By Robert Auers and John Auers
Last week we discussed Renewable Identification Number (RIN) prices and the growing prominence of Renewable Fuel Standard (RFS) compliance costs in refiners’ earnings reports. This has been a subject very much in the news in recent days, even leading to a meeting at the White House last week between the Trump Administration and nine Senators from states with significant oil refining capacity. The goal of the meeting was to push forward potential modifications to the RFS program to ease burdens on the refining industry. Subsequent to the WH gathering, representative of the Administration have made calls to Senators representing corn growing states to join in the dialogue and we will likely see further discussion in the coming days and weeks among all these parties. Certainly a key issue to address is who really pays the costs of the RFS mandates. In our blog last week we noted that a case can be made that consumers ultimately pick up much of the tab in the form of higher market prices for gasoline and diesel. In today’s blog we analyze the numbers to see how true this hypothesis really is and if refiners truly do “pass it (RFS compliance costs) on down”. It’s perhaps ironic that we use the title from Alabama’s 1990 hit single in this blog, as that song focused on the subject of environment stewardship, which is widely used (rightly or wrongly) as a major justification for the RFS rules.
“They’ll have to pay for what we did” – The Theoretical Basis of RFS Cost Allocation
In general, when we examine tax incidence (the analysis of where the burden of a particular tax ultimately falls), taxes on goods with relatively elastic demand will typically be borne by the producer, while taxes on goods with relatively inelastic demand will ultimately be borne by the consumer, regardless of on whom the tax is actually administered. For example, let’s suppose that we examine the market for apples and pears, each of which, in our hypothetical example, initially sell for $2.00/lb. Now let’s suppose the government decides to levy a $1.00/lb tax on the production of apples. Thinking back to economics 101, this increase in the cost of apple production essentially shifts the apple supply curve to the left, as shown in the figure below.
If these two fruits are not replacements for each other and consumers will consume the same amount of each fruit at any price (demand is perfectly inelastic), the price of apples will simply increase to $3.00, and the tax incidence will fall on the consumer.
The RFS is essentially a tax on petroleum-based transportation fuels, for which demand is relatively inelastic. (We realize that we’ve argued for the price elasticity of gasoline demand on several occasions before, but in an economic sense gasoline, and especially diesel, demand is much more inelastic than it is elastic. i.e., as the price of gasoline increases, consumers will spend more money on gasoline and vice versa.) Moreover, the market for both gasoline and diesel is a global one, so any change in U.S. demand has an even smaller proportional effect on global demand. As a result, we expect that the majority of RIN costs will ultimately be passed on to consumers, especially over the medium to long term. Independent analysis conducted by a variety of sources supports this conclusion, showing that RIN costs have been increasing passed onto consumers since 2013. Theoretical analysis supports this trend, as many refiners (especially on the Gulf and Atlantic Coasts) have the optionality to sell into export markets when RIN prices are high, pushing up the prices of domestic gasoline and ULSD relative to their foreign counterparts. Furthermore, this affects the entire domestic market due to the fact that Gulf Coast refining capacity constitutes nearly half of total U.S. refining capacity. Additionally, all refiners include RFS compliance forecasts when evaluating the economics of capital investment decisions and will expect essentially the same rate of return regardless of where RVO compliance costs stand. As a result, refiners will expect higher crack spreads to justify investment when RFS compliance costs are high.
ULSD Test Case
Given then above reasoning, we would expect diesel crack spreads in the US relative to those in Europe (and other parts of the world) to increase to account for the increased cost of RFS compliance. We chose to compare ULSD margins in the US to those in Europe specifically because the products are very similar and because there is significant trade between the regions. Therefore, this should result in a long term equivalence in valuation between the two markets, adjusting for location and RFS costs. For this exercise we have compared ULSD at both the U.S. Gulf Coast (USGC) and New York Harbor (NYH) less ULSD at the Amsterdam-Rotterdam-Antwerp (ARA) trading hub in Europe to per-barrel RFS compliance (RIN) costs. In addition, we have assumed constant $3.36 and $1.57 location premiums for the USGC and NYH, respectively, to account for transportation costs (due to the fact that the U.S. is a net diesel exporter to Europe). The data shown below are monthly averages for September 2010 through November 2017.
These graphs illustrate a strong correlation between wholesale ULSD prices in the U.S. compared to European prices after adjusting for transportation and RFS compliance costs. This would seem to support the fact that RIN costs are substantially passed onto consumers and not absorbed by refiners.
This correlation is demonstrated in another way in the two graphs below, showing RFS compliance costs / barrel on the x axis and USGC and NYH ULSD, respectively, less ARA ULSD less the previously stated transportation costs on the y axis. The data points shown are monthly rolling trailing twelve month (ttm) averages beginning with the period ending in March 2013. We chose this date due to the fact that it represents the first twelve month period when RFS compliance costs rose above $1.00/bbl. Additionally, we have removed Jan 2014 – Mar 2014 and Oct 2014 – March 2015 from the NYH comparison due to unrelated large blowouts in NYH ULSD crack spreads during these periods.
The R2 values of the linear regressions shown in each of the above charts of 0.93 and 0.84, respectively, indicate a strong correlation between per barrel RFS compliance costs and US vs Europe diesel crack spreads. Furthermore, the trend line slopes of 1.03 for both comparisons indicate that over time substantially all of the cost of RFS compliance is passed onto consumers, at least in the USGC and USAC, where refiners are given the option to export product to Europe to avoid RVO generation.
It is a bit more difficult to perform the same analysis for gasoline due to the increased variance in specifications for different grades of gasoline, not only in different regions of the world, but also between different regions of the United States. Moreover, due to the high-octane and high-RVP properties of ethanol, US refiners typically produce a “Blend for Oxygenate Blending” (BOB) that has both lower octane and RVP than finished gasoline. Still we would expect to identify a trend for finished gasoline blends and BOBs that have similar properties. For this exercise we chose to compare NYH winter RBOB premium to ARA winter Euro 95 gasoline, with winter being defined as the period from September – March. These blends have similar effective Octane and RVP specifications, after accounting for the effect of ethanol blending with RBOB. Winter NYH RBOB has stricter RVP specifications (that vary by month) than Euro 95. In addition RBOB effectively requires an R+M/2 octane rating of 90.8 while Euro 95 must have a minimum RON of 95 and minimum MON of 85. In addition, we recognize the differing compliance methodology between the two products. We chose to exclude summer gasoline from our analysis due to the use of the complex model for summer RFG, which reduces the comparability of the two blends. Furthermore, we begin our analysis with the winter of 2012-2013 due to the fact that this is when we first neared the ethanol “blend wall”, which effectively required 10% ethanol in virtually all gasoline in the United States. Prior to this time period, different BOBs could be produced for blending with a lower proportion of ethanol. Lastly we have added $2 to NYH RBOB Premium – ARA Euro 95 differential to account for quality and locational differentials between the two products. These first graph shows the average value of these two variables for each winter season dating back to 201-2013 through the first three months of the current winter season. The second graph shows the differential between the two blends (including the constant $2 differential) as a function of per barrel RFS compliance costs.
These two graphs illustrate that costs RFS compliance for gasoline blending are, similarly to those for ULSD, substantially passed onto consumers. The R2 value of 0.89 in the second graph illustrates a strong correlation between the two variables and the trend line slope of 0.9 indicates that approximately 90% of the cost of RFS compliance is passed onto consumers, at least on the Atlantic coast.
While our analysis only examined the USGC and NYH, we expect these results largely carryover to the majority of the U.S., especially considering that PADD I and PADD III are the two largest consumers of petroleum products in the country. Furthermore, significant volumes of petroleum products continue to move from PADD III to PADD II (the U.S.’s third biggest consumer of petroleum products) through the Explorer pipeline, and this prevents long term product price differentials between the two regions from increasing too far. Therefore, we believe the above analysis supports the view that RFS compliance costs are substantially passed from refiners onto consumers. Although we have grown accustomed to seeing large and continually growing numbers for RFS compliance costs in refiners’ quarterly reports, most of these costs have, and likely continually will, be substantially passed onto consumers in the form of increased pump prices. Independent refiners with small or nonexistent marketing arms and limited access to export markets are likely at the biggest risk of being negatively affected by RFS in the short term, but we still expect that increased RFS compliance costs will generally be met by higher crack spreads in the medium-to-long term.
TM&C constantly monitors changes and proposed changes in regulations which can impact all segments of the petroleum industry. Many of these are associated with transportation fuels, affecting not only demand, but also production costs, compliance challenges, and other aspects of petroleum refining. We include our independent analyses of these impacts in our semiannual Crude and Refined Products Outlook (the 2018 Edition is scheduled to be released in early February 2018) and our various other studies. TM&C also assists clients involved in all aspects of transportation fuel production, blending activities, planning and compliance-monitoring. More information on these publications and our other work involving oil industry developments and dynamics can be obtained by contacting either one of us, visiting our website at turnermason.com or calling Cindy Parker at 214-754-0898.