RINatomy Part 5 – The RIN As A Contingent Claim
The Renewable Identification Number (RIN) is an option.
Anatomy noun, anat·o·my ə-ˈna-tə-mē a study of the structure or inner workings of something
Read other posts in this series RINatomy –
- Part 1 The RIN As A Subsidy
- Part 2 The RIN As A Tax
- Part 3 The RIN As A Mandate
- Part 4 The RIN As An Asset
- Part 5 The RIN As A Contingent Claim
Quoting Wikipedia,
In finance, a contingent claim is a derivative whose future payoff depends on the value of another “underlying” asset.
Wikipedia
It is a little known fact that the RIN is a form of contingent claim. A familiar form of contingent claim is a stock option, whose value depends on the price of a stock at a specific date in the future called its expiration date.
A call option
One type of stock option is a call option. The value of a call option on its expiration date depends on the difference between the market price of the stock on the expiration date minus a fixed price called the exercise price of that option.
If that difference at expiration is positive, the owner of the call option will exercise it and receive that difference.
If that difference at expiration is negative, the option will expire worthless. Unlike a futures contract, the call option owner has no obligation to pay the exercise price for a stock worth less than that on the expiration date.
Heightened complexity
The option feature adds to the complexity of the RIN which, as we have seen, is already complex enough being a subsidy, a tax, a mandate, a tradable and a bankable financial asset all in one package.
The option feature places the RIN in the special category of financial assets called a contingent claim, which heightens the complexity because it is not at all obvious why the RIN is a contingent claim and furthermore, this category of asset is confusing on its own to those unfamiliar with it.
Will the RIN price go negative?
Last week, I participated in the following exchange on LinkedIn which directly addresses a point of confusion related to the RIN as an option. A commenter asked:
With the current ramp up in RD (renewable diesel) + imported RD from Singapore, and 35 SREs (small refiner exemptions) pending ahead of elections, could RINs go negative?
LinkedIn commenter
I responded:
RINs won’t go negative. RIN = 0 happens when all bio-fuel that enters that market does so by earning its way in on economic grounds without a RIN subsidy, that is, when the bio-fuel is cheaper than the petro-fuel it replaces and so the free market pulls it in. Negative RIN would mean refiners are getting paid a subsidy to supply petro-fuel subsidized by an implicit tax on bio-fuels, as if the renewable fuel obligation was being imposed on bio-fuels. That won’t happen.
George Hoekstra
The commenter’s good, sensible question shows the RINs market is now grappling with the concept of RIN prices possibly going negative. But those who understand the RIN as an option do not grapple with that. They immediately see why the RIN will not go negative.
A blurry picture
Thinking about it at a high level, one can see intuitively that the RIN has something like an “expiration date” (set by its vintage), and something like an “exercise value” (set by something like the soyBean Oil – Heating Oil (BOHO) price spread). Those two features reflect, in a high level way, the RIN’s fundamental nature as an option.
If you make this high level intuitive comparison between an option and a RIN, you can begin to see the family resemblance. And then you might think something like, for example, if the RIN is an option, then maybe, like an option, the RIN’s price can’t go negative.
But these high level, intuitive resemblances involving expiration dates, exercise values, and price behavior are conceptual insights, too vague to fully see the connection, that give only a blurred mental picture of the RIN as an option.
Digging deeper
You must go deeper, to the level of equations and/or diagrams, to see precisely why the RIN is indeed an option. You can then see clearly what it would mean for the RIN price to go negative and why that won’t happen. You can also then see clearly other important implications of the RIN being an option.
With that fundamental grounding in equations and/or diagrams, you can also then apply economic and option pricing principles to quantify the RIN’s theoretical value with a number, as we did four years ago with our licensed “D4T” theoretical value, and go further to proactively study and understand historical RIN price behavior, and anticipate expected price behavior for different future scenarios, which is done with the help of our ATTRACTOR spreadsheet.
By the way . . .
(Most of us would not ordinarily even think about comparing the RIN to an option, as an idea that dawns on us out of the blue. That would ordinarily only happen when someone who already understands the RIN to be an option suggests the idea to you. That is certainly how it came to my attention 4 years ago.)
Heavy weights
The market is now grappling with the possibility the RIN might go negative because the RIN price has collapsed under heavy weights like the ramp up of renewable diesel, imports of renewable diesel from Singapore, uncertainties surrounding 35 unresolved Small Refiner Exemptions, and an upcoming election.
But these heavy weights and uncertainties are not news. They had all been headline news back in early 2023, before we were assured by the most credible of sources that the RIN market price, now at 43 cents, was predestined to stay securely in the $1.25-$1.75 range, and that it would be “business as usual” for RIN prices for the foreseeable future. That was before the RIN market price collapsed to 1/4 of its value, and long before anyone even considered the possibility it might go negative.
In fact, the 2023 RIN price collapse blindsided most in the market and cost some industry heavyweight players hundreds of millions of dollars each.
A road map
A fundamental grounding in RIN pricing and economics brings a wealth of insights and practical advantages to those interested in RIN prices. Seeing the RIN as an option is one such insight that brings important advantages to the RIN trader. Furthermore, that fundamental grounding provides the framework for you to study and anticipate likely price implications proactively before, instead of after you learn about them retroactively.
The fundamental grounding comes in the form of fundamental equations and/or diagrams that function like a roadmap, showing how the structure and inner workings of this price control system will lead to different outcomes. With that fundamental grounding, the RIN price control system is no more confusing than the processes and control systems typically employed in our industry.
The only real differences are this is a price control system and it runs on economic principles.
Options trading
In today’s publicly traded, listed stock options market, which has now been with us 50 years, you would not be allowed to place your first order without understanding you are trading options.
The RINs market is large and not yet nearly that mature, meaning big opportunities exist for those who do understand.
Attractor update
Ambitious leaders
Last week’s blog included an E-mail from a young, ambitious leader who asked his supervisor for help in finding a way to expense a training course he strongly wanted to take in order to enhance his contribution to his department’s objective.
Hoekstra Trading’s Research Reports are not exactly training courses – each Research Report contains the results of a 1-year original research project with new data, findings and recommendations not previously available. But each report also include tools for application and a 6-month period of unlimited support to help our clients reach top level understanding of the subject and immediately increase their capabilities and contributions toward their department’s objectives – so the purchase of a Hoekstra Research Report accomplishes the purpose of a training course, and more, in a slightly different way.
Faced with the request in that Email, a good supervisor would probably ask this employee for a 1-page business case to justify the spend, like an edited version of something like this sample 1-page project proposal, and clarify the employee’s plan and accountability to deliver tangible results this year from the spend.
A good supervisor would then take that employee’s request seriously, discuss the merits of the proposal, and respond in some way to this request for help in getting a purchase order for $20,000 issued by Friday.
In some cases, I have seen the purchase order the following day.
In other cases it takes longer, often because many supervisors (even VPs!) don’t often issue purchase orders for 3rd party purchases, so it is something new for them to step up and help their team with this non-routine request.
Sometimes it takes creative leadership from the employee and the the supervisor to overcome more significant obstacles to improvement that often exist, especially in big companies.
In mediocre companies, the request would be turned down or ignored because it is unusual and/or there is no budget that was specifically designated for it.
In some companies, this ambitious young leader would be told 20 thousand dollars is too much money to pay for something that will help us capture tangible benefits or stop realizing losses worth 100 million dollars each.
Recommendation
I recommend any company with a stake in RIN pricing should take action this year to ensure they have at least one person who understands RINs at a fundamental level. In all good companies, this can be done where there is a creative leader or two, young or old, at any level, who see the value and want to make it happen.
Get Hoekstra Research Report 10 and the Attractor spreadsheet
