Why Are Refiners Still Underperforming?

During this oil bust, one sub-sector of energy should have been raking it in - the refiners - and yet their stocks have remained relatively flat for 2016. Low oil prices, combined with an increase in gasoline demand as we have seen here this summer in the U.S. should have translated into big moves for Valero (VLO), Tesoro (TSO) and CVR Energy (CVR), but instead we've seen the refiners lag throughout most of the year.

We can isolate two reasons for this; A domestic glut that was slow in clearing and the cost of Ethanol credits. One of them - the glut - has been getting better, while the other is getting worse. And this continues to hold me back from getting excited about refining stocks going into 2017. Let's look at this big hurdle to independent refiners right now, the Ethanol credit (Or RIN) game.

President Bush signed the Ethanol and Biodiesel program into law, designed to make the US more energy self-sufficient. It outlined a minimum use of biofuels as a blend to gasoline, with a scheduling program that would ratchet up the percentage of Ethanol in motor fuels as time passed. We could talk about the misguided purpose of the law, because blending ethanol into gasoline does little to move this country towards energy independence, nor does it help at all, on balance, in emissions.

Instead, let's just talk about the program, which mandates an increase in the amount of ethanol (or other biofuels) that needed to be blended into gas every year. This is an immediate problem, because the program does not take into account how much gasoline is actually being refined. And as blending mandates continued to mechanically increase while gasoline production in the U.S. didn't grow much, refiners are looking at the forced blending of a mandated amount of biofuel that has outrun the supply of refined gasoline being produced.

How much has it outrun it? EPA mandates are currently at 10.5% of gasoline, above the auto makers recommended MAXIMUM of 10% of ethanol in order to keep engines running properly. In essence, the EPA is currently mandating you to use fuel that is bad for your car.

Of course, the refiners don't actually need to use all that ethanol, and they don't. They can, instead of actually blending ethanol into their gas, buy ethanol credits (RINs) that count towards the EPA program. The idea is that some refiners exceed their ethanol mandate and can sell the rest of their excess as credits for someone else who prefers not to blend up to the EPA directive. RINs have become a market in themselves, and as independent refiners don't make ethanol, they're far more likely to want to buy RINs to fulfill their EPA requirements, as opposed to finding and blending ethanol. It's more cost efficient, as well.

But credits are getting dear and the prices on RINs have soared: Since spiking in 2013 from under 25 cents a gallon to nearly $1.50 a gallon, prices relaxed a bit in 2014 and 2015. But again in 2016, as EPA mandates continued to increase, the RIN market began spiking again towards a dollar a gallon.

The major beneficiaries of this market spike have been the major integrated oil companies. Because credits are generated where gasoline in blended, oil companies with a strong retail presence with gas stations are always ahead of everyone else in accumulating RINs. When Valero and Tesoro go into the open market to buy RINs, they are often coming from Shell, BP and Chevron. Independent speculators have also been getting in on the action, trading RINs like Super Bowl tickets and helping to spike prices. For the majors, these extra windfalls on RINs aren't spectacular in moving their bottom line, but for refiners they pose a major hurt: Valero estimates a cost of up to $850 million this year for RIN's, PBF Energy claims their costs will be near to $300 million.

And the problem really is that these numbers are only going to get worse as the EPA's schedule on ethanol blending continues to automatically ramp up. Without a change in the program, RINs must inevitably get ever more expensive and continue to drain the profitability of refiners.

Washington has shown a certain understanding of the ridiculousness of the Ethanol program as it currently stands; the Obama administration relaxed the standards once, although we see the mandates again outrunning gasoline production today. Conversely, Washington has shown little appetite for scrapping the Ethanol and Biofuels program completely - with the optics of an abandonment of environmental sensitivity. But something more permanent needs to be done - if this pace of ethanol blending is allowed to continue to increase, weaker refiners are literally going to be put out of business

And until something is changed, even large independent refiners continue to represent a difficult investment, even as they have benefited from low oil prices.