The refining sector has had an up and (mostly) down year, and last week the Environmental Protection Agency (EPA) made an announcement that ensures the group will face more headwinds in 2017.

In a move that surprised many industry observers, the EPA finalized 2017 renewable fuel requirements under the Renewable Fuel Standard (RFS) program that are 6% above the 2016 quota. It was a surprise because the EPA had previously proposed a 4% increase over 2016 volumes — and refiners complained loudly about that potential increase.

The RFS has been law since the Energy Policy Act of 2005. Its purpose is to increase the use of biofuels in the U.S., and the EPA requires obligated parties — which means those who supply fuel — to demonstrate compliance. The mechanics of verifying compliance were explained previously in RIN and Bear It.

In a nutshell, the RFS forces refiners to subsidize biofuel producers. Refiners have complained bitterly about the costs imposed upon them by the RFS. In the first half of the year, the top 10 refiners spent $1.1 billion to comply with the mandate. Those costs eat into refiners’ margins, and are partially passed on to consumers via higher gasoline prices.

Valero (NYSE: VLO) noted in its Q3 earnings release that it had incurred $198 million of costs to meet biofuel blending obligations for the third quarter. This is a significant amount relative to Valero’s Q3 net income of $613 million.   

Responding to the EPA’s decision, Tesoro (NYSE: TSO) vice president Stephen Brown, called the new quota “unworkable” and said that it highlights the need for a legislative overhaul of the program. Billionaire investor Carl Icahn, who indirectly owns the majority of independent refiner CVR Refining (NYSE: CVRR), has warned that the current system threatens to bankrupt some refiners.

Although the RFS was instituted by a Republican president, it has also enjoyed the favor of the Obama Administration. But the election of Donald Trump may finally provide the impetus to overhaul the RFS. Trump has repeatedly indicated his desire to eliminate some regulations on the oil and gas industry, and Icahn was a vocal Trump supporter who is sure to let Trump know his views on the RFS.

On the flip side, Trump spoke in favor of ethanol during the campaign, and the RFS enjoys wide support among farm state senators. He will be lobbied hard by the farm lobby on one side and the oil lobby on the other. So it’s hard to say definitively that Trump will end or water down the RFS, or even that he could get Congress to go along if that is his intent. But it’s more likely now than it was a month ago.     

Refiners rallied following the election on expectations that the regulatory headwinds they’re fighting will ease up over the next four years. But the group gave back some of those gains following the EPA announcement, while biofuel producers like Green Plains (NASDAQ: GPRE) and Pacific Ethanol (NASDAQ: PEIX) surged.

Our view is that renewable fuel producers will be much more sensitive to any decisions around the RFS. The downside could be steep should the system be overhauled. If the RFS is completely eliminated, some biofuel companies will go bankrupt. Refiners, despite Carl Icahn’s warning, will survive the RFS, but they will definitely do better if it is eliminated.

We will be monitoring the situation closely, and as always provide actionable advice in response to the latest developments for subscribers of The Energy Strategist and MLP Profits.    

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