Latest / WTR Small-Cap Spotlight / WTR Analyst Perspectives | Renewable Fuels Decoded: Geopolitics, Mandates, and the Carbon Payday

Transcript

WTR Analyst Perspectives | Renewable Fuels Decoded: Geopolitics, Mandates, and the Carbon Payday · WTR Small-Cap Spotlight

• 0:00
  SPEAKER_00: Welcome to the WTR Small Cap Spotlight Podcast.
• 0:04
  SPEAKER_00: I'm your host, Tim Gerteman, Vice Chair and Co-Founder and Chief Marketing Officer of Water Tower Research.
• 0:10
  SPEAKER_00: Welcome to the inaugural WTR Analyst Perspectives Podcast.
• 0:14
  SPEAKER_00: I'm your host, Tim Gerteman, co-founder of Watertower Research.
• 0:18
  SPEAKER_00: In this new series, we step back from our usual focus on small cap companies and dedicate the space to our analyst-owned read on where a sector stands and what investors should be watching.
• 0:29
  SPEAKER_00: In today's episode, I'm pleased to be joined by my colleague Peter Gastrike, Managing Director of Energy Transition and Sustainable Investing at Watertower Research.
• 0:38
  SPEAKER_00: We will discuss what's new in the high-growth renewable fuel space and why investors should be paying attention.
• 0:44
  SPEAKER_00: Good morning, Peter.
• 0:44
  SPEAKER_00: Great to see you again, and thanks for joining me.
• 0:47
  SPEAKER_00: Morning, Tim.
• 0:48
  SPEAKER_00: Great to be here.
• 0:48
  SPEAKER_00: Looking forward to our chat today.
• 0:50
  SPEAKER_00: Peter, before we get into the Outlook, given that this is your first time as our actually our first guest, in fact, on this new series, I want listeners to know why they are hearing from you.
• 1:01
  SPEAKER_00: You spent two decades on the sell side, most recently running Asia Oil, Gas, and Chemicals research at UBS out of Hong Kong.
• 1:10
  SPEAKER_00: How did that path lead you to energy transition and sustainable investing?
• 1:15
  SPEAKER_01: That's right.
• 1:15
  SPEAKER_01: And the last 10 years at UBS, I was the head of Asia Oil, Gas, and Chemical Research.
• 1:21
  SPEAKER_01: Over there in Asia, the larger energy and chemical companies were looking for the transition opportunities.
• 1:29
  SPEAKER_01: A lot of these companies were state-owned and operating in countries where there are large fossil fuel net importers.
• 1:37
  SPEAKER_01: So you can imagine that the strategies for those types of companies were not always with the objective of maximizing returns for shareholders.
• 1:46
  SPEAKER_01: However, you also had the big successes over there.
• 1:49
  SPEAKER_01: The best examples on the success side would have been maybe the Korean energy and chemical companies that used their platforms and transformed into dominant global EB battery suppliers.
• 2:02
  SPEAKER_01: But again, you know, as these traditional energy companies followed those transition strategies, whatever their motivation for following them, we as analysts had to go on that same path to follow those companies.
• 2:14
  SPEAKER_01: So I relocated back to the US on the tail end of COVID and picked up with water tower research not long after that to run sustainable investing.
• 2:24
  SPEAKER_01: My background meant that the energy, chemicals, and fuel side of the sustainable investing sector became a really uh you know natural fit from the start.
• 2:33
  SPEAKER_01: Uh, and I've since tacked on a few other sectors as well.
• 2:37
  SPEAKER_00: As you know, I have a soft spot in my heart for chemicals as a former sell side chemicals analyst.
• 2:42
  SPEAKER_00: Um, moving on, please tell our listeners more about what you cover at Watertower Research.
• 2:47
  SPEAKER_01: Sure, happy to.
• 2:48
  SPEAKER_01: So I focus most of my time on circular carbon and environmental solutions.
• 2:54
  SPEAKER_01: Uh, and that really breaks down into five subsectors.
• 2:57
  SPEAKER_01: Uh, the first is renewable fuels, which we'll talk about today.
• 3:01
  SPEAKER_01: So that includes things like sustainable aviation fuel, renewable diesel, uh, low-carbon ethanol, and uh natural gas, uh renewable natural gas.
• 3:09
  SPEAKER_01: Uh, next you've got uh waste to value.
• 3:12
  SPEAKER_01: So these are really interesting and innovative companies with proprietary technologies that are profitably converting things like uh discarded solar panels, discarded batteries, and waste plastics into usable and sometimes scarce commodities like uh you know silver, lithium, and sustainable aviation fuel.
• 3:31
  SPEAKER_01: Uh some of these are critical minerals that are coming out of these uh these wastes.
• 3:37
  SPEAKER_01: Uh next, we've got carbon management.
• 3:39
  SPEAKER_01: So these are companies that are capturing CO2 emissions from industrial processes and either permanently sequestering that CO2 or converting it into usable commodities.
• 3:51
  SPEAKER_01: That circular carbon component is what can turn an ordinary product into something that becomes extremely valuable.
• 3:58
  SPEAKER_01: So things like uh low-carbon ethanol, SAF, low-carbon ammonia all benefit if you can remove the CO2 emission.
• 4:07
  SPEAKER_01: Or you can even detach that carbon credit, which some companies are doing, from the commodity altogether and sell that uh you know benefit, that attribute to someone else.
• 4:16
  SPEAKER_01: Uh next, we've got clean tech.
• 4:18
  SPEAKER_01: So these are uh proprietary technologies that are powering industrial decarbonization and distributed energy.
• 4:26
  SPEAKER_01: So uh think about things like um you know tight tightening uh knock standards.
• 4:31
  SPEAKER_01: Uh and finally, um, I look at uh environmental solutions.
• 4:34
  SPEAKER_01: There's a lot to unpack there, uh which we can talk about in the future.
• 4:37
  SPEAKER_01: But this is removing some of the hardest contaminants from air, water, and waste streams.
• 4:42
  SPEAKER_01: And this includes companies that are uh also providing you know specialty feedstocks to get this job done.
• 4:48
  SPEAKER_01: So these include things like activated carbon uh used in air and water remediation, or companies that are providing those uh you know specialty coal uh feedstocks.
• 4:58
  SPEAKER_01: So if any investors want to uh dig deeper into these sectors, uh the themes in the companies, I'd point to our sector primer uh for a deeper dive on this.
• 5:07
  SPEAKER_00: So, Peter, we've just finished earnings season for the renewable fuel sector, and you issued a new report to capture this.
• 5:13
  SPEAKER_00: What do you see as the key takeaways for investors?
• 5:17
  SPEAKER_01: Well, for renewable fuels, this was the uh best earnings season the sector has had in a long time, Tim.
• 5:23
  SPEAKER_01: Um margins are running at uh multi-year highs right across the board.
• 5:28
  SPEAKER_01: Uh the balance sheets are in uh better shape than they have been in years.
• 5:32
  SPEAKER_01: And the carbon side of the business uh has grown into a meaningful earnings contributor, and that has happened a lot faster than uh investors have expected.
• 5:41
  SPEAKER_01: Uh so about five themes that stood out for me.
• 5:43
  SPEAKER_01: Uh the first on the policy side, uh, we have uh you know record renewable fuels mandate in place, and that's the most uh important demand driver this industry has had really in years.
• 5:54
  SPEAKER_01: Uh, but August uh last month was a reminder that that ride is not always entirely smooth.
• 5:59
  SPEAKER_01: Uh, we also have policies overseas, which we can talk about later.
• 6:02
  SPEAKER_01: Uh the second is geopolitics, something everyone has been following very closely this year.
• 6:07
  SPEAKER_01: Um, if you're looking at these margins and giving credit to the policy, uh, I think you're really only seeing half of the picture.
• 6:14
  SPEAKER_01: A global supply squeeze is doing uh much of that work.
• 6:18
  SPEAKER_01: The third is carbon intensity.
• 6:20
  SPEAKER_01: So this has quietly become a direct revenue line.
• 6:23
  SPEAKER_01: So part of that is credit stacking, uh, several programs layering layering onto the same gallon.
• 6:29
  SPEAKER_01: Uh, and part of that is a new kind of buyer who wants the carbon attribute separated from the fuel uh itself.
• 6:36
  SPEAKER_01: Uh fourth, you have uh sustainable aviation fuel, what's going on there?
• 6:40
  SPEAKER_01: So there's a very good problem to have that has been uh emerging, and that is that there is growing evidence that demand is running um ahead of the industry's ability to certify and build that SAF capacity.
• 6:54
  SPEAKER_01: And finally, you have capital discipline.
• 6:57
  SPEAKER_01: So, uh, and it's great to see the companies are you know laser focused on their balance sheets.
• 7:01
  SPEAKER_01: Uh, they're paying down their debt, they're funding growth out of the assets that they already own and being very careful about dilution.
• 7:09
  SPEAKER_01: So the strong margins and cash flows that we've seen coming this year, particularly into the second quarter, uh, caught a lot of people by surprise.
• 7:17
  SPEAKER_01: Uh, but a lot of management teams have uh um appreciated that and taken that to the bank rather than uh you know spending it.
• 7:25
  SPEAKER_00: So let's take a deeper dive into each of those points individually, starting with policy.
• 7:31
  SPEAKER_00: You mentioned the mandate picture looks more favorable than it has in years, but the process has not really been smooth.
• 7:37
  SPEAKER_00: How do you separate signal from noise and how durable is this support?
• 7:41
  SPEAKER_01: Yeah, Tim, yeah, we really need to separate the direction of travel here from the week-to-week noise, and August gave us a really uh good example of that.
• 7:50
  SPEAKER_01: Um, you know, the direction, I think, is genuinely favorable, and it's been that way for the past year or so.
• 7:56
  SPEAKER_01: Um, we have a record blending mandate uh in place, uh, and that is the strongest demand support this industry has had in years.
• 8:04
  SPEAKER_01: Uh the noise was really in August.
• 8:06
  SPEAKER_01: Um, you know, refiners can petition for exemptions from this mandate, uh, and the APA granted a large batch of them, and that knocked down the value of these compliance credits down by like 30% in a single day in early August.
• 8:19
  SPEAKER_01: But then by the end of the month, the agency promised to put those exempted volumes back into the next two years, and the credits snapped right back uh uh almost in a single session.
• 8:29
  SPEAKER_01: So my read here is that the mandate itself is durable, uh, and most of that uh was really implementation issues rather than an intent to alter that uh you know trajectory.
• 8:41
  SPEAKER_01: Um but there is litigation still pending, so the reallocation rule is not final uh and the 45Z rule is not due until uh November.
• 8:49
  SPEAKER_01: Uh the other thing I'd say is that you know the the policy story is not just US.
• 8:53
  SPEAKER_01: This is a global market, and the credit market here uh is only one input into that.
• 8:58
  SPEAKER_01: So take ethanol.
• 8:59
  SPEAKER_01: So you know, exports are now supporting a lot of growth for the US, with other countries now having their own blending programs, which is pulling American product into those markets.
• 9:09
  SPEAKER_01: Uh with SAF, uh, the demand curve out to 2030 is being set really by the EU and UK mandates, not and by Corsia, uh, not by anything that the EPA does.
• 9:20
  SPEAKER_01: And in renewable diesel, you you have a mandated European market which sits right alongside the US one.
• 9:26
  SPEAKER_01: Uh, so that's you know why producers will tell you you really have to pay attention to the economics on you know both sides of the Atlantic there.
• 9:34
  SPEAKER_00: I know your second theme was the geopolitical supply squeeze, Peter.
• 9:38
  SPEAKER_00: Make the case for why that matters as much as domestic policy right now, and tell us what worries you about it.
• 9:44
  SPEAKER_00: I imagine covering global oil refining and petrochemicals for as long as you did gives you a very particular angle or viewpoint on this.
• 9:52
  SPEAKER_01: Yeah, it does.
• 9:53
  SPEAKER_01: And I think that's uh the right frame for it.
• 9:55
  SPEAKER_01: So, you know, margins uh, as I mentioned, have been at uh multi-year highs.
• 10:00
  SPEAKER_01: And on almost every interim earnings call uh from these companies, and management put that down to supply disruption, not just a you know jump in demand.
• 10:10
  SPEAKER_01: So between the Middle East conflicts and the war with Russia and Ukraine, we have a genuine shortage of refining capacity, and you can see it in the spread between crude and middle distillates like uh, you know, diesel and jet.
• 10:22
  SPEAKER_01: So, what the refining background uh gives you is a feel for you know how that sort of travels.
• 10:27
  SPEAKER_01: Uh, fuel is a global trade business.
• 10:30
  SPEAKER_01: You know, cargoes move to where the prices are highest.
• 10:33
  SPEAKER_01: So capacity lost in one region does not stay a regional problem.
• 10:37
  SPEAKER_01: It becomes global.
• 10:39
  SPEAKER_01: So let's take uh you know a faraway market like uh India.
• 10:42
  SPEAKER_01: Um, one of the companies in Interim Results was talking about this, how you know the pressure on Russian crude purchases has pushed up diesel prices so far that biodiesel is suddenly becoming competitive at the pump in India.
• 10:55
  SPEAKER_01: That's renewable fuels demand created entirely by you know crude oil trade flow.
• 10:59
  SPEAKER_01: Um, the other piece is the substitutability.
• 11:02
  SPEAKER_01: Renewable diesel sits in the same pool as regular diesel.
• 11:06
  SPEAKER_01: So when the conventional barrel gets expensive, renewable one looks better without anything changing on the renewable side.
• 11:12
  SPEAKER_01: And producers can often switch between renewable diesel and SAF depending on which pays more.
• 11:18
  SPEAKER_01: So that flexibility is something that's very, very important right now.
• 11:22
  SPEAKER_01: But the part that matters most is not only a margin story, it's changing the policy conversation.
• 11:28
  SPEAKER_01: So when jet fuel spikes, because of a choke point on the other side of the world, energy security suddenly becomes front and center.
• 11:36
  SPEAKER_01: And that's becomes you know a genuine issue this year, not just a risk that's kind of talked about.
• 11:42
  SPEAKER_01: Um we had a really great example of this from uh Comstock in one of our uh previous or recent podcasts.
• 11:48
  SPEAKER_01: Um, uh that they said that after the Strait of Hormuz uh disruption, its uh Biolium Corp investment, uh, which is their biofuel uh company, was fielding inquiries from Australia, Ethiopia, and even Zambia, uh, all asking how to build domestic biomass to fuel a capability.
• 12:08
  SPEAKER_01: So you see the same logic at home here in the 45Z credit being restructured to reward US producers who are using domestic feedstocks.
• 12:17
  SPEAKER_01: So that is really a structural shift uh toward localized uh production.
• 12:23
  SPEAKER_01: That's really the direction of travel here.
• 12:25
  SPEAKER_00: The uh intricacies are the intricacies of this are actually pretty mind-boggling.
• 12:30
  SPEAKER_00: It's uh very interesting to think about kind of on a macro basis.
• 12:33
  SPEAKER_00: So you called carbon intensity the most structurally durable of your sector's tailwinds.
• 12:38
  SPEAKER_00: What does that mean in practice for a producer's earnings?
• 12:40
  SPEAKER_00: And is the market pricing it correctly, in your opinion?
• 12:44
  SPEAKER_01: Well, in in practice, um, you know, most of the producers we heard from now run what amounts to a second business layered on top of physical fuel sales.
• 12:56
  SPEAKER_01: So you have the 45Z production credit, you've got uh 45q for carbon sequestration, uh, state low carbon fuel standards programs, uh, and now you have the voluntary carbon markets.
• 13:08
  SPEAKER_01: So, and the key point here is that you can stack several of those on the same gallon of fuel.
• 13:14
  SPEAKER_01: So carbon intensity score translates to a direct input into your revenue per gallon.
• 13:20
  SPEAKER_01: So now for several of these producers, that carbon line is a genuinely material contributor.
• 13:28
  SPEAKER_01: In some cases, it's the biggest for some companies.
• 13:30
  SPEAKER_01: Um, so you know, whether the market has it right, um, I would say maybe not yet.
• 13:35
  SPEAKER_01: Uh a lot of investors still look at these as one-time credits or a subsidy that could disappear.
• 13:42
  SPEAKER_01: So they discount the earnings heavily, you know, or maybe ignore them.
• 13:46
  SPEAKER_01: Uh my argument is that these programs are structurally, you know, distinct from the credit system that is currently in flux.
• 13:54
  SPEAKER_01: So, you know, you have different statutes, you have different mechanisms, and you know, different politics.
• 14:00
  SPEAKER_01: So, but the honest caveat here is that the clarity is still uh kind of incomplete.
• 14:05
  SPEAKER_01: Um, I think as I mentioned earlier, we're still waiting for that 45Z final rule in November, uh, and producers with the least mature carbon verification are the the most exposed if the rules do shift.
• 14:17
  SPEAKER_01: So this is a place where the diligence uh, you know, and in following these things closely really matters.
• 14:23
  SPEAKER_00: Great.
• 14:23
  SPEAKER_00: So let's move on to SAF, which uh at least my belief is the subsector within your space that gets the most attention.
• 14:30
  SPEAKER_00: Where does the market actually stand today?
• 14:33
  SPEAKER_01: Uh well, what stands out uh and what's really starting to come through now is that you have a demand-rich and supply short market, which is uh emerging.
• 14:45
  SPEAKER_01: Um this reminds me of what a you know chief engineer at Boeing said at a staff conference that I attended uh uh before.
• 14:53
  SPEAKER_01: Um he said that aviation really only has uh two levers.
• 14:57
  SPEAKER_01: Number one, how efficiently you fly the plane, this as regards the fuel and decarbonization.
• 15:03
  SPEAKER_01: And the second is what goes into the tank.
• 15:05
  SPEAKER_01: Uh and Boeing is uh going to keep building aircraft that burn jet range molecules for decades to come.
• 15:13
  SPEAKER_01: So he called aviation a captive audience for this.
• 15:16
  SPEAKER_01: The demand is locked in by the fleet, not just by the mandates.
• 15:20
  SPEAKER_01: Uh, the constraint is all on the supply side and its certification and construction timelines, not a lack of interest here.
• 15:27
  SPEAKER_01: So there's also uh you know a second demand source, I think that some people uh you know miss.
• 15:33
  SPEAKER_01: Corporate buyers were seeing that they're purchasing the environmental attributes directly, separate from the airlines that actually burn the fuel.
• 15:41
  SPEAKER_01: Um, I saw this firsthand uh on a tour uh that I joined of Givo's North Dakota facilities earlier this year.
• 15:49
  SPEAKER_01: Uh, Givo hosted one of the largest airlines in the US, and that airline brought along a dozen or so of its own corporate customers.
• 15:57
  SPEAKER_01: Those were the people asking most of the questions, and they were there because they want to claim credit for the carbon attributes of that sustainable aviation fuel.
• 16:06
  SPEAKER_01: That is a demand channel that did not really exist even like you know three years ago.
• 16:11
  SPEAKER_01: Uh so who wins?
• 16:12
  SPEAKER_01: Uh to a large degree, this is really about first movers.
• 16:16
  SPEAKER_01: Uh, if you have certified capacity running by 2030, you're in a very different position from someone you know still working through that uh you know front-end engineering.
• 16:25
  SPEAKER_01: And it favors the capital light approaches, brownfield conversions, and licensing over those large greenfield builds.
• 16:33
  SPEAKER_01: And as mentioned, buyers want to see low carbon intensity or the ability to isolate that attribute for sale.
• 16:41
  SPEAKER_01: Um, the last thing that I would say that is that this is not a winner, you know, winner, winning technology takes all sort of a race.
• 16:50
  SPEAKER_01: Um, you know, there's going to be multiple coming in here.
• 16:53
  SPEAKER_01: So HEFA is the most mature pathway today.
• 16:55
  SPEAKER_01: That's what almost every almost all staff you're seeing today is coming from that, renewable diesel as well.
• 17:00
  SPEAKER_01: Um, but its feedstock gets tight beyond 2030, which is exactly when the mandated volumes step up.
• 17:07
  SPEAKER_01: So for that, we will need alcohol to jet, and that covers a lot of ground on its own.
• 17:12
  SPEAKER_01: That's everything from uh, you know, corn, uh, you know, corn ethanol to woody biomass and uh captured waste gases.
• 17:19
  SPEAKER_01: So does pyrolysis of waste plastics.
• 17:22
  SPEAKER_01: So meeting long-term SAF demand is going to require an all of the above approach, and multiple streams will qualify, you know, selling into a tight market in uh in 2030.
• 17:32
  SPEAKER_01: So, anyway, bottom line here, keep an eye on those first movers, all of which we cover.
• 17:37
  SPEAKER_00: Understood.
• 17:38
  SPEAKER_00: So, Peter, I always enjoy having you on the podcast because you always have very diligent and detailed views, which are appreciated.
• 17:45
  SPEAKER_00: In closing, looking out over the next few months, what are you watching most closely and what would change your view on the sector?
• 17:53
  SPEAKER_01: Well, there's a real, you know, cluster of catalysts that are coming.
• 17:56
  SPEAKER_01: Um, I would say there are two that matter most.
• 17:58
  SPEAKER_01: Uh, the first is whether the EPA actually follows through on uh reallocating those exempted volumes that I talked about.
• 18:06
  SPEAKER_01: Um, the notice at the start of September finalized the exemptions, but left the reallocation language out.
• 18:12
  SPEAKER_01: So right now, uh it's really more of a promise and not a rule.
• 18:16
  SPEAKER_01: Uh what the EPA committed to is putting out a proposal by the end of October, and a proposal is still not a final rule, of course.
• 18:25
  SPEAKER_01: The other piece I'd watch is how they split those volumes between 2026 and 27.
• 18:30
  SPEAKER_01: With so little left of this year, a 2027 weighted split looks very likely, and that would push most of the demand effect, you know, really into next year effectively.
• 18:39
  SPEAKER_01: Um, the second is the 45z rule in November.
• 18:44
  SPEAKER_01: Uh that sets the per gallon value of the carbon credits across the sector.
• 18:48
  SPEAKER_01: So given what I said about carbon becoming a durable earnings line, uh that's the that's uh it matters very much to what's happening here.
• 18:57
  SPEAKER_01: Uh California's E15 implementation implementation bill is sitting with the governor.
• 19:03
  SPEAKER_01: Uh, even once it is signed, carb rulemaking makes means that you are not seeing volume at the pump until 2027, but it's worth 600 to 800 million gallons of ethanol demand where it stands.
• 19:17
  SPEAKER_01: And you have a slate of SAF investment decisions over the next year or two, which is the real test of whether the economics are good enough to turn demand into actual capacity.
• 19:28
  SPEAKER_01: So, really quite a few things to follow here.
• 19:30
  SPEAKER_01: Um, as for what would change my view on things, um, the first would be you know capital discipline.
• 19:35
  SPEAKER_01: I mean, I I mentioned that as the fifth theme.
• 19:38
  SPEAKER_01: We didn't go into too much detail here, uh, but uh, you know, capital discipline breaking down would be a big problem, obviously.
• 19:43
  SPEAKER_01: So if companies start, you know, chasing capacity again with dilutive financing, uh, that will tell me that there's a shift uh in what I described was happening this year.
• 19:52
  SPEAKER_01: Um the other is really, you know, any kind of a court ruling that reopens the mandate math, uh, which the scenario, uh, which is that scenario where the policy floor you know turns out to be less solid than it looks.
• 20:06
  SPEAKER_01: Uh but anyway, so I think for all of this, uh if investors want to take a look at our report, uh, we have this uh WTR circular economy focus report, the five key themes driving renewable fuels, evidence from interim results season.
• 20:18
  SPEAKER_01: So please take a look at that to dig deeper into these themes and into uh the companies that are affected by them.
• 20:25
  SPEAKER_00: Yes, for our uh listeners, please uh look for that report on W Wwatertower Research.com.
• 20:31
  SPEAKER_00: We will see you next time for another another edition of the WTR Analysts Perspective Podcast.
• 20:36
  SPEAKER_00: And Peter, thanks for joining me, and I look forward to checking back in with you again soon.
• 20:40
  SPEAKER_00: Thanks very much, Tim.
• 20:42
  SPEAKER_00: Thank you for listening, and don't forget to subscribe, as well as visiting wwatertowerresearch.com to stay up to speed on the company's small cap written research reports, podcasts, fireside chats, industry specific symposiums, and conference schedules.
• 20:58
  SPEAKER_00: We will see you next time for another edition of the WTR Small Cap Spotlight Podcast.
• 21:04
  SPEAKER_00: Finally, a special thanks to the producer and editor of the podcast, Krista Fitzpatrick.