Description

Thesis Summary

• Green energy play with massive demand tailwinds; economic returns on projects are hugely attractive even assuming a considerable haircut to current spot prices; compelling valuation on out-year numbers; potential to receive an ESG valuation premium; several massive upside options.

• Demand for RNG is growing rapidly with a long runway to continue.

• Companies are facing significant political, regulatory, and shareholder pressure to move towards sustainable forms of energy

• RNG is chemically indistinguishable from normal natural gas, so the theoretical market size for RNG is the same as the size of the natural gas market. RNG is currently only 0.15% of the total natural gas supply today, leaving significant room for growth.

• RNG is an attractive choice for decarbonization relative to alternatives:

• RNG utilizes existing natural gas infrastructure and equipment (pipelines, industrial facilities). As a result, substituting brown gas for green gas is a substantially cheaper and easier method of achieving decarbonization than scrapping existing natural gas infrastructure and pursuing an electrification path.

• RNG is a very low carbon-intensity energy source and the lowest carbon-intensity transportation fuel.

• Capturing emissions from landfill gas is environmentally equivalent to electrifying ~75% of U.S. passenger vehicles.

• RNG is the  only viable option for gas-based utilities to reduce their carbon footprint.

• Several large utilities, including SoCalGas, NW Natural, Vermont Gas Systems, FortisBC, and many others have already adopted mandates pledging to source a specified portion of their energy supply from RNG. These mandates are being made both to comply with regulation (independent of environmental credit programs) and on a voluntary basis. SoCalGas’ 20% target by 2030 represents 200mm mmBTU of incremental demand. Adding in the contribution from FortisBC, VGS, and NW Natural’s mandates brings the total to well over 260mm mmBTU. The incremental demand from these already-announced utility mandates alone represents 13%-28% of projected total 2030 RNG supply (depending on the supply forecast used). This is before considering additional utilities adopting similar targets and incremental demand from the transportation sector (which represents the overwhelming of RNG demand today and likely well into the medium-term).

• Many corporate consumers of natural gas and other utilities (including large consumers of transportation fuel such as Amazon and UPS) are also committing to using RNG.

• Returns on RNG projects are highly attractive. Based on the company’s base case assumptions (which assumes a considerable decline from current spot prices), returns on projects are as follows:  

• D-3 RIN Price:

• Archaea’s base case projections assume a $1.50/gallon D-3 RIN price vs. ~$2.75/gallon currently. As such, there’s already a ~45% decline in spot prices baked into management (and our) numbers.

• Though RIN prices have historically been volatile, the key swing factor has generally been the Renewable Volume Obligation targets set by the federal government (which essentially forms the demand side of the supply/demand equation driving RIN prices). The EPA Administrator has de factor (and beginning in 2023, de jure) sole rulemaking authority to set volume targets for D-3 RINs (the category of RINs relevant to RNG). While the EPA considers input from industry stakeholders when setting volume targets, politics unsurprisingly plays a large role in the decision-making process. Biden, for whom environmental groups are an important constituency, should be supportive of RNG and other sustainable sources of energy.

• Importantly, the EPA considers (among other factors) projected increases in biofuel production (supply) in setting their volume targets. So even a significant supply response to capitalize on the rapid growth in RNG demand wouldn’t necessarily derail D-3 RIN prices.

• In addition to being broadly supportive of RNG, Biden likely doesn’t want to continue providing a windfall to corn growers. Beginning in 2023, the EPA could begin to reduce D-6 (ethanol) RIN volume targets in order to shift a greater portion of the RIN pool towards advance biofuels (including D-3 RINs). While the powerful influence of the ethanol lobby will likely mitigate this, at the margin policy should shift from favoring ethanol to RNG and other advanced biofuels during the Biden administration.

• Currently, the only method that RNG producers can take advantage of RINs under the Renewable Fuel Standard program is to deliver RNG for fuel in CNG or LNG vehicles. In 2014, the EPA authorized an "eRIN" pathway to allow RNG producers to generate RINs when RNG is used to produce electricity for electric vehicle (EVs) charging. To date, the EPA has not approved applications that would allow producers to begin generating eRINs, but the Biden administration could pursue this. This would massively expand the scope of demand for RNG.  

• LCFS Credit PRice

• Archaea’s base case projections assume a $140/ton LCFS credit price vs. $200/ton currently. As such, there’s already a ~30% decline in spot prices baked into management (and our) numbers.

• LCFS credit prices are capped at $200/ton (plus inflation). The price has been at the cap for most of the last two years, suggesting limited scope for incentivizing more alternative fuels as the standard tightens.

• “Demand” for LCFS credits is set by statute and will grow by ~2.5x between now and 2030. To date, credits have been generated primarily from the diesel pool, but the state is approaching the limit of what can be achieved with biodiesel. A UC Davis analysis found that even with a tripling in the miles driven by electric vehicles, achieving LCFS compliance while adhering to the $200/ton LCFS credit price cap would require between 60% and 80% of the diesel pool be produced from biomass by 2030.

• Many states outside of California are developing LCFS-like programs. Oregon has established a carbon pricing program which calls for a 20% reduction (using 2015 as the baseline) in carbon emissions from transportation fuels by 2030, which is expected to take effect beginning in 2022. Additionally, Washington state’s legislature has passed a law creating a similar program which would reduce the carbon intensity of transport fuel by 20% between 2023 and 2038. While this program cannot be enforced until the state passes a new transportation spending bill, this is also expected to pass. Several other states, including New York and Minnesota, are also seeing a significant push to pass similar legislation. This would provide additional outlets for Archaea to sell its RNG into.

• Long-Term Contract Price:

• Archaea assumes a $15.50/mmBTU price for long-term contracts.

• The $15.50/mmBTU that management is assuming is similar to what they’re earning on contracts already in place, so in the absence of a massive increase in the amount of RNG supply relative to demand, this number should be achievable.  

• As discussed above, RNG mandates already announced by several utilities and corporate customers account for 13%-28% of projected total 2030 RNG supply. Given the amount of demand already accounted for, the fact that much of the 2030 RNG supply will go towards satisfying demand related to environmental credits, and likely announcements of further such mandates by more entities over the next several years, it seems unlikely that there will be a significant deterioration in supply/demand fundamentals.

• We spoke with the Head of Public Policy at a Canadian gas utility, who confirmed that a $15.50/mmBTU contracted price should be defensible even as new supply comes online.

• In the event of a lack of sufficient demand from RNG mandates, the company could always shift its commercial strategy to monetize a greater portion of its volume through environmental credits. Current spot prices for RINs and LCFS credits would imply a ~$45/mmBTU realized price, roughly triple the targeted price for long-term contracts (though this would introduce more volatility to the model).

• Based on the below RNG cost curve, only ~500mm mmBTU of RNG can be produced at $15/mmBTU or less. On this basis, already-known demand from RNG mandates would account for half of this supply.

• Archaea’s base case doesn’t contemplate several significant upside options

• Spot Prices: If the company is able to sell RINs at current spot prices (rather than the significantly discounted prices that their base case assumes), it would generate an $100mm+ incremental of EBITDA by 2025E.

• Development of Additional Projects: Management’s base case forecast assumes limited development of “High Probability” RNG Development opportunities. 

• Archaea has already secured feedstock (gas rights) representing essentially all of its contemplated 2025 volume.

• The company is fully funded based on cash on hand expected operating cash flow

• SPAC formed by the Rice family, who have a very successful track record of investing in the energy space

• All existing investors (including Rice Investment Group, the Rice family’s investment vehicle) except for Ares are rolling over the entirety of their investment into NewCo. The Rice family also invested in the PIPE. The CFO also has a material investment.

Valuation

• Utilize management’s base case assumptions, which as articulated above we believe are achievable (if not conservative)

•  $15.50/mmBTU long-term contract price

•  $1.50/gallon D-3 RIN price

• $140/ton LCFS credit price

• 65% of volume sold under long-term fixed-price contracts; 35% monetized by selling environmental credits

• Under the company’s base case assumptions, stock would be worth $45/share using a ~15x EBITDA multiple.

• RNG, alternative energy, and ESG comps generally trade at much higher multiples

• Numerous upside options

• Assuming the company can sell RINs at current spot prices would generate $100mm of incremental EBITDA by 2025. At the same 15x multiple, this should translate into an additional ~$12 of equity value per share

•  eRIN pathway would significantly expand scope of demand for RNG

• Development of additional projects

• Company trades closer to aspirational comps based on ESG halo and rapid growth

Catalyst

• Execution on business plan
• Discovery post closing of merger. Two small sell-side firms have already launched coverage, but more could follow.
• ESG/index inflow