What’s the real story behind Philadelphia Energy Solutions’ bankruptcy, crude oil, and the Renewable Fuel Standard?

February 1, 2018 |

By Joelle Simonpietri
Special to The Digest

On Jan 21st 2018, Carlyle-backed Philadelphia Energy Solutions (PES), the largest refinery complex on the U.S. east coast at 335,000 barrels per day, filed for Chapter 11 bankruptcy, blaming Renewable Fuel Standard (RFS) compliance costs. In the week since the filing, the Washington Examiner reports several other small refiners have piled on, asking the Environmental Protection Agency to waive the Renewable Volume Obligations under the RFS.

The governors of Pennsylvania and Delaware weighed in as well, writing letters to the EPA requesting to have the refineries in their states receive hardship exemptions from RFS obligations

“The whole reason we’re filing for Chapter 11 is that this is a massive expense,” said CEO Gregory Gatta in telephone interview with Bloomberg on Jan 22nd.  He went on to state that in 2017, meeting the amended federal Renewable Fuel Standard (RFS2) regulatory burden cost Philadelphia Energy Solutions more than twice as much as payroll and about 1.5 times more than its average annual capital expenditures. Since 2012 the refinery has accrued $832 million in credits.

Under terms of the filing in Delaware late Sunday reported by Bloomberg, PES seeks to sell off assets while leaving behind $300 million to $350 million worth of the compliance liabilities, effectively erasing the RFS2 liabilities.

The Blame Game

Union leaders piled on to the EPA and RFS blame wagon, despite PES’s announcement that the refineries will keep operating and none of the 1,100 employees would lose their jobs. In a letter last week to the EPA, Pipefitters union boss Mark McManus echoed Philadelphia Energy’s statements, opining that the Chapter 11 bankruptcy filing is proof of the harmful effects of the RFS on the smaller classes of refiners and the need for EPA Administrator Scott Pruitt to address the concern soon.

None of the union statements appear to touch on the large debt load carried by the company since the launch of the leveraged buyout/joint venture in 2012, or the original market reasons why the Philadelphia refineries were shuttered in the first place and needed rescuing in 2012. In an interview on Fox News on Tuesday, EPA Administrator Scott Pruitt agreed that the RFS needs to be reformed and updated. “As you know the RFS statute is something that impacts our economy, sometimes in a very difficult way and [the PES bankruptcy] is an example of that,” Pruitt said.

Opinion pages in the conservative blogosphere about this news have registered hundreds of comments by readers to date, weighing in to agree that blame should be placed on the EPA, King Corn, anti-business Liberals, swamps that need draining, etc, many with the usual (and inaccurate) popular wisdom that ethanol costs more energy to make than it yields, and is stealing land from food producers.  Less than 5% of the comments were critical of the company’s statements.

What’s the real story?

The question is, what is the real story?  How could Philadelphia Energy Solutions (PES) have (mis) managed its business as to accrue an aggregate $832 million in RIN compliance costs in five years, over 3 times the value of the refineries themselves, while others in the independent petroleum refining sector were enjoying record high profits and earnings per share at the same time and under the same regulatory regime?

Looking at PES’s bankruptcy filing from a different point of view, that of a student of private equity finance, it tells a very different story. The non-bankrupt parent company, Philadelphia Energy Solutions LLC, will invest $65 million in exchange for 25 percent of equity in the newly reorganized PES, thereby valuing the newly reorganized company at $260 million. This is less than half the value of the debt that the company took on in Carlyle’s and Sunoco’s original leveraged buyout deal in 2012. In the bankruptcy filing, the company also asks the court to effectively erase the company’s RFS renewable volume obligations, along with its other liabilities. In doing so, they take the highly unusual step of asking the court to approve their walking away from statutory compliance obligations, as well as financial ones.

What PES didn’t mention…

PES also didn’t highlight in the company’s public statements that they actually had held sufficient RIN credits to meet their compliance needs for 2017. Nearly a quarter of a billion dollars in 2017 RINs were dumped on the RFS exchange from a single large East Coast seller on January 19th, according to OPIS reports. “Everyone knew Philadelphia was selling,” stated some market insiders to me. Now with the bankruptcy declaration made public, it looks like the company sold the RINS in an attempt to raise cash after they decided they were going to enter Chapter 11 reorganization, and banked on a political strategy to modify the RFS to erase their volume obligations.

The volume of 2017 RINs held out for sale was sufficient to move the market downward, settling at 66 cents per RIN, over 30% lower than the flirting-with-$1 level that RINS had touched in the last quarter of 2017. Could PES have been trying to do what Patrick Keefe’s article in The New Yorker alleged Carl Icahn and CVR did, which was to effectively “short” the RIN market and sell RINs at high value, then try to move the market downward by lobbying the White House and EPA to relax the obligations and thereby move the value lower, then buy the RINs back in time to close their short position and meet their obligations at the end of the year? It’s unclear what view the EPA has on the totality of these actions, but the EPA did respond to PES’s petition with an agreement to issue a month-long extension, allowing PES until 31 May to acquire enough 2017 RINs to satisfy its obligations.

Why didn’t other independents falter?

Other independent refiners, like Andeavor (NYSE:  ANDV, formerly Tesoro), and Par Pacific (NYSE:  PARR), among others, had managed to achieve higher-than average profits and earnings per share during this same five-year period.  They also figured out some simple math to use the RFS to their benefit:  Ethanol at roughly $1.45 per gallon average price in 2017 as reported by the Oil Price Information Service (OPIS) was cheaper than wholesale gasoline average price at $1.67/gal over the same time period as calculated by the Energy Information Administration (EIA).

At the same time, wholesale ethanol buyers get the D6 RIN credit automatically when they buy the denatured unblended ethanol. This “free” RIN ranged between 50 cents and $1.00 per gallon in value for wholesale contracted bulk ethanol for much of 2017, according to OPIS.  As an additional sweetener, ethanol has a high octane value as well, allowing refiners to save money by making sub-octane gasoline blendstock to blend with the ethanol.

It is fair to say that those independent refiners who were actually changing their operations and making investments to be in compliance with the spirit of the RFS are watching this situation closely and are not amused. In fact, they deserve to be fuming. “Declaring bankruptcy doesn’t suddenly relieve a company’s OSHA regulations. Why should the RFS regulation be any different?” opined one of my colleagues from one of the RFS-compliant actors in the independent refining line of business.

PES coulda, shoulda…

PES could have followed suit and bought some gasoline and ethanol blending and distribution capability in the Northeast market with some of the $832 million, but instead spent time and money in a failed lobbying effort to the EPA to reduce the Renewable Volume Obligations, and also to change the “point of sale obligation,” from blenders to distributors, a position which their competitors in the independent refining industry opposed.  (See Tesoro’s docket filed with the EPA in opposition).  The EPA went so far as to publish a notice on Sep 26th 2017 to reduce the volume obligations for 2018 to less than 30% of 2017 levels. After pointed calls and tweets from “Big Corn” Republican Party governors and Senators to the White House and EPA in October 2017, the EPA set the 2018 volume obligations at roughly the same level as 2017.

During this period and the preceeding four years, it appears PES continued to neither buy nor blend biofuel, and therefore accrued but did not pay $832 million in aggregate RFS compliance costs. The bankruptcy reorganization (theoretically) wipes out the costs, and also much of the remaining debt used to purchase the assets in 2012. I note with irony that if PES had paid the $832 million as a fine to the EPA, it would have been the equivalent of a third of the $2.6 billion cut from the EPA’s budget for fiscal year 2018.

PES’ strategy

PES seems to have fallen victim as much to a flawed business model and failure to manage through change as to political gamesmanship between Small Oil and King Corn. In the PES CEO’s statements to the public and press about the drivers for the bankruptcy, he appears to have focused primarily on the RFS accruals. There appeared to be little substantive discussion of the company’s inability to:

  • Take advantage of historically high crack spreads, which traditionally benefit independent refineries in this narrow-margin business;
  • Reposition itself after the Marcellus and Bakken shale boom and bust bankruptcies;
  • Engage in qualifying biofuel procurement and blending in order to satisfy its Renewable Volume Obligations with organic operations;
  • Properly oversee JP Morgan Chase who was both their supplier and customer for crude oil and product sales; and
  • Conserve precious leadership time and bandwidth, instead spending years and political capital lobbying the EPA to reduce the RFS2 volume obligations and change the point-of-sale obligation

The Stranding of PES by…cheap oil

A joint venture between Carlyle Group LP and Sunoco Inc., Philadelphia Energy Solutions was launched to great political fanfare by the Governor of Pennsylvania in 2012, revitalizing one shuttered refinery and capitalizing on the disruptive change of the Marcellus shale boom. It was the same time period in which Delta Airlines purchased another ailing refinery, the Trainer Pennsylvania refinery with pipeline supply to Newark Airport. The PES new joint venture planned to use hundred-car-long rail lines to bring in domestic crude oil suddenly made available by hydraulic fracturing in the Marcellus and Bakkan shale regions, and raise the share of domestically supplied crude oil processed at the refinery to 50%.

The joint venture accepted $25 million in state and local government support and subsidies, and took on over $580 million in debt to purchase the two refineries and reorganize them into one company in 2012.  The joint venture then hired JPMorgan Chase & Co’s commodities traders to buy the crude oil and sell the fuel products for the refineries.

It is ironic that PES, as an East Coast refiner not connected by pipeline to any major crude supply location, and unable to refine cheap heavy Canadian crude, fell victim to the success of one of the other partisan battles of 2016-2017 and a Republican party rallying point – the Dakota Access Pipeline. As soon as the pipeline was complete and began operations, the cheap crude-by-rail trains (literally) stopped loading and going to Philadelphia. PES’s investment in the crude oil rail yard there in Philadelphia was stranded, but the company continued to avoid making similar infrastructure investments to be able to bring in, blend, and distribute ethanol or other biofuels.

Difficulty capturing large available crack spreads

Crude oil prices are coming off of all-time lows since 2012, when PES’s renewable fuel obligation problems supposedly started. Crack spreads ranged $18-20/BBL in 2017 and peaked at twice that level, at $31.38 per barrel in 2017, after Hurricane Harvey disrupted much of the Gulf Coast refining and upstream petroleum industry.  Larger crack spreads benefited other independent refiners during that same time period, especially those in the Northeastern U.S. who are not connected by pipeline to the Gulf Coast.

However, it appears that PES may not have been able to take advantage of the Hurricane Harvey windfall. Perhaps it was due in part to the mis-matched incentives in Carlyle’s deal with JPMorgan Chase’s commodities division to supply its crude oil and sell its refined products.  Perhaps it was PES’s failure to reposition itself after the Marcellus shale bust and Dakota Access Pipeline ended its new world order of U.S. crude supplies shipped to Philadelphia via rail, and the company suddenly needed to find international suppliers of more expensive Atlantic Ocean crudes who could deliver by sea again.

As to the political argument that ethanol, corn states, and renewables are to blame for putting a good Philadelphia employer down, it’s important to note that the U.S. is the world’s largest exporter of biofuels, specifically ethanol, according to annual global commodity data tracked by the U.S. Department of Agriculture.  Last I checked, ethanol refining is, like petroleum refining, part of the U.S. manufacturing sector and employs lots of plumbers and pipe-fitters.  It is also an important manufacturing sector for rural economic areas in America inside and outside the rust belt.

Philadelphians deserve better than a political whitewash

To sum up, blaming this chapter 11 bankruptcy on the RFS smells like a political cop-out.  It sounds very similar to coal companies blaming their bankruptcies on EPA environmental regulations, rather than on competition from natural gas.  As a tactic to deflect attention from the company’s (mis)management and strategic errors, however, it appears to have been highly effective.

The hard-working people of Philadelphia deserve better than political whitewash by private equity vulture investors just doing business as usual to clean up a balance sheet.

Unlike Philadelphia Energy Solutions, the Philadelphia Eagles football team didn’t make it to the Super Bowl by playing poorly and then blaming the referees for bad calls and lobbying the NFL to change the rules. They made it by trading for good players who fit well with the team, playing at the top of their game, and within the rules of the game on a frosty but level playing field.

Go Eagles!

About the author. Joelle Simonpietri is an independent advisor to strategic investors in renewable fuels projects and technologies that integrate food, feed, fuel, fiber, and waste conversion.  She is a member of the industry advisory committee for the Federal Aviation Administration’s Aviation Sustainability Center of Excellence (www.ascent.aero), convenor of the public-private Commercial Aviation Alternative Fuel Initiative’s regional focal for Hawaii (caafi.org), and a member of the Hawaii Energy Policy Forum. 

During an Innovation and Experimentation detail at the U.S. Department of Defense’s Pacific Command Headquarters (PACOM) 2012-2016, she developed the stakeholder groups, road maps, and strategies that led to the Joint Deployment Energy Planning and Logistics Optimization Initiative for greater physical security of U.S. military fuel logistics movements in the Asia-Pacific, the $510 million Defense Production Act Title III biofuel refinery establishment program, U.S. Navy’s Great Green Fleet demonstrations at the Rim of the Pacific exercises, Defense Logistics Agency’s biofuel procurement requirements development for the Pacific theater, and the Joint Deployable Waste to Energy mobile micro-gasifier procurement program. 

Prior to her service at U.S. Pacific Command, she was a plankowner and biofuels lead of Waste Management Inc’s Organic Growth Group corporate venture capital fund, a special venture partner at Honolulu-based Kolohala Ventures, and interim CEO of algae biotech company Kuehnle Agrosystems.  Ms Simonpietri also served eight years on active duty in the U.S. Navy.  She still serves in the Navy Reserve, where she was awarded the 2017 Admiral Layton Award for Leadership and Mentorship for helping bilateral teams to optimize ballistic missile defense of Japan and the western Pacific.  Ms. Simonpietri holds a B.S. in neurobiology from Duke University and an MBA from the Tuck School of Business at Dartmouth. 

 

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