Prove It

Thus far, previous posts have explained the following ideas. First, the current RFS point of obligation supplies Big Oil with free RINs. Second, those free RINs prevent full recovery of merchant refiners’ RIN expenses in the spot market. Third, this incomplete pass through unjustly enriches marketers at the wholesale rack. Fourth, this unjust enrichment enables rigged competition at the wholesale rack harming small refiners and mom-and-pop retailers. Along the way, another of my posts argued greater RIN pass through identified by Wells Fargo Securities is most likely due to Big Oil exporting more blend stock (“Blend stock for Oxygenate Blending” or “BOB”), thereby forfeiting some domestic market share to merchant refiners’ “paid RIN” BOB. The increased pass through cannot be attributed to more blending by merchant and independent refiners. Further, RIN costs are not borne by consumers to the extent some claim.

All of these ideas are self-evident – logical consequences of free RINs for a few obligated parties as enabled by the current point of obligation. The time has come to test this logical analysis with evidence and data. Proof lies in the primary assumption underlying EPA’s defense of the current rule. In its decision denying several refiners’ petitions to reconsider and move the point of obligation, EPA said:

Stated another way: merchant refiners can indeed expend significant funds to purchase RINs needed to demonstrate compliance with the RFS program, but the cost is offset by a corresponding increase in the market price of the fuel they sell that is attributable to the RFS obligations. The market price they receive for the gasoline and diesel fuel they sell reflects the cost of RINs.

If this statement is true, the values of BOB to a refiner blending E10 and to a refiner selling BOB without blending should the same. On the other hand, if the value of BOB used in E10 is more, the market is compensating spot BOB less. To explore this thought, I conducted an analysis of posted prices at the Mitchell, South Dakota pipeline terminal distribution rack over twenty-four months in 2014 and 2015. This work was done while I worked at Wyoming Refining Company in support of RFS hardship petitions and rule-making comments submitted to EPA. Mitchell was selected because it is the rack posting both E10 and BOB prices closest to Wyoming Refining’s geographic market. With a few simple steps, rack economics were analyzed using publicly available E10, BOB, ethanol and RIN prices to produce an oranges-to-oranges comparison of BOB’s value to both Big Oil and merchant refiners.

The study used the following methodology. Mitchell posted prices for E10 and BOB (“suboctane”) were extracted from the Oil Price Information Service (“OPIS”) daily reports covering all U.S. racks. Chicago ethanol and national RIN prices were obtained from Platts, a division of S&P Global. Using Chicago ethanol, which is priced higher than ethanol from plants in close proximity to Mitchell, will overstate ethanol’s and understate BOB’s contribution to the combined value of E10 at the rack.

The workbook containing the monthly and two-year averages for these prices can be viewed here. If you want a version that is not password protected, please contact me. I am deeply indebted to Ken Risden, then VP of Planning and Strategy at Wyoming Refining, who painfully collected these data on a daily basis over two years. If you wish to see the original daily values from the OPIS and Platts historical databases, those data were lost when I left Wyoming Refining. I do not subscribe to the relevant OPIS and Platts services and cannot help in that regard.

In the following table, I calculated the net BOB value when blended into E10 and when sold by the merchant refiner without blending. For Big Oil, I started with the E10 posted price and subtracted both the cost of blended ethanol and the gain from selling ethanol as higher priced E10. No adjustment was made for RIN value since it is assumed the Big Oil blender retains the RIN or sells it and buys another for RFS compliance. For the merchant refiner selling BOB, I started with the posted price and subtracted the RIN obligation per BOB gallon (1/9 RIN).The results are striking. On average, blending by Big Oil generated a BOB value 1.35 ¢/gal higher than selling BOB in the spot market or 23.4% of the compliance cost at a 10% standard. BOB’s market value should be the same for both refiners. Yet, it is not. As offered to the spot market, the only economic difference between Big Oil and merchant refiner BOB is that Big Oil’s RINs are free. As a result, 23.4% of the merchant refiners’ RIN costs are not showing up in BOB prices at the Mitchell rack. This is consistent with the idea that competition between “free RIN” and “paid RIN” BOB results in less than 100% pass through of RIN costs.

I used the same methodology to compare small refiner and unobligated marketer/blender economics. The posted price of E10 was adjusted for the cost of its components. The only difference between the small refiner and the unobligated marketer is the RIN. The unobligated marketer gets to sell the RIN obtained from blending while the obligated small refiner must surrender the RIN for compliance. Note well, the small refiner realizes a loss at the wholesale rack.The bottom line is the unobligated marketer/blender does better at the rack than the small refiner by 100% of the RIN value. The unobligated marketer also realizes a rack gain equal to 79% of the RIN. This advantage means the marketer/blender can discount its posted prices by up to 79% of the RIN value in the manner described to EPA by Cumberland Farms and still realize a gain at wholesale. The small refiner simply cannot afford to match such deep discounts.

Finally, the methodology was applied to retail supply costs for stations branded by unobligated marketer/blenders and for independent mom-and-pop stations purchasing E10 supplies at posted prices. Again, the results are striking. In this situation, the marketer/blender can supply its branded stations with E10 for 4.1 ¢/gal less than the mom-and-pop purchasing its supplies at posted prices, an advantage equal to 79% of the RIN value associated with blending.In all cases, Big Oil refiners and unobligated marketer/blenders do significantly better in head-to-head competition with merchant refiners, small refiners and mom-and-pop retailers. No wonder merchant refiners, small refiners and mom-and-pops want the point of obligation moved to the point of compliance. Also, no wonder Big Oil and unobligated chain marketers are opposing the move. What is worth wondering is why EPA refuses to believe or admit this is happening.

A final question is worth addressing: why do studies on which EPA relies conclude 100% of merchant refiners’ RIN costs are passed through to spot prices? These studies express support for the EPA statement quoted near the top of this post. “The Pass-Through of RIN Prices to Wholesale and Retail Fuels under the Renewable Fuel Standard” by Knittel, Meiselman and Stock (“Knittel”) is a prime example.

My primary concern with these analyses is, for gasoline, they base conclusions on New York Harbor. The East Coast, including New York Harbor, is a significant net importer of gasoline BOB. In a previous post, I discussed the relative pricing power of both Big Oil and merchant refiners. I explained the spot market price will pass through less than 100% of RIN expenses when neither can single handedly satisfy domestic demand but, combined, both exceed that demand resulting in exports. The Mitchell data prove that. In New York Harbor, however, domestic supply is insufficient to meet demand and imports are required to fill the gap. In that situation, the importer has almost total pricing power. If New York Harbor prices do not pass through 100% of the importer’s RIN costs, gasoline BOB will stay on the proverbial ship, and a supply shortage will result.

If ever there were a place where RIN expenses are passed through to the market, New York Harbor is the place to look. Extrapolating to the rest of the United States conclusions drawn from market prices powered by imports is not valid. While the Knittel approach is certainly valid to identify connections between RIN and product prices, the wrong conclusions are drawn from the results. I have not reviewed the paper with respect to diesel and offer these comments only with respect to BOB.

Knittel examined the difference in BOB prices, i.e., the spread, between New York Harbor (“NYH RBOB”) and Rotterdam (“EBOB”) and examined the correlation between that spread and RIN prices. The hypothesis is, while market prices go up and down, both NYH RBOB and EBOB are subject to most of the same price drivers except for one. RINs must be purchased for NYH RBOB while EBOB sold in Rotterdam is not subject to any RFS requirements. Therefore, if the NYH RBOB-EBOB spread grows in tandem with RIN prices, one can confidently conclude RIN prices are passed through in the price of NYH RBOB. This is exactly what the paper concluded.

One chart in the paper demonstrates the response of NYH RBOB-EBOB spread to RIN prices is fast.Knittel, however, also examined the spread between Los Angeles BOB and Brent crude oil prices (“LA RBOB-Brent”) on the same theory: Los Angeles BOB carries a RIN obligation but Brent crude oil does not. Again, a positive correlation between changes in this spread and RIN prices should indicate pass through of RIN expenses in LA RBOB prices. Here is the same chart for the LA RBOB-Brent spread analysis.I am not an economics PhD, but it seems abundantly clear the responses of these two spreads to RIN prices are not in any way similar. NYH ROB-EBOB has a positive response in two or three days while the LA RBOB-Brent spread has no response at all. This is not to say there is no pass through; the LA RBOB-Brent pass through coefficient appears to be about 0.5 on this chart indicating about 50% of the RIN expense is passed through to BOB prices. However, there simply appears to be no response to changes in RIN prices. The paper also noted, for long term equilibrium evaluations, the LA RBOB-Brent to RIN price correlation had the highest standard error in the study. I am wondering what an analysis of LA RBOB-EBOB spread, not in this paper, would show.

If I am reading the paper correctly (it contains significant econometric mathematics above my pay grade), the stark contrast of NYH RBOB to LA RBOB is consistent with my logic. New York Harbor depends on imports to satisfy gasoline demand. The East Coast was a net importer of 226,397,000 barrels of finished gasoline and BOB in 2016. That was 11.6% of East Coast consumption. Importers, therefore, have pricing power to recoup their RIN costs. Note the pass through coefficient in the NYH RBOB-EBOB chart above approaches 1.

The West Coast including Los Angeles, on the other hand, was a net exporter of finished gasoline and BOB in 2016 to the tune of 12,703,000 barrels. Imports are not needed in the West Coast, and the market is indifferent to importers’ RIN costs. Importers, therefore, have little to no West Coast pricing power. Rather than demonstrate nearly complete pass through of RIN costs in spot BOB prices, the Knittel results appear to support this blog. Where merchant refiners needing 100% pass through and Big Oil striving for no pass through over supply the market, the actual pass through will be somewhere in the middle.

Best,

Bob

For those wishing to check the statistics on East and West Coast exports and imports, the links to EIA tables are below.

PADD 1 exports: https://www.eia.gov/dnav/pet/pet_move_exp_dc_R10-Z00_mbbl_a.htm

PADD 5 Exports: https://www.eia.gov/dnav/pet/pet_move_exp_dc_R50-Z00_mbbl_a.htm

PADD 1 Imports: https://www.eia.gov/dnav/pet/pet_move_imp_dc_R10-Z00_mbbl_a.htm

PADD 5 Imports: https://www.eia.gov/dnav/pet/pet_move_imp_dc_R50-Z00_mbbl_a.htm

PADD 1 Consumption: https://www.eia.gov/dnav/pet/pet_cons_psup_dc_r10_mbbl_a.htm