Biofuels and the Oil Price, Gloomy Gus, Energy Bear, Express Train to Mood Hell

January 6, 2015 |

hell-barbecueOil prices are down, energy stocks are plunging, and the investor mood is giving Lord of the Flies a run for its money for mix of peril, fantasy and pessimism.

So why is the hard data for biofuels so much rosier than the global mood?

AFICIONADOS OF SATURDAY MORNING CARTOONS of the early 1970s may well recall the character of Glum, a Lilliputian in The Adventures of Gulliver show, whose trademark line was a number of variations on:

It’s hopeless, It’ll never work, we’re all doomed, we’re all going to die, we’ll never make it,” spoken in a monotone right out of Walter Matthau.

Glum’s unrelieved pessimism is the spirit of the times of late 2014 and early 2015 amongst biofuels observers — a time of unrelenting gloom and panic, generally induced by an overdose of oil price watching.

From the Department of Fashionable Pessimism

“No one is going to invest, you can’t make any money, this’ll kill the market”— sentiments of that type flood the Digest’s Department of Fashonable Pessimism each day.

It’s generally induced by a 49% drop in crude oil prices since we first began publishing the weekly Digest Dashboard last June, accompanied by a 49% drop in gasoline prices.

Before anyone gets any more down in the mouth, let’s look at the hard data. Specifically, at the market most obviously afflicted by gloomy outlooks and pessimism — the first-gen ethanol business, which is relatively tied in to gasoline prices because of ethanol’s role as a gasoline substitute.

But first-gen producers, it needs to be pointed out, are in some combination of up to five markets: ethanol, distiller’s grains, corn oil, RINs and in some cases CO2.

We looked at the prices we are reporting on the Dashboard, comparing this weeks’ data with the Dashboard prices as reported for the week of June 30th

Here’s the tale of the tape on raw prices

BD TS 010715 ethanol-1

It’s clear that prices have gone down for fuel ethanol — and sunk faster than corn prices — but hardly as intensely as gasoline prices have fallen. And other products are not tracking oil — in fact, RIN and distillers grains prices are up substantially since the summer.

Let’s look at the values, using standard metrics in how much of each product comes out of a bushel of corn — and see how a mythical biorefinery might be holding up in hard times:

BD TS 010715 ethanol-2

Bottom line, a 4% drop in the gross profit between the value of a bushel of corn and the value of the products — and an increase in the spread from 55% to 57%.

(Note to readers: not every biorefinery makes all five products, commodity prices will vary from state to state, and RIN value is not captured by the producer, but rather by the obligated party that receives a RIN with every gallon purchased, and not every RIN is sold in the open market because most of them are needed for compliance purposes, only excess gallons result in traded RINs. But we have include RIN values to illustrate the overall inherent value produced from a bushel.)

Why so gloomy, Gus?

So, why all the gloom? As Raymond James analyst Pavel Molchanov wrote yesterday,

There are certain geographies where [product] prices can be influenced by oil prices, but the relevance for [share prices] is overwhelmingly sentiment-based rather than fundamental.

He adds that:

Amid the collapse in oil prices (down ~40% from mid-year highs to five-year lows near $60/Bbl), it might seem counterintuitive that clean tech would outperform…Once we delve into the underlying businesses, it becomes more logical. For the purpose of gauging oil price impact, we can segment the clean tech universe into three “buckets.” Loosely speaking, the breakdown is 20/60/20. 

In the first bucket are those companies that do not have even a theoretical connection to oil prices. This includes, for example, solutions providers (hardware and/or software) for the power grid. The second bucket – the largest of the three – consists of companies that have only a superficial or derivative connection to oil prices. Just about everybody in the solar space fits into this category. 

The same goes for other clean power types: wind, geothermal, fuel cells, etc. Bioindustrial developers, such as Amyris and Solazyme, are also in this category, since their product mix (solvents, lubricants, flavors/fragrances) has only minimal correlation with oil. Finally, the third bucket has the petroleum substitutes: biofuels and natural gas fuels. While each individual firm’s exposure to oil prices certainly varies – and some of these stocks (notably corn ethanol producers) had a strong 2014 – these businesses feel at least some pressure from the oil price meltdown.

Looking through the investorscope

A more nuanced view of companies in the sector might focus on:

1. How much of the product mix is a direct substitute for petroleum — as opposed to products that have only a “minimal correlation with oil”.

2. How are prices holding up for a) the products in the mix that compete directly with petroleum and b) those that don’t?

In the case of first-gen fuels, the first answer is “about 50% right now” and the second answer is “not much change, taken as whole”.

One more thing

Another thing to keep in mind — how do fuel prices impact demand. Falling gasoline prices will increase demand — but not as much as you might think. The Energy Information Administration writes:

The U.S. average retail price per gallon of regular motor gasoline has fallen 28% from its 2014 peak of $3.70 per gallon on June 23, to $2.68 per gallon on December 8. However, this price decline may not have much effect on automobile travel, and in turn, gasoline consumption. Gasoline is a relatively inelastic product, meaning changes in prices have little influence on demand.

Price elasticity measures the responsiveness of demand to changes in price. Almost all price elasticities are negative: an increase in price leads to lower demand, and vice versa. Air travel, especially for vacation, tends to be highly elastic: a 10% increase in the price of air travel leads to an even greater (more than 10%) decrease in the amount of air travel. Price changes have greater effects if the changes persist over time, as opposed to being temporary shocks.

Automobile travel in the United States is much less elastic, and its price elasticity has fallen in recent decades. The price elasticity of motor gasoline is currently estimated to be in the range of -0.02 to -0.04 in the short term, meaning it takes a 25% to 50% decrease in the price of gasoline to raise automobile travel 1%. In the mid 1990s, the price elasticity for gasoline was higher, around -0.08, meaning it only took a 12% decrease in the price of gasoline to raise automobile travel by 1%.

But we shoud be seeing a 2+% increase in gasoline demand, and that will take some pressure off the ethanol blend wall — where gasoline demand had been expected to fall so sharply that it would have curtailed E10 blending.

The RIN market at work

Part of the reason that the ethanol market is holding up relatively well in tough times is the impact of the Renewable Fuel Standard, and its traded RIN system. RIN prices have jumped as oil prices have slumped — and a $0.76 increase in the RIN value of a gallon of fuel is a striking increase in value.

The value of product portfolios and balancing commodity risk with product mix

Now — an advanced biofuels producer whose only target product was a direct petroleum substitute, well, we’d be seeing a lot more damage to the bottom line. So, we are seeing, close-up, the value of spreading a product mix in order to combat commodity price volatility.

What about those oil prices?

With respect to the outlook for oil prices, Molchanov adds:

We expect a rebound in oil prices towards the end of the year (averaging $62/Bbl for WTI and $68/Bbl for Brent). In addition to directly helping those clean tech companies that have a close connection to petroleum, there may be some sentiment boost for clean tech as a whole. However, as noted earlier, clean tech is coming off two years of relative outperformance (vs. most other energy stocks) and a third such year might be a stretch. 

But he warns:

Most importantly, it again bears repeating that clean tech simply does not lend itself to making broad calls. Within each subsector – even the narrow “niche” ones, with a handful of public players – we still have to focus on each individual company’s positioning (product mix, margin structure, industry partners, geographic footprint, etc.) Of course, all this needs to be seen in the context of inherently high risks in young, rapidly evolving industries and a market mood that can swing rapidly from risk aversion to risk appetite, and vice-versa.

The Bottom Line

If you’ve fallen for the fiction that falling oil prices means inescapable gloom for biofuels — think again, by following the hard data.

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