A thread on renewable diesel.

Why it matters. Why you should care. Where you can look.

#EFT

In a nutshell, this. $NESTE. Largest player in renewable diesel. Up >600% in 5 yr vs US Energy sector down 40%.

$NESTE trades at >20x EV/EBITDA with FCF yield and dividend yield both <2%

This is the kind of energy stock you can own and sleep soundly at night

Context:
- Renewable diesel only works thanks to government credits and subsidies
- That’s OK
- The market LOVES green/renewable assets/companies
- That’s OK too

Renewable diesel (RD) is a non-petroleum fuel made from renewable wastes and residues, also referred to as Hydrotreated Vegetable Oil (HVO). Every molecule in RD is in petroleum diesel

It is NOT biodiesel

Biodiesel is a mixture of compounds are combined with petroleum diesel in 5-20% blends. RD composed of hydrocarbon chains that are identical to petroleum diesel - it meets specifications for use in existing infrastructure and diesel engines & is not subject to blending limits

Renewable diesel yields GHG emissions reductions of 45->80% relative to petroleum diesel (depending on feedstock)

For reasons including blend limits, water absorption, and GHG emissions, RD is set to outpace biodiesel in the 2020s

Common RD feedstocks:

- vegetable oils including palm oil, soybean oil, rapeseed oil
- used cooking oil (UCO)
- animal fat from food industry waste
- fish fat from processing waste
- technical corn oil (residual from ethanol production)

The decarbonizing landscape. Global initiatives seeking to curb emissions attributable to hydrocarbon consumption abound

The transport sector is the largest consumer of oil products. Diesel is the largest single oil product consumed globally

'19, fossil fuel CO2 emissions ~37b tons (35% oil). Diesel & jet fuel consumption of 36 mmbbld was 37% of overall oil consumption, potentially responsible for ~5 Bn tonnes of CO2 emissions. Renewable diesel helps reduce emissions in the diesel-run heavy transport industry

The aim is to reduce emissions in part through the substitution of renewable energy sources for traditional hydrocarbons

Low carbon policies, not economics, will drive increase in RD demand

Europe is at the forefront of the adoption of many policies. The US (led by Californian) and Canada are catching up in low-carbon policy development/adoption

Global demand for renewable diesel is thus expected to grow significantly in the coming decade as policies incentivize displacement of hydrocarbon diesel for RD

US RD demand of ~1b gal/yr is driven by existing policies in CA & OR. WA, NY, CO, MN, IA, SD, & UT are in various stages of evaluating low-carbon policies similar to those already active in CA & OR. Canada’s Clean Fuel Standard is expected to follow a similar approach

Global RD demand will nearly double '20-'25

NAM RD demand growth will come from CA LCFS mandating stricter renewables consumption. LCFS rollouts in Canada & other states will add. Europe’s Renewable Energy Directive (RED) II drives regional growth

The RD industry in the US is still in its nascent stages. 400 mm gal/yr RD is produced in only 5 plants, the bulk of that from only two facilities

The remainder of the 1b gal/yr RD demand in US is met by imports from Singapore – $NESTE operates an enormous RD facility and exports into US markets

In ‘20, the US refining sector reazlied its economic fortunes had been impaired by the new NAM shale slow/no growth paradigm. Margins won't return to the glory days. As a result, the market gets a wave of new RD anncmts from the group. Everyone is doing RD or contemplating RD

US RD S/D balance. 1.8b gal/yr projects already in flight come close to covering the demand outlook through ‘25. Incremental 2-2.5b gal/yr proj under consideration, US runs the risk of the latecomers overbuilding the industry and becoming scarily reliant upon the export market

RD Economics

Before looking IRR & NPV, need to look at margins. If the projects cannot generate positive op margins, there’s no need to assess capex to conclude that the economics are … not strong

Not unlike O&G, the basic economics of RD are poor, but there’s a catch

Gross Margin = (Revenue + Govt Incentives) – Feedstock Cost

Looking 1st at Revenue – Feedstock. We’ll come back to Gov’t Incentives

Generic RD project using soybean oil as feedstock has decidedly negative gross margins before the effect of gov’t programs; -$1.50/gal today

Hence the need for government programs to incentivize the production of otherwise uneconomic fuels

3 programs of note
- Renewable Fuel Standard (RFS)
- Blenders Tax Credit (BTC)
- California Low Carbon Fuel Standard (LCFS)

1) Renewable Fuel Standards (RFS) RINs. RINs are used to demonstrate compliance with RFS objectives of targets for renewable fuels in US pool. 1 gallon of RD creates ~ 1.7 D4 RINs which can be sold or used to offset RIN expenses incurred through traditional fuel production.

2) Blenders Tax Credit (BTC). RD is eligible for the BTC of $1/gal to be taken as a credit against tax liability or as direct payment from the IRS. Congress has extended or retroactively applied the BTC five times since 2011. The BTC has been authorized through YE22

3) CA Low Carbon Fuel Standard (LCFS) – standards to gradually decrease carbon intensity (CI) of fuels. Fuels with CI lower than annual standard earn credits. Criteria become more stringent every year. The lower the CI of the fuel, the more credits are earned

The cumulative impact of RFS, BTC, and LCFS can bring the -$1.50/gal gross margin up to $2.00-$2.50/gal

To recap, as price takers, RD producers will maximize gross margin with lower feedstock cost, more RINs (RFS), and lower Carbon Intensity score (LCFS)

Here’s how RD margins compare to regional refining margins. It’s not even close.

RD margins > refiners’ revenue

RD economics, inclusive of govt benefits, are grossly superior

As price takers, RD producers will maximize gross margin with 1) lower feedstock Carbon Intensity (CI) score, 2) lower feedstock cost, and more 3) RINs (RFS). BTC is not variable ($1/gal flat) and is lagniappe

Let’s see how an RD producer can go about maximizing margin

1) Feedstock CI. Better RD projects have lower CI feedstocks & generate higher LCFS credits. Below CI scores based on individual fuel sources into CA

Takeaway here: tallow & UCO feedstocks yield much lower CI scores (higher LCFS credits) than soybean or corn oil

Based on CA LCFS credit of $200/ton (remarkably stable for quite a while) and the carbon intensities listed prior, tallow/UCO feedstock generates $1.58/gal LCFS credit while a soybean feedstock generates $0.88/gal. 80% uplift in LCFS value attributable to feedstock

2) Lower feedstock cost

The raw gross margin of RD is the HOBO spread - diff btwn heating oil (HO) & soybean oil (BO) px .

Less transparency into tallow/UCO feedstocks, but can approximate using DGD data

Feedstock cost advantage of ~$0.50/gal in favor of tallow/UCO

3) RINs. RIN value based only on product, not feedstock. All get 1.7 D4 RIN/gal RD

Value of federal/state credits based on feedstock. Toggle is LCFS value derived from the feedstock CI. More revenue from tallow/UCO further augments feedstock cost advantage vs soybean oil

That’s before the new RD projects run head long into a tightening soybean oil market & drive up cost – further challenging relative economics

Revisiting the project queue, ~1.8b gal/yr new RD capacity (in motion today) will be added ‘20-’25. The largest feedstock of that will utilize ag oils (esp soybean), given limited availability of uncommitted tallow/UCO

The RD-led incr in veg oil demand represents 75-100% dmd growth in RD feedstocks. Repeat: RD projects will double feedstock consumption in 5 yrs

RD growth will increase TOTAL veg oil demand in US by over 1/3 in just 5 years

The US doesn’t have billions of lb/yr of veg oil feedstocks sitting idle. RD demand growth will exceed US supply capacity

What happens when regional demand spikes >30% in a tight commodity?

The call from RD feedstocks will exceed domestic capacity with a price-driven increase in net imports the plug to fill the gap. Soybean oil especially sensitive to the demand growth

The relative cost advantage of tallow/UCO vs soybean oil should further widen as new soybean-oil fed RD projects tighten an already tight domestic soybean market

Soybean-based RD projects will be forced into a competitive war bidding up price of feedstock

Recap:
- Renewable diesel demand increasing in NAM and Europe
- Govt programs materially aid in RD profitability
- UCO/tallow feedstock advantaged vs veg oils (esp soybean)
- Early movers with scale & exposure will benefit most

WAYS TO PLAY

1) $DAR (sleepy food processor now RD powerhouse)
- 50% own DGD, largest, most economic US RD facility
245% RD expansion online ‘21
- Largest collector of US UCO/fats
- RD MARGIN > diesel price
- >50% EBITDA from DGD by '22
- Upside to tightening global ag mkts

2) $VLO (best refiner exposure to RD)
- 50% owner in DGD, largest, most economic US RD facility
- Lowest exposure to soybean based RD feedstock-
DGD scale offers most corp exposure to RD of refiners

3) $NESTE (RD, clean fuel juggernaut)
- Largest global RD player, further expansions on horizon
- Growth in renewable aviation & chems
- Bulletproof financials

4) & 5) $BG & $ADM (more speculative)
- Ag processors likely beneficiaries of tightening soybean oil mkt
- International exposure likely source of increased soybean oil imports into US
- Exposure to broader tightening global ag markets

6) $REGI (speculative)
- 2nd largest RD producer in US (today) with large expansion under consideration
- Has the words “Renewable Energy” in corporate name

NAMES TO AVOID

$PSX $HFC $MPC $CVI $PBF

Refiners with impaired economics coming as late entrants to RD party adding huge debt to build projects sourcing disadvantaged feedstock