1 EPA Rule Change Might Lift These Ethanol Stocks Soon

The ethanol industry has long had February 2019 circled on its calendar. That's because the U.S. Environmental Protection Agency (EPA) has previously signaled it would be the month it formally changes a long-standing rule prohibiting high-ethanol content fuel mixtures during certain times of the year. If the agency follows through, then the nation's gasoline supply could see up to 15% ethanol blended in, up from a 10% ceiling today.

While most refiners will stick to the current limits, a healthy amount are exploring the potential to begin selling higher blend rates to customers. That has an ethanol industry trade group seeing domestic demand rise by 1.3 billion gallons per year within five years, equivalent to a roughly 10% increase. The timing couldn't be better for struggling ethanol producers swimming in a glut of supply and reeling from the lowest average selling prices since 2002. 

Here's how the rule change could permanently lift the fortunes of the nation's largest ethanol manufacturers, including Archer Daniels Midland (ADM 0.25%), Valero (VLO -1.01%), and Green Plains (GPRE -0.85%).

Check out the latest Green Plains, Valero, and Archer Daniels Midland earnings call transcripts.

Image source: Getty Images.

Understanding the importance of the potential rule change

The EPA currently mandates that gasoline sold in the United States contain 10% ethanol by volume. That requirement isn't going to change. Rather, throughout the year, fuel retailers will be able to sell gasoline containing up to 15% ethanol -- already approved for safe use in model year 2001 and newer passenger vehicles. If fuel retailers are willing to purchase gasoline with higher ethanol blends to sell to customers, then more refiners would manufacture such transportation fuels. Thus, refiners would have to purchase more ethanol. 

The number of retail stations in the United States selling the fuel had grown from just 12 in 2012 to over 2,000 in 2018, which hints there was already growing interest. The potential for a policy shift might turbocharge that trend. Indeed, Growth Energy CEO Emily Skor recently said the trade group was working with 13 of the top 20 independent retailers interested in selling gasoline with 15% ethanol. The group estimates the policy change could result in an additional 1.3 billion gallons of ethanol demand per year within five years. That would mark a significant increase. 

In 2017, the United States consumed 143 billion gallons of gasoline containing 14.4 billion gallons of ethanol, according to the U.S. Energy Information Administration. That's a lot of fuel, but the American ethanol industry has never done a great job balancing supply and demand. In June 2018 it boasted an annual operating production capacity of 15.8 billion gallons -- and 16.3 billion gallons of installed capacity if idled facilities are counted.  

In other words, there were at least 1.4 billion gallons of excess production in 2018. While year-to-date exports hit a record 1.6 billion gallons through November 2018, years of overproduction have built up a healthy national inventory that will take time to work through. But if the EPA allows year-round ethanol blends of 15%, then the industry could strike a balance between supply and demand much more quickly. 

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These three stocks could benefit

The nation's three largest publicly traded ethanol producers couldn't be more different. Archer Daniels Midland has a globe-spanning agricultural raw materials and processing business, while Valero is far and away driven by its refining business. Green Plains is much more dependent on ethanol sales for its overall operations, although years of underperformance caused it to recently sell 280 million gallons of annual production capacity (to Valero, no less), pay down debt, and refocus on higher-margin opportunities in the ethanol value chain.

In addition, both Archer Daniels Midland and Valero report all ethanol-related business -- including sales of animal feed, logistics services, and energy production -- in their ethanol segments, whereas Green Plains separates each into unique segments. That makes the latter's ethanol segment revenue and operating income look relatively weak by comparison, but it's not that far behind its peers in reality.

With those distinctions noted, here's how the nation's three largest publicly traded ethanol producers fared through the first nine months of 2018.   

Data sources: SEC filings, company presentations. Income statement metrics through first nine months of 2018. 

Valero reaps the most benefit from its ethanol segment out of the trio. That's because it can feed production into its crude oil refinery network to meet regulatory requirements for transportation fuel, which provides value even in a weak ethanol market. Nonetheless, a more balanced ethanol market, driven by booming exports and increased domestic demand from new policies, could have a profound effect on each business.

The last time the ethanol markets were close to balanced was 2013. When coupled with low raw material costs and booming demand for fuel credits, ethanol producers made money hand over fist. Archer Daniels Midland reported operating income of $322 million at an operating margin of 4%, Valero delivered $491 million in operating profit at a 9.6% operating margin, and Green Plains touched $63 million and 3%. What's more, each business has invested in new technology aimed at significantly boosting operating efficiency in the years since then, so the upside could be even higher.  

If the market tips into undersupplied territory -- possible if exports continue rising and high-ethanol content fuel demand rises faster than expected -- then 2014 might serve as a better guide. Archer Daniels Midland and Valero reported operating income that was 118% higher and 60% higher, respectively, than the healthy performance from 2013. Green Plains posted $214 million in operating income in 2014.

Of course, the more important thing for investors is the ability for the new policy change to result in a stable and comfortably profitable market for the long haul, not one that fluctuates between unrivaled highs and crushing lows from year to year.

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Despite the upside, ethanol remains a tough investment

Ethanol stocks have simply not been very good investments in the past five years. Only Valero has beaten the total return of the S&P 500 in that span -- and its 104% gain had little to do with ethanol. Archer Daniels Midland stock rose just 31% with dividends included, mostly because of a sluggish global agriculture market, while shares of Green Plains lost 28%. The S&P 500's total return was 73%.

Therefore, while the expected rule change from the EPA has the potential to lift the ethanol segments of each business, investors might be understandably restrained in their expectations for a sustainably healthy ethanol market to emerge. That makes a cautious approach to this opportunity the best for individual investors right now. There might be more room for optimism if the EPA follows through and an influx of retailers demonstrate interest in 15% ethanol blends, but it would be better to see how each company responds and what each business expects. Nonetheless, this is one renewable energy storyline to keep a close eye on in 2019.