A Closer Look At The Court Decision On HollyFrontier’s Biofuels Exemptions

Source: By Tristan R. Brown, Seeking Alpha • Posted: Tuesday, February 11, 2020

Summary

  • A federal appellate court recently held that HollyFrontier had improperly received a large number of small refinery exemptions from the U.S. EPA over the last decade.
  • The value of these exemptions has varied over time and, while comparatively small in individual years, adds up over the time spans involved.
  • The ruling has important implications for the broader U.S. refining sector as well, especially if it prompts a rollback of the Trump administration’s “hardship waiver” expansion.
  • This article examines the appellate court’s ruling in detail.

Late last month the U.S. Court of Appeals for the 10th Circuit ruled against refiner HollyFrontier (HFC) in a lawsuit brought by a coalition of biofuels producers. The subject of the lawsuit was the small refinery exemptions [SRE], or so-called “hardship waivers”, that HollyFrontier has received from the U.S. Environmental Protection Agency [EPA] over the last decade that reduced its biofuels blending obligation under the federal biofuels blending mandate. The biofuels coalition argued that HollyFrontier should not have received as many waivers as it did on the grounds that it did not qualify for all of them under the biofuels mandate. The federal appellate court agreed in a ruling that also found fellow refiner CVR Energy (CVI) to have also improperly received waivers.

At issue is the vast expansion of hardship waiver allocations that has occurred under the Trump administration. The volume of biofuels gallons that were covered by these exemptions more than doubled on a YoY basis in 2016 and again in 2017 (the actual award decisions being made well after the end of the calendar year) (see figure). The expansion had the practical effect of reducing demand for biofuels under the federal revised Renewable Fuel Standard [RFS2] at a time when the industry was already struggling with the effects of low fuel prices, prompting the lawsuit by biofuels producers.

Source: EPA (2020).

The SRE mechanism was created by Congress to ensure that the mandate’s biofuels blending obligation would not impose undue economic hardship on small refineries (as opposed to small refining companies). The Trump administration’s expansion of the SRE allocations has been contentious in large part due to the coinciding rise in refining margins. HollyFrontier in particular has seen its profitability rise sharply since the SRE expansion began in 2017 (see figure), which made it, as a recipient of SREs for two of its refineries, a natural focus of the biofuels companies’ lawsuit.

Chart
Data by YCharts

The appellate court’s decision focused on the terms under which refineries are selected to receive hardship waivers. The number of both refineries that have petitioned to receive SREs and been allocated the same has also increased sharply since 2016 (see figure). This, according to the court, should not have happened. Specifically, the court pointed to the use of the following language in the legislation that created the biofuels mandate:

In the case of a small refinery that the Secretary of Energy determines…would be subject to a disproportionate economic hardship if required to comply…the [EPA] Administrator shall extend the exemption…for the small refinery for a period of not less than 2 additional years. (emphasis added)

Source: EPA (2020).

“Extend” is the operative word here. All small refineries were initially exempted from the blending mandate until 2010. In 2011 the U.S. Department of Energy determined that 13 small refineries should receive SREs, and 24 small refineries ultimately had their pre-2011 exemptions extended. The number of extensions continued to decline annually until reaching a low of seven in 2015, then rebounded to 19 and 35 in 2016 and 2017, respectively. Such a rebound could only have occurred if the EPA issued SREs to small refineries that had either never received an extension or had seen an earlier extension ended for at least one year.

The appellate court determined that, by using the word “extend”, Congress did not intend for such standalone waivers to be issued. As such, then, any small refinery that was not initially approved for a waiver by the DOE and EPA, or had received a waiver that was subsequently discontinued, should not have received additional waivers in subsequent years. As the ruling itself puts it:

The amended Clean Air Act allows the EPA to grant an “extension” of the small refinery exemption – not a stand-alone “exemption” – in response to a convincing petition. The statute limits exemptions to situations involving “extensions,” with the goal of forcing the market to accept escalating amounts of renewable fuels over time. None of the three small refineries here consistently received an exemption in the years preceding its [2017-2018] petition. The EPA exceeded its statutory authority in granting those petitions because there was nothing for the agency to “extend.”

The ruling further noted the argument that Congress intended for the extensions to be phased-out until “eventual compliance with the renewable fuels program for all refineries” was achieved. It referred to an intended “funneling” effect in which the SRE allocations dwindled in number until a complete phase-out was achieved. One of HollyFrontier’s small refineries, Cheyenne, saw its original exemption expire in 2013, while the other small refinery, Woods Cross, never received an exemption. The appellate court determined that the EPA was not authorized to award additional SREs to these refineries as a result.

These improperly-awarded exemptions were not inconsequential. HollyFrontier reported the value of the Cheyenne and Woods Cross waivers to be $58 million and $97 million in 2016 and 2017, respectively, as compared to total RIN expenditures of $242 million and $288 million in the same years. With reported EBITDA in 2016 and 2017 of $820 million and $1,243 million, respectively, it was not as if the waivers pushed HollyFrontier’s earnings into the green, of course, but they were more than a rounding error by the same measure. The cumulative effect of the reversal of several years’ worth of these allocations will presumably need to be accounted for in a future earnings report.

The biofuels producers’ successful lawsuit has still more substantial implications for the refining sector as a whole. Only three small refineries were the subject of the immediate lawsuit, but the appellate court’s ruling made clear that a much larger number of small refineries improperly received SREs. While the government does not release the identities of the recipient refineries (the identities of the initial waiver recipients is redacted in the 2011 DOE report, for example), the sheer numbers involved in the 2016-2018 waiver expansion makes it very likely that subsequent lawsuits directed at other owners of small refineries will follow.

More immediately, the prices of Renewable Identification Numbers [RIN], which are the tradable compliance commodities that refiners use to demonstrate their compliance with the federal blending mandate, have moved to their highest levels of 2020 in response. The price of D6 RINs, which cover most of the blending mandate’s volumes, have increased from $0.10 at the end of 2019 to $0.26 (see figure). While still low relative to pre-waiver expansion prices, this rebound will cause refiners to reevaluate their expected 2020 RIN expenditures if it persists. It will be interesting to see how HollyFrontier’s management addresses this subject when it reports its FY 2019 earnings later this month.

Source: EcoEngineers (2020).

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