Refiners around the world have been hard-hit by the global virus outbreak and the mobility constraints that followed it. As a result, capital expenditure by these companies has been reduced dramatically as companies tried to remain solvent. Interestingly, investment in renewable diesel (RD) production capacity does not seem to be affected. On the contrary, the past few weeks saw an additional wave of announcements of RD production capacity addition.
Most of this investment seems to be driven by the impressive margins showcased by renewable diesel producers, especially in California under the LCFS. Neste, the world’s biggest RD/HVO producer, achieved an operating profit margin of 45% on its renewable diesel business unit in 2019. Valero, the US’ biggest RD producer, achieved an operating profit margin of 47% on its RD division in 2019 – compared to a 2.25% operating profit margin on its ethanol division.
The profitability of RD has been driven by the fuel’s eligibility for three different subsidies in the California market. RD generates RIN credits, LCFS credits and benefits from the Blenders Tax Credit (BTC), recently retroactively reintroduced through 2022. As of 9 June 2020, the value of these combined subsidies amounted to $3.32 per gallon of tallow-based RD, or $1124 per tonne. In most cases, the revenue from these subsidies alone is enough to cover the RD production costs. With California’s LCFS reduction targets to increase by 1.25% annually through 2030, refiners are determined to take a slice of this profitable market.
Whereas the California RD market is currently supplied by Neste, Valero and REG. In the following years, Marathon, Phillips 66 (Ryze Renewables), HollyFrontier and BKRF (private equity-backed) will join the field of dedicated RD producers. Moreover, Valero and Neste both have significant capacity expansions underway.
These new players are hoping to bank in on the increasing demand of renewable diesel, which will need to be blended by obligated parties to stay compliant with the increasing GHG reduction targets under LCFS. Although renewable diesel has played an important role in achieving reduction targets over the past years, there are other pathways that can play an important role in compliance going forward.
The graph displayed above shows the credits generated per renewable pathway. Historically marginal pathways such as hydrogen and bio-LNG have been left out for oversight. The relevance of renewable diesel in achieving GHG reduction targets is evident, with the fuel representing one-third of all credits generated in 2019. That said, a significant increase in credit generation is also visible for Ethanol <65 gCO2e/MJ, most of which is sugarcane/molasses ethanol imported from Brazil. Shell and BP, who are active on the California market, have been sending increasing volumes from their respective ethanol JVs in Brazil to bank in on the high price California offers for their low carbon-intensity product. Although the market share of Brazilian ethanol in California is still relatively modest, its low-CI score, combined with the vast size of California’s gasoline pool make that there is a lot more potential for the generation of LCFS credits through sugarcane/molasses ethanol blending. If the average carbon intensity of ethanol blended in California would drop to 45 gCO2e/MJ – the typical value of Brazilian product – an additional 2.5 million LCFS credits could be generated under 2019 gasoline demand. From a cost perspective, Brazilian ethanol is eligible for D5 credits, whereas US corn ethanol only qualifies for the less lucrative D6 RIN credits, giving the former another advantage.
Besides ethanol and biomass-based diesel, renewable natural gas (RNG) has been another major source of credit generation, although bio-CNG credit generation growth has been relatively flat over the past few years. This is set to change, however, as a new kind of RNG is about to hit the market in California. Traditionally, RNG has been produced mostly from upgraded landfill gas, that was sold as bio-CNG/LNG to heavy duty vehicle operators. Recently, however, additional investment has been directed towards producing RNG from animal manure, mostly through cooperatives with cattle farmers. Looking at the graph below, the volumes of animal waste RNG are still very modest, but the impact on the overall carbon intensity of RNG sold is already significant. This is due to the fact that animal waste RNG enjoys extremely favorable CI-scores, pathways currently approved under the LCFS sport a score of between -372.35 gCO2e/MJ and -151.41 gCO2e/MJ – compared to around 40 gCO2e/MJ for landfill gas RNG. CalBio is a company that is investing heavily in animal waste RNG production capacity, in partnership with Chevron. CalBio has expressed that it aims to produce 20 million gallons equivalent, potentially generating 900,000 LCFS credits annually. Investment in animal waste RNG is also underway in Oregon, Georgia, Nevada, North Dakota, Colorado, New Mexico and Utah.
There are other pathways that are expected to generate significant additional credits going forward. Most importantly, credits generated by EVs are expected to grow substantially through 2030. California’s previous governor, Jerry Brown, targeted 1.5 million EVs on the road by 2025, going up to 5 million in 2030. It is currently unlikely that this target will be met, 2019 sales being at 156 thousand – down from 178 thousand in 2018. In addition, around a third of the 2019 sales were made up by PHEVs. That said, in spite of lower-than-expected growth in EV sales, there will still be a significant increase in credit generation by EVs in California – also driven by the increasingly lower carbon intensity of the Californian power grid. Other pathways that will lead to an increase in credit generation are upstream emission reductions, FCC co-processing, refinery investment credits and fuel infrastructure credits for public hydrogen and EV fast-charging stations.
All the LCFS deficits that will not be met by the main pathways shown in the LCFS credit generation graph, will likely be met by renewable diesel. The main question is, however, whether or not there will be overcapacity on the renewable diesel market – given the dramatic increase in production capacity. When adding up the capacity of operating, proposed and approved production projects, one can see that there may not even be enough total diesel demand in California for all this renewable product. Although there will be RD demand arising in Canada and other US states, it is inevitable that a few of the “proposed” projects will have to be axed. Most likely this will be the Omega Green Diesel project in Paraguay, whereas Valero might also reconsider its plans to add 400 mmgy of production capacity in Port Arthur, TX. Besides known RD projects in the US, below graph also includes capacity from Neste in Singapore, and Omega Green Diesel in Paraguay.
Besides the threat of oversupply, RD producers will also have increasing difficulties in sourcing sufficient low-CI feedstock for their facilities. Where producers as Neste and Valero have access to established supply chains of waste feedstocks, new players may struggle to consistently source the right feedstock for their facilities. Besides driving up the price for established waste feedstocks as UCO, tallow and technical corn oil (TCO), prices for soybean oil will likely benefit as well.
To conclude, the extreme profitability of Valero and Neste’s RD businesses has left other refiners scrambling to take a slice of the growing market for RD in the US. Although some of them will be successful, demand for RD will not be unlimited. In addition, if the BTC will not be extended beyond 2022, and additional supply will suppress the price, profitability will be negatively affected. A declining diesel pool, and additional credit generation by low-CI ethanol, animal waste RNG and electricity can lead to the fact that some companies’ RD assets will only be profitable for a limited number of years, not justifying some of the high investment that is currently flowing into these projects.