How the New Coronavirus and Crude Price War Could Dampen the RINs Markets and Boost the LCFS Credit Bank
March 10, 2020
By Leigh Noda
The last week of February marked the biggest drop in the stock market since the financial crisis of 2008. The S&P index was down 11.5% on the week ending February 28th. The Dow Jones was down 12.4% over the same week. This compares to the week ending October 10, 2008 when the S&P index and the Dow Jones index were both down 18.2%. The pullback in each of these market weeks was caused by vastly different reasons. The underlying causes of the 2008 financial crisis were a collapse of the subprime mortgage market in the United States, liquidity issues of some financial institutions due to risk, and a full-blown international banking crisis. This late February market pullback was caused mainly by fears of the economic effect of the new coronavirus (COVID-19) that originated in Wuhan China and has spread to numerous countries. As of this writing, the coronavirus is still on the ascending portion of the curve around the globe.
The shock that the coronavirus gave to the global economy was compounded by events in the crude oil markets stemming from fears of a crude oil price war between Saudi Arabia and Russia. On March 9th, WTI crude fell from an already depressed close of $41.28 per barrel on Friday, March 6 to $31.13 per barrel – a 25% decline in value in one day. The crude price drop triggered another big loss in the financial markets. The Dow Jones fell 2,014 points – the largest point drop in history – exceeding the previous record, set on February 27th when the Dow fell 1,191 points.
There is, however, a bit of optimistic news: The Chinese government’s response to this health crisis – to quarantine Wuhan and aggressively restrict travel – seems to have slowed the spread of COVID-19 in China. These aggressive, restrictive actions, far beyond measures taken in the U.S., have also greatly reduced that country’s economic activity and consequently their consumption of oil. China is the second-largest consumer of oil in the world behind the United States. The expectation of sharply reduced demand with the reduction of activity in China and daisy-chain impacts on downstream components of the manufacturing value chain, especially for jet fuel and ship bunkers, drove crude oil prices down. Demand is expected to remain low until China’s normal level of economic activity has been restored.
This week, the Saudi-Russia crude price war has driven down crude oil prices to levels not seen since February 2016. The chart below plots the West Texas Intermediate (WTI) spot price from November 2019 through today. As can be seen, the oil market reacted quickly to news of the coronavirus and its accompanying expected sharp drop in oil demand in Asia. The WTI spot price fell from about $60 per barrel at the beginning of 2020 (when the crisis became a concern) to levels in the mid $40s by March 1st, before dropping sharply to near $30 per barrel the week on March 8th.
Prior to the coronavirus’ spread and the Saudi-Russia price war, there had been a steady trend of record highs of the Dow Jones. In the span of less than three months, however, crude oil prices have been cut in half, reflecting about a $0.75 per gallon reduction in the raw material cost of refined products. Over the same time period, the crude oil markets have absorbed the implementation of a regulatory event, IMO 2020; an epidemiological event, COVID-19; and a political event, the Saudi-Russia price war for market share.
Market Downturns and Renewable Fuels Programs
So, what are the potential impacts of these global market gyrations on the Federal Renewable Fuels Standard (RFS), California’s Low Carbon Fuel Standard (LCFS), and the biofuels markets that these programs incentivize? We see potential for significant impacts on the Renewable Identification Number (RIN) and LCFS credit markets and the price and demand for biofuels if the events of the day lead to a significant economic slowdown and transportation fuel demand reduction.
The U.S. has experienced several market downturns in the past two decades – the two mentioned in the opening of this article in addition to the bursting of the “dot com” bubble in 2000. After the downturns in 2000 and 2008, we saw a marked decrease in gasoline demand that reflected the economic slowdowns. The following chart illustrates U.S. gasoline demand before, during, and after the 2008 financial crisis. The actual peak in gasoline demand was July 2007, indicating that the economic effects underlying the October 2008 market crisis were already affecting gasoline demand long before the market crisis hit. As can be seen in the chart, about 3% of gasoline demand was lost between July 2007 and May 2009.
Unlike in 2008, fuels suppliers today must account for new carbon and renewable fuels markets in addition to traditional energy markets. Given the relative newness of these carbon markets, we don’t have historical data about how an economic downturn and decline in fuels demand affect programs like the Federal RFS and California’s LCFS. Below, we discuss a hypothetical case in which the current fuels markets decline by 3%, as they did in 2008, and we extrapolate what impact that might have on RINs obligations and credit balances under the RFS and LCFS programs.
It is important to note that we are not forecasting that the COVID-19 health crisis or Saudi-Russia crude war will cause a global economic downturn like that experienced in 2008. However, such a scenario is not outside of the realm of possibility. Much is still unknown. We could see closure of the COVID-19 crisis in a short timeframe, in which case markets would likely return to their previous trajectories. Alternately, the coronavirus may persist and further impact international commerce and travel, sap confidence out of the economy and have profound impacts on the greenhouse gas (GHG) regulations and transportation fuels markets. The Saudi-Russia crude war could end tomorrow with an agreement between the parties or it could drag on for weeks or months.
Impact of a 3% reduction in petroleum gasoline and diesel on Renewable Identification Numbers (RINs)
The U.S. Environmental Protection Agency (EPA) annually establishes the final volume requirements – or renewable volume obligations (RVO) – for each category of the four renewable fuels – cellulosic biofuels, biomass-based diesel, advanced biofuel and renewable fuel – effectively setting the volume targets for each fuel category. Estimated gasoline and diesel volume projections from the U.S. Energy Information Administration (EIA) are used to calculate an RVO percentage in each fuel category. Subsequently, during the compliance year, these RVO percentages are applied to the actual volume of gasoline and diesel produced or imported by each obligated party to determine their RINs obligation in each category.
The EIA’s gasoline and diesel 2020 volume estimates used to establish the 2020 RVO percentages were from its October 2019 Short Term Energy Outlook (STEO). This STEO was published prior to the coronavirus outbreak and could not have included any demand impacts resulting from it. In other words, for the 2020 RFS volumes to be met, the total gasoline and diesel demand must be close to the STEO volumes. If total gasoline and diesel volumes are below the October 2019 EIA estimate, refiners will require smaller volumes of renewable fuels in order to achieve their RVOs.
If the aggregated volumes of gasoline and diesel are 3% lower than projected, actual volumes in each fuel category would decline proportionally, resulting in a corresponding 3% reduction in RINs demand in each RFS fuel category. Although not large, a 3% reduction in obligated volumes equals nearly half of the volume exempted in 2018 by EPA’s granting of small refiner exemptions.
If RVO volumes fall short, demand for biofuels – particularly biodiesel and ethanol which are blended with petroleum fuels with declining demand – will decrease. In short, a world with the combination of reduced transport fuels demand and declining petroleum gasoline and diesel cost does not bode well for biodiesel and ethanol producers.
Impact of a 3% reduction in petroleum gasoline and diesel on the LCFS
The impact of a 3% reduction in gasoline and diesel demand would be different for California’s LCFS than the federal RFS. The key differences in the two programs:
- LCFS credits held by entities do not expire
- Any credit can retire any type of fuel deficit
- The nature of compliance – meeting an average fuel carbon intensity (CI) reduction – gives entities more flexibility for compliance and more value and demand for low-CI fuels
What we expect with a fuel demand decrease is that the impact differs between the two major fuel pools – gasoline and diesel. For gasoline, where the ratio of ethanol to gasoline is effectively fixed, falling demand would reduce the deficits generated by the petroleum portion of the fuel while also reducing the credits earned by the 10% portion that is ethanol. There should not be a change in the contributions for alternative fuels to gasoline like electricity and hydrogen. In the diesel pool, we see any reduction in demand being absorbed by the petroleum diesel volume, not the biodiesel and renewable diesel volumes. Instead we see all the alternative and renewable diesel fuel volumes (renewable diesel, biodiesel, CNG and LNG) holding steady or continuing their historic growth. Ethanol and biodiesel producers with low-CI products will continue to have a marked advantage over those with higher CI product.
Stillwater estimates that a sustained 3% drop in gasoline and diesel demand would generate fewer deficits resulting in an approximate 0.5 million MT net increase in LCFS credits each year. This is a significant change, as we expect that for 2019 there will be a 1.1 to 1.2 million MT deficit position. An additional 0.5 million MT will help extend the credit bank that we expect to be at 7.7 million MT at the end of 2019 (when the 2019 data is finalized). With a few big surprises on the credit-generating side and a 3% reduction in gasoline and diesel demand, 2020 or 2021 could show an annual net credit position and change the market view for LCFS credits.
Bottom line: The coronavirus is of concern and could impact the RFS and LCFS credit markets if the virus proliferates and significantly impacts economic activity. In a worst-case scenario, the coronavirus impact could drive LCFS credit prices down from their high near the credit clearance market (CCM) price and RINs to levels experienced when the EPA granted numerous small refinery exemptions. We are hopeful that our public health and medical professionals might yet keep the worst from happening.
Stillwater Associates see things others miss, and we stand ready to partner with you. Contact us for personalized, in-depth analysis around GHG policies and downstream fuels markets.
coronavirus, COVID-19, COVID-19 and the LCFS, Crude, Crude Price, LCFS, LCFS credits, Market, RFS, RINs