a gap between the 2014 (implied) renewable mandate of 14.4 billion gallons of ethanol and the E10 blendwall of about 13 billion gallons. Ignoring the available stock of RINs and assuming minimal E85 deployment for illustration purposes, the renewable gap becomes an additional biodiesel mandate. If the biodiesel mandate itself is set at 1.28 billion gallons, the total effective biodiesel mandate becomes 2.21 billion gallons (1.28 + (14.4 - 13.0)/1.5). Under the assumption that the tax credit is extended, the model then predicts an equilibrium biodiesel price of $6.00 per gallon and a wet RINs price of $2.10 per gallon ($6.00 - $2.90 + $1), which converts to $1.40 in ethanol equivalents. If the tax credit is not extended, the wet (ethanol equivalent) RINs price would be $3.10 ($2.07). So, depending on EPA rulemaking for 2014 and the status of the blenders tax credit, plausible D4 biodiesel RINs values in 2014 range from $0.47 to $2.07 in ethanol equivalents. The lower value is near present D4 prices, but the upper end is obviously much higher.
illustrates another significant potential source of uncertainty about D4 RINs prices in 2014. The main shifter of the biodiesel supply curve is the price of the feedstock that represents the main input cost for producing biodiesel. The supply curve used here was estimated assuming soybean oil as the feedstock, so the price of soybean oil shifts the supply curve in and out. Two scenarios are presented in Figure 5. The first assumes a soybean oil price of $0.47 per pound, which is the average for January - August 2013. This is the same soybean oil price assumed for the supply curves in Figures 3 and 4. The second supply curve assumes a soybean oil price of $0.41 per pound, near the level in the market during recent weeks. This shifts the biodiesel supply curve down and sharply reduces RINs prices. Under the assumption that the tax credit is extended, the model predicts an equilibrium biodiesel price of $4.14 per gallon and a wet RINs price of $0.24 per gallon ($4.14 - $2.90 + $1), which converts to $0.16 in ethanol equivalents. If the tax credit is not extended, the wet (ethanol equivalent) RINs price would be $1.24 ($0.83). This part of the analysis shows that a relatively small shift in soybean oil prices can result in D4 RINs prices as low $0.16 per gallon in 2014.
From a conceptual standpoint, RINs prices can be thought of as consisting of two components--intrinsic and time value. The intrinsic value should track current blending margins, and it was shown that this is generally true for D4 biodiesel RINS. The time value of RINs reflects the chance that blending margins will be even larger (bigger losses) in the future. The time value of D4 biodiesel RINs has tended to be small in the past, but this may not be the case moving forward because there is great uncertainty about the future value of RINs depending on the outcome of EPA rulemaking and the status of the blenders tax credit. Variation in soybean oil prices adds to the uncertainty. Estimated supply and demand curves can be used to generate plausible D4 biodiesel RINs values for 2014 anywhere from $0.16 to $2.07 per gallon (in ethanol equivalents). This illustrates the tough job facing the RINs market in evaluating the probabilities of the high vs. low blending margin scenarios, which is central to determining the time value of a RIN. With D4 prices in recent days trading as low as $0.27 per gallon, it appears that the RINs market is heavily discounting the chance that any of the high price scenarios will occur in 2014. Time will tell if this turns out to be the smart play.
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