Buying into Risk Management

Should future producers commit to putting the same high-level focus and development effort toward commodity risk mitigation as they do with other elements of project development?
By Neill McKinstray | January 01, 2004
With throngs of project development groups vying for capital at the start of 2004, equity and debt participants simply aren't getting excited about average ethanol projects. Projects that aggressively structure and plan to be the best will move forward. The others will fade away or regroup.

Not surprisingly, I have yet to speak with a project development group that does not plan to pick the best site, utilize the latest technology, build a state-of-the-art facility and hire competent personnel to run it. Typically, development groups put considerable focus and professional effort into utilities, plant design and construction, technology, component quality, permitting, procurement, regulatory management, personnel selection and training, safety, market development and many, many other aspects.

Certainly, all of these things must be doneand done rightif lofty performance objectives are to be achieved. But when it comes to feedstock procurement and risk management, some projects seem to fall short.

I would submit that, once construction is completed, by default many groups are actually planning to operate their business on an "average" basis. How can this be? Is this consistent with financial success on a long-term basis?

It is commonly understood that primary feedstock costs comprise upwards of 70 percent of plant operating expenses. It also well understood that ethanol sales account for upwards of 80 percent of total operating revenue. Most people involved in this business understand also that corn and ethanol prices are highly volatile and not correlated. They are also commodities, implying that individual participants cannot impact the price of either. Thus on a long-term basis, the key to financial survivaland the hoped-for returnlies in the interplay and management of price risk associated with the feedstock and the primary product produced. In ethanol production, this is essentially the relationship between corn prices and ethanol prices.

I believe that most development groups generally understand these facts. I believe furthermore that most groups understand that these risks can be managed to a significant degree. Even so, many projects fail to structure to be the best in this area because they are not equipped to adequately address risk management. They fall short because they lack two, very crucial, and hard-to-acquire elements to help address this riskworking capital and execution capability.

In this context, working capital is the lifeblood of the ethanol enterprise. It is the cash, or equivalents, that allow the business to function on a day-to-day basis. Working capital is comprised of such things as cash equity, payables and short-term lines of credit.

Often, new ethanol enterprises generate barely enough equity investment and debt to build the physical plant, and purchase supplies, equipment and raw materials. Too often, they do not have adequate working capital to support a comprehensive risk management program. Lenders are often reluctant to provide additional credit for this activity because they're already stretched on financing the physical plant.

Beyond the working capital challenge, some plants struggle to understand the multiple types of risks they face, and the mechanisms for mitigating these risks. This is a complicated process. Simply tracking and evaluating risk is an every-day challenge. Execution involves having a means to know what to do, how much to do, what mechanism to use, when to do it, and with whom to do it, and more. Again, some projects simply have not prepared to do this in a "best of class" fashion.

Lacking the fundamental working capital and execution capability, prospective ethanol producers simply can't address the inherent volatility of the business, and manage the price risk and commodity arbitrage gameeven when they know they're in it.

Instead, they are relegated to dealing in spot markets. They assume more risk than their balance sheet can readily support, and essentially operate their business on an average basisor maybe worse.

In order to work around this dilemma, some plants "transfer" risk to producer stakeholders via indeterminate-price corn delivery requirements. Others seek to acquire working capital from (or shift financial risk itself to) suppliers, lenders, contractors or marketers. While this may work for a time, and to a degree, economic players are not prone to accepting risk without adequate compensation. If third-party participants are willing to accept this "risk transfer," my guess is that it is actually costing the ethanol plant more than its management team realizes. At the same time, they may be getting less effective risk mitigation as a result.

Let's say that the combination of corn price and ethanol value, along with other revenues and projected expenses result in a projected gross margin of 30 cents per gallon. This might be a very attractive margin to lock into, particularly for a start-up operation. Let's say further that the plant has the knowledge, opportunity and wherewithal to lock in the ethanol value and hedge the corn price. Ideally, all things being equal, a plant might want to lock in as much of this as possible. However, given the demands of "rational economic players," these risks may not be hedgeable without performance assurances in the form of marginswhich take working capital. Lacking adequate working capital, the plant simply can't do the right thing.

Despite the substantial challenge, there are ways to address the issues. However, projects must first commit to putting the same high-level focus and development effort toward adequately funding and executing commodity risk mitigation as they do with other elements of their project. They must commit to understanding the issues well enough to question and evaluate prospective third-party service providers, and understand the true costs of the service. They must commit capable people on an ongoing basis to oversee the day-to-day process, communicate with stakeholders, and literally guide the process. (In my opinion, no plant should ever "turn over" their risk management process entirely to a third party.)

Here are few of my "success keys." Good luck.

-A successful ethanol plant is as much about managing price risk as it is about producing ethanol.
-Profit is the No. 2 priority. No. 1 is to not sink the ship.
-Risk management is not so much a matter of corn or ethanol price, but a matter of corn and ethanol price.
-Working capital is the fuel for effective risk management.
-Risk management is not so much an issue of price prediction, as it is a matter of market awareness, tool selection and execution. EP

Neill McKinstray is director of ethanol services for The Andersons Inc.