Alternative fuels: Our future energy source or a myth?

We have initiated coverage on two renewable fuels companies: Clean Energy Fuels Corp. (NASDAQ—CLNE) and Darling Ingredients Inc. (NYSE—DAR).We rate Clean Energy at “sector outperform” with a one-year price target of US$13 per share; and Darling Ingredients at “sector outperform” with a one-year price target of US$101 per share.


Scotiabank adds 2 renewable fuel companies to its coverage

Clean Energy is the leading natural gas fuel distributor in North America with an extensive network of over 550 stations that provided nearly half of all the RNG (renewable natural gas) used for transportation in the United States last year. The company’s long-standing relationships with feedstock owners and fleet operators established over its 20 years in the industry provides the basis for growth in key customer markets along with securing additional RNG supply.

We think the company’s expansion into upstream RNG production will leverage existing downstream capabilities to provide vertical integration opportunities. This will not only ensure better supply availability but also enhance economics through the capture of more of the RNG value chain. Additionally, it will allow for optimization of gas flows across Clean Energy’s network to maximize environmental incentives.

The partnership with big oil companies, BP PLC. and TotalEnergies SE, decreases investment requirements while maintaining control over RNG supply and generating substantial environmental credits with hugely negative carbon RNG fuel.

We expect Clean Energy’s total fuel volumes to increase at a 13 per cent CAGR (compounded annual growth rate) from 2022 through 2026 while RNG volumes are projected to grow at a faster rate of 25 per cent CAGR.

Darling’s rendering operation controls about 15 per cent of the world’s animal byproduct processing and over 50 per cent of the domestic used cooking oil (UCO) collection. The RD (renewable diesel) business, through a joint venture partnership with top refining operator Valero Energy Corp., is also the largest producer in North America. With dominant positions in both the rendering and RD segments, the company is getting the best of both worlds.

The legacy rendering business should benefit tremendously from the rising agriculture commodity prices while providing the RD segment with its industry-leading advantaged feedstock position.

As the pioneer of the U.S. RD boom, the accumulation of operational and technological experience from years of trial and error will provide Darling with invaluable advantages that investors might have overlooked.

Aside from the core operations, the expansion into the higher-margin hydrolyzed collagen market through its food business as well as exposure to European biogas could support its growth profile down the road. Additionally, given the expected FCF (free cash flow) inflection in 2023, the company is well-positioned to significantly accelerate cash return.

Adoption of alternative fuels requires government support

We believe that although there is strong support for alternative fuels, none will be able to stand on their own without government support and none will be able to compete directly with existing conventional fuels. We do not see a clear path to the elimination of fossil fuels based on the technology available today. As such, we think it will be a long and bumpy road to net zero.

Given the high cost of production of renewable fuels that is often well above their conventional fuel counterparts, renewable fuels are not economic and do not compete with existing fossil fuels without policy incentives and mandated volume requirements.

As a result, the consumption of renewable fuels is almost entirely dependent on government policies such as RFS (Renewable Fuel Standard) and LCFS (Low Carbon Fuel Standard). As well, development of such fuels requires economic incentive whether through environmental credits or tax credits (e.g., Blenders’ Tax Credit, or BTC, Alternative Fuels Tax Credit, Investment Tax Credit or ITC, and Production Tax Credit or PTC). Therefore, renewable fuel stocks are similarly driven by policy developments, such as the recent Inflation Reduction Act that is set to invest US$369 billion in energy security and climate change.

Policies remain supportive. We think that U.S. President Joe Biden’s administration is committed to supporting the biofuel industry and the overall climate agenda, as demonstrated through the IRA (Inflation Reduction Act) as well as the EPA’s (Environmental Protection Agency) strong stance on denying all SREs (small refinery exemptions) and maintaining RVO (renewable volume obligations ) mandates.

As a result, we think RIN (renewable identification number – credits that the U.S. EPA uses to track and enforce compliance with the renewable fuels mandates) prices should continue to be supported and expect the surplus in D4 RINs (i.e. these RINs are created by blending diesel made from soybean oil, canola oil, waste oil or animal fats into diesel) to be offset by the shortage in D6 RINs (the most basic RIN – it is generated by blending corn-based ethanol into gasoline). For D3 (RINs generated by blending ethanol made from cellosic material e.g. corn stover, wood chips, miscanthus, biogas into gasoline), given production is still well below statutory mandated levels, we believe RVO will continue to match actual production, meaning D3 RIN prices will remain well supported.

As for LCFS, while we do think credits will soon become oversupplied with all the new RD capacity coming online, we believe CARB will accelerate its carbon reduction plans given the faster-than-expected progress in meeting targets. We think more stringent requirements could be implemented as soon as 2024, which could lift LCFS credit prices.

Paul Cheng is a Scotiabank equity analyst based in New York City.

This is an edited version of an article that was originally published for subscribers in the October 14, 2022, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

Investor’s Digest of Canada, MPL Communications Inc.
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