Oil price drop impacts beyond the obvious – Part 1
I am analyzing many areas as a result of the oil price drop. There are a ton of discussions of oil price drop and the impact it will have on oil production and economy. However there are impacts at the secondary level which can have billions of dollars of impact on the market.
The oil market drop will impact the Renewable Fuel Standard (RFS). EPA suspiciously delayed the release of the Renewable Volume Obligations (RVO) for 2014 twice. With the latest oil price drop, I suspect they will have support for revising and recalculating gasoline demand expectations, which will then thwart any attempts to modify the RFS. Most of the support for revising the RFS requirements was due to falling US gasoline demand and the theoretical limit of the amount of ethanol allowed in the market – aka “blend wall”. This is based on gasoline with greater than 10% ethanol will impact the mechanical aspect of the existing auto fleet. I will not argue the point surrounding this and save that discussion for another time. Given this conclusion, I do anticipate you will see renewable identification number (RIN) prices move up once they do finalize the 2014 and 2015 volumes in the spring.
What are RIN?
For those not involved in the power markets, you will be slightly lost. For those who have gone through the trials and tribulations of the Clean Air Act (CAA) and the emissions markets the government created in order to create an “optimal” path to emissions reductions – it is very similar. Very similar to SO2 and NOx markets, the government assigns a target of volume and produces a certification for each unit of volume. The only difference this time is rather than wanting the volume to be reduced, they want the volumes to grow. Instead of assigning an emission credit, they assign a production credit. As a producer of gasoline or diesel, you are required to obtain a set amount of RIN for each volume produced. One can do this by physical blending and/or purchasing a RIN. Another difference is instead of assigning a multi-year level of commitment ahead of time as they did in the CAA, the EPA is supposed to assign it each year in the spring. The market does have a general idea given the RFS does state targets, but as a fuel producer you don’t know your specific requirements. The brilliance of this design, and at the same time the most confusing, is the banking system which is very similar to the CAA construct.
The RFS includes the magical banking system. They have learned from the initial CAA markets and have adopted the banking restriction similar to the NOx markets, but actually slightly easier to follow as they limited the banking system to 20% of the total RVO for each year. There is no decline in values on vintage basis. The vintages from each bank can be carried into future years. The banking system is the greatest invention since slice bread for those into Operations Research and Game Theory – my two favorite subjects. I have spent much time in the analysis of emissions banking and game theory, and I presented to AEP management the relationship between the CAA emission markets and the Nash Equilibriums which can be generated. Funny enough Dr. Nash grew up near one of AEP power plants, which I believed is pictured in the movie – Brilliant Mind. There are fixed outcomes for these types of systems. They are equilibrium points when all market participants achieve a certain goal.
I was the lead proponent in AEP to sell the emissions credit heading into the newly created NOx market in 2005. The NOx market once introduced and, upon an extreme winter, decided to go crazy. The prices of NOx went over $5500/ton. This far exceeded any of the equilibrium points. The other nuance you need to realize in markets which turn in a credit on a fixed date is the cost of a credit in a given time is somewhat irrelevant since the only real value of a credit is when you turn it in. If you want to make money on a system like this you had better spend time on the end market vs. what the market is now. Starting the NOX season with a huge rise in price was pointless, and one could run 50+ simulations and show even the hottest summer could not generate a demand level of NOX that would necessitate the price above the highest market equilibrium point. In the end, after a few years, the market achieved one of the lowest equilibrium points – variable cost of running the control equipment.
The other unique aspect of the RFS is the three levels of targets – Conventional, Biodiesel, and Advance. In theory, and so far in practice, this is the order of greater complexity and cost. The order also represents the highest volume targets to the lowest. The rules do allow one to use a credit from the more complex target into the simpler target not vice versa e.g. Biodiesel RIN can be used for Conventional RIN.
With the lower oil prices and the market structure with banking, I don’t see how one anticipates the modification of RFS with lower goals. The main argument of “blend wall” will succumb to greater oil demand as consumers not only drive more, but consume more. The US will not likely save more given the design of our system and culture. The very act of consuming more whether food or services increases petroleum demand. The banking ability of 20% gives much room to buffer the changing weather from crop issues to the changing economy from driving.
The low oil prices will impact the economics of many ethanol plants, particularly those that have not been built. On a sunk cost analysis, the economics should allow them to continue to produce ethanol. This situation only leads to even greater value for RIN. The trading and risk mitigation of RIN need serious consideration for those producing transportation petroleum for the US or for those making the RIN. At All Energy Consulting, we can take our knowledge in the emissions and petroleum market to help you weather the storms of the RIN market.
Other topics to come due to the drop in crude oil prices – Condensate Value …Octane Value…..
Your Energy Analyst Thinking Beyond the Obvious for Your Success,
David K. Bellman
All Energy Consulting LLC- “Adding insights to the energy markets for your success.”