Producers should consider risk management

Integrated risk management program can be put in place to help a manufacturer achieve enhanced profit margins.
By Jason Sagebiel & Peter Nessler FCStone | April 01, 2002
What is Risk Management? Risk is defined as "a possibility of loss or injury." Businesses are subject to many forms of risk and the risks associated with any business need to be identified. For ethanol producers, risk from commodities can be a major influence to the profitability of this industry.

Risk exposure for Ethanol Plants entails corn (or other grains), natural gas, ethanol, DDGS/DWG and the cost of money just to name a few. How do you determine the price you pay for your input? For your output? Hedging can be a valuable risk-management tool if used at the right time. Hedging is simply used to lock in a certain price or basis level. Hedging can mitigate price swings of inputs (both nearby and future delivery ownership); allows for the opportunity to budget cost; and helps a producer stay competitive. One can hedge input cost by utilizing futures, future options and/or OTC (Over the Counters).

To understand exactly what risk exposure an ethanol plant may be involved with, take into consideration 40 million gallons of production produced annually. This typical plant would utilize one bushel of corn to produce 2.7 gallons of ethanol; equating to 15 million bushels of corn. In addition, 40,000 Btu (British thermal unit) of natural gas is needed to produce the same gallon. These two inputs have a major influence on the cost of the gallon produced. However, the gallon is marketed without the recognition of the input cost. Therefore a 10-cent price move in corn equates to 3.7 cents per gallon of ethanol and a $1 move in natural gas may equate to a 4 cents per-gallon of ethanol.

Now, consider the other side of the equation. Above was just the input side, what about the output side? Co-products can be just as vital to a risk management program. The same typical plant would roughly produce 140,000 tons of DDG. In this instance, a $10 dollar per ton move would equate to a 3 cent move per gallon in ethanol. If a sound Risk Management program is initiated, these price changes can minimize input cost and maximize output revenues.

To even better understand price volatility and price risk, take a look at Figure I. This is a monthly natural gas futures price chart. The graphic indicates how natural gas climbed from just over $2.10 Btu in early January 2000 to $10.10 Btu in December of 2000. If an ethanol plant's natural gas was not protected early in the year, this price difference would equate to a $0.32 margin deficit. Figure II illustrates how corn prices can affect ethanol margins. Corn prices in January 1996 were pegged at $3.47 a bushel. Corn prices climbed to reach a high in 1996 at $5.54 per bushel. If the ethanol plant had not hedged its corn consumption during this period, this would have equated to a $0.765 margin deficit. These illustrations reflect how implementing a risk management program ahead of an unexpected rise in prices can protect you in the market place.

By staying open on inputs and outputs, the market is dictating your pricing. These types of risk management decisions are more volatile throughout the year. Factors such as supply and demand in both the domestic and global markets could impact price scenarios. In addition, weather situations, government programs, and economic trends can affect supply and demand of all inputs and outputs. A dry growing season can affect corn supply, a cold winter can alter natural gas consumption or a worrisome economy can reduce ethanol use. This style of risk management leaves you open to all factors and is often referred to as spot market pricing.

Futures market
A futures market is a market mechanism that essentially claims the future price of a specific commodity at today's market conditions. Futures exchanges exist because they provide two vital economic functions for the marketplace: Risk Transfer and Price Discovery. This form of market allows you to lock in a fixed price of a product in advance for future consumption or future delivery. A futures contract represents a standard quality and size for a specific commodity. An ethanol producer can lock in a desired price for inputs and outputs, therefore, allowing the business to budget accordingly.

Options are another tool used to help mitigate price fluctuations. Options offer an attractive alternative to the futures market. Options are conducted in the manner a futures market is by allowing you to forward contract. However, unlike hedging using futures, buying options do not involve a price commitment unless you so decide. Basically, an option is a choice for a premium fee.

What is an OTC?

An OTC (also known as a swap) is a tool that can be fashioned for your business needs. OTCs are non-exchanged traded contracts, customized and tailored to meet the needs of the client, that settles financially. This is a risk management instrument enabling commodities that may not be traded within the futures market to have a risk management approach.

Production of ethanol involves many input factors that can influence the overall margin in ethanol production. An Integrated Risk Management Program can be put in place to aid a manufacturer to achieve enhanced profit margins. n