Straight Through the Curves

Producers can slide through ethanol price dips and rising corn costs by implementing sound risk management plans that hedge forward and keep profit margins steady.
By Ron Kotrba | October 26, 2006
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Ethanol producers who locked in forward margins in early 2006—when ethanol was trading north of $3 a gallon and corn was hovering just above $2 a bushel—might not be concerned about this year's third- and fourth-quarter pricing squeeze. Those who didn't hedge forward, however, are probably less comfy right now.

Low-cost corn and high ethanol prices together stimulate what some risk experts say is inherent to human nature—avarice and emotion, rational or otherwise. While trusting these instincts can produce fortuitous results in the short-term, abiding by them for too long—or too often—can be financially ruinous. Risk managers don't care why humans do what they do—that's a psychologist's job—but rather how to override this apparent disposition in favor of a well-thought-out, targeted and profitable operating plan for the company. Nevertheless, a producer with a sound risk management strategy and experienced people focusing on the day-to-day fulfillment of that plan, plus forethought and financial wherewithal, can benefit from more timely opportunities in the market while having protections in place to ensure meeting predetermined profit margins.

Not so long ago, the collective identity of those in the ethanol industry was rather homogenous—they were farmers—but that sameness is all but gone. Now, high-dollar investors like Sun Microsystems founder Vinod Khosla and Microsoft founder Bill Gates are being associated with this historically agricultural industry. This exemplifies how the ethanol industry is metamorphosing into an industry that, on one hand, includes farmer-investors with innate knowledge of the commodities business and, on the otherhand, is permeated by high-dollar investor groups with significant capital but perhaps no real experience with volatile commodities markets. As one expert tells EPM, "Many of these big company players don't understand commodities. … They think they know corn, but wait ‘til a drought hits." However, money can buy the services to manage forward margins, and that's where those in the profession of risk management are a valuable commodity in their own right.

While the U.S. ethanol industry is adjusting to its own compositional change, those to the north in Canada, to the south in Latin America and elsewhere in the world are either developing industries of their own or participating in the maturation of their existing production and distribution infrastructures. "The global nature of the market further drives the need for disciplined risk management strategies," says Will Babler, risk manager with First Capitol Risk Management LLC, a company specializing in commodities risk management for producers of renewable fuels. "On a free-market basis, we have seen the impact of Brazilian and other imports during the ethanol peak earlier this year. Global price arbitrage can quickly close opportunities—like when Brazilian cargoes hit New York Harbor with ethanol at its peak. Fortunately, these opportunities, although fleeting, can be managed with risk management tools and strategies." Babler goes on to say the advantages of the cost of production, globally, could make risk management even more critical under potential breakdowns of existing importing or exporting "regulatory regimes."

Peter Nessler, vice president of FCStone LLC's Renewable Fuels Group, says the reason ethanol producers need risk management is because the business environment they are in is a commodity-driven business. The cost of corn represents anywhere from 75 percent to 85 percent of the input costs, Nessler says, "with the balance being natural gas." By today's valuation of a plant's ethanol output, however, the liquid fuel being produced from all of that corn represents upward of 85 percent of the producer's revenue, with distillers grains making up the balance—and, in some cases, carbon dioxide contributing to that remainder.

"To me, the best definition of [risk management] is margin management," Nessler says. "This, in our viewpoint, is the profitability of the clients we represent. Mitigation of risk lets customers budget appropriately for forward quarters of their operations and have an idea of future profitability. When they have this knowledge, it allows them to look at other issues that are involved in day-to-day operations, and it lets them expand operations or add needed infrastructure." Conversely, those without a regimented plan to mitigate risk may have to sacrifice focus—capital or otherwise—away from such growth plans to remain above water.

Eyeing Ethanol Futures Through Murky Lenses
Nessler says the New York Mercantile Exchange's (NYMEX) reformulated blendstock for oxygenate blending (RBOB) gas futures contract prices and cash-ethanol prices generally move together, with ethanol prices normally bringing 40 cents to 42 cents per gallon more than gasoline on an average delivered basis, he says. "We've seen them move as much as $1 over and 45 cents under," he says.

Babler says ethanol prices "in an equilibrium world would trade at a stable spread to gasoline that would embed energy content, subsidies, taxes and other factors." However, in practice ethanol prices are subject to the same constantly changing dynamics in addition to local supply, demand and logistical issues, he says. Babler's case-in-point is the gas/ethanol trend deviation experienced early last year.

In February 2005, ethanol and gasoline prices deviated from this "normal" relationship. Julie Ward, assistant vice president of Commercial Ag & Energy at R.J. O'Brien & Associates, tells EPM she doesn't recall the last time before February 2005 that ethanol prices didn't parallel gasoline prices. "That was the first time ethanol dipped below gas prices in a long time," she says, noting that several market conditions prompted the dip. Later in the year, ethanol prices rallied nationally, and Ward says excess supply and weak demand—part of which was attributed to a temporary suspension of the metro-Atlanta area's federally required use of ethanol—drove the price of ethanol down hard.

Various factors contribute to market swings, and upward adjustments are caused just as abruptly as downward ones. As such, ethanol prices soared to record highs in the months that followed, as many states continued phasing out the use of MTBE, and the 7.5 billion-gallon floor of the renewable fuels standard (RFS) caused the market to tighten. With record-high ethanol prices being reported for several months in a row, interest from Wall Street investor groups and other big-dollar players contributed to the changing face of the industry like never before.

Now, with downward-trending ethanol prices, CBOT corn futures steadily ticking upward and somewhat manageable but still-volatile natural gas prices, it appears that margin management is as important as ever in this field. "That's why having a sound risk management policy in place is worth its weight in gold," Nessler tells EPM. "This is—and will always be—a commodity-driven market. Commodity prices ebb and flow, and when forward margins can be locked in, we must as an industry utilize the opportunity and the structures available to us to lock in some of those margins. What is happening today, in my opinion, reinforces having a solid risk management program."

While the commodity of corn comprises up to 85 percent of the input costs needed to make ethanol, prices for the producers' outbound product aren't so easily determined. "In any commodity business, and particularly in ethanol where input prices are disconnected from output prices, risk management always emerges as important," Babler says. This disconnect between inputs and outputs has given way to some saying ethanol's trading identity is in crisis. "Take the ethanol contracts on the (Chicago) Board of Trade [CBOT]," Ward says. "Do they trade like an energy contract or a grain contract? It is tracked more like an energy contract, [but] the jury is still out on that question."

In establishing its ethanol futures contract, CBOT claimed the U.S. ethanol market would become more transparent. If it worked as intended, they said, ethanol prices would be accessible at any given time in any given area of the country. Unfortunately, due to the low volume of contracts, this hasn't happened quite yet. "It's difficult for new contracts to take hold," says Brenda Tucker, commodities group manager with CBOT. "We're being patient though. These things don't get established immediately. I'm positive the contract will succeed, but companies right now are focused on development. We knew we'd be early with our contract." She tells EPM that the slow going start the contracts are experiencing isn't uncommon for new contracts. The last successful futures contract established, to her recollection, was oats futures back in the 1970s.

Ward says CBOT's open-interest ethanol futures contracts only number 500, while Tucker says it's more like 1,000, neither one of which (when multiplied by 29,000 gallons each) adds up to any appreciable volume to offer market transparency yet. "The ethanol market isn't transparent, [and] there's no ability to identify the value of the commodity at any point," Ward says. "There are companies like OPIS and others that report on rack prices, but rack prices are area-specific … not the value that the plant is seeing."
Part of the reason more volume isn't being traded in futures contracts is that some of the very large producers in the United States don't want market transparency because it would eat into their profit margins, experts say. For them, it is better that no one "knows" what ethanol is worth.

Those currently involved in futures contracts consist of two main "natural" players, Tucker tells EPM. "These are producers, who are always in a short position (needing to sell) and the blenders who take a long position (needing to buy)," she says. "Those aren't the only participants, but they represent a majority. Then there is interest from the speculative industry," which she says includes those working for hedge funds or commercial trade advisors. Therefore, while the ethanol market is far from transparent, optimists like Babler say CBOT futures contracts are making improvements toward that goal. "A vast majority of risk management in the ethanol industry is still focused in the cash market," Babler says. "CBOT reflects what is going on in the cash market [and vice versa]. The futures market converges to the cash market, and it's a window into where the cash market is … but a lot of the futures contracts still go to delivery," which isn't the norm in futures trading, he says.

Corn, Natural Gas and DDGS
"Every 10-cent-per-bushel move in corn equates to roughly 3.5 cents per gallon of ethanol margin," Nessler says. "And every $1 per MMBtu in natural gas equates to roughly 3.5 cents per gallon of ethanol margin." While all the hype surrounding potentially rising corn prices isn't all pure speculation—CBOT corn futures two years out are trading well above $3 per bushel—the transparency of the corn market greatly assists in managing input costs for U.S. ethanol producers. "Far and away, the corn market is the most transparent with [CBOT] as the pricing platform," Nessler says.

According to Ward, there are two components to buying corn: the flat price and the basis price. "By buying futures, you reduce the risk on flat pricing," she tells EPM. A flat price risk is taking a long or short position that doesn't involve a spread, which is the difference between a bid and an offer. "An ethanol plant has corn coming in at a flat price and ethanol going out at another price" Ward says. "An ethanol plant needs to care about the basis but needs to be cognizant of the flat price risk." Ward adds that while the basis is important, a move in the futures market is a bigger risk.

What some experts have called the "Corn Belt Model" of buying corn every day and selling ethanol the same way may eventually cease to work as more giant dry mills coming on line effectively eat away at surpluses, tightening the corn markets regionally and nationally. The importance of securing future prices and the delivery of corn will become even more evident. "Risk management has always been important, but it [will] become even more important as the volatility is heightened in a tightening corn market and [a] more volatile and potentially overextended energy market," Babler says. "Further, as more competition enters the business, it will become a larger factor in separating the winners from the losers."

Ward says natural gas costs are as low now (nearing press time) as they have been in the past year, which bodes at least temporary good news for ethanol producers. "What if someone bought [natural gas futures] last spring, paying $7 per MMBtu, and now prices drop to $4.50 per MMBtu?" Ward asks. "At the time they bought the [natural] gas they could have also bought a ‘put,'" she says, which is an option to sell futures early once prices drop to a specified level. "They could have bought a put spread, which limits how far down [in price] we could go." Due to the limits of a put spread, it's a cheaper option than a put. Ward says this is one tool to help protect margins in a volatile natural-gas market, but this happens more in the corn market than in its natural gas counterpart.

Distillers grains doesn't have an established futures contract yet. Sources say CBOT has been considering distillers grains contract development, but CBOT isn't confirming it. All distillers grains is moved in the cash market. "There is no commodity exchange for [distillers grains], but pricing should have some correlation to the underlying price of corn and the proteins that it competes against in the feed sector," Nessler tells EPM. Distillers grains cash contracts can be spot, monthly or up to 24 months out, says Steve Markham, senior merchandiser with Commodity Specialists Co. Markham tells EPM he has seen ethanol producers spend undue amounts of time on issues related to managing margins with distillers grains. "We're lucky if we're handling 10 percent of an ethanol's revenue stream," he says. Ethanol-producing companies' financial staff and risk managers working with these producers need to look at ethanol because "it's 90 percent of the plant's revenue stream," he says. "Most producers look at ethanol prices, corn and then [distillers grains], and that's how it should be."

As a physical commodity, distillers grains exports to Asia are up today. Nessler says it's mostly because of back-haul meaning the containers were delivered to the United States with products in them, and they need to be returned when emptied to send back more products. Asian importers can take advantage of the cheap freight costs. "It's a good value," he says.

Babler says risk management strategies for distillers grains are not unlike those for other products. "Proactively managing distillers [grains] prices will become of greater importance as the amount of the product on the market continues to increase," he says, which speaks volumes about the overall importance of risk management in coming times.

Looking Forward
Nearing press time, Nessler says ethanol may trade down to $1.50 per gallon over the next six months. He stresses how gas prices have dropped 60 cents per gallon, how the corn markets have rallied quite a bit and how producers need to lock in protection from higher-priced corn.

Shifts in the ethanol industry affect the providers of risk management and financial services who are working with ethanol producers. "Several things are changing," Ward says. "There's consolidation of risk management for some of the marketing groups. One management team may be offering themselves to multiple plants." These plants are getting bigger, too.
Whether a plant is big or small, Nessler says a sound risk management plan is essential. "The only difference is the total dollars at stake," he tells EPM. "It's the same on a gallon-per-gallon basis."

Most experts agree that risk planning with necessary financial staff, directors, and analysts or consultants should begin as early as possible during project development. This includes determining what margins a company needs to remain within to make a profit later in an increasingly competitive global market. Planning should include input from commodities-savvy members of agriculture and those from the world of lending or finance.

Jeff Kistner, vice president of finance for BBI Project Development, highlights what could happen when too much representational weight is put on either side. "The difference between a farmer board and the newer, larger corporate-owned boards is that farmers look at risk from the perspective of selling grain, not from the perspective of buying it," he says.

In tandem with a maturing industry, project development outside of the Corn Belt is occurring more frequently than ever. "Eastern Corn Belt corn is higher priced than western Corn Belt corn, so more working capital is needed in the East," Kistner says. "But transportation costs are more if you're pulling corn from the western Corn Belt to the East." Ultimately, he says each plant needs to figure out what the cost of doing business is from its location and work from there.

Experts suggest having an adequate amount of working capital on hand in order to be in the financial position to execute sound risk management practices that protect margins as input costs rise and output prices dip, and offer flexibilities to take advantage of those favorable but fleeting market conditions. "Knowing the capacity of your working capital is absolutely essential in a sound risk management program," explains Nessler, who says a 50 MMgy dry-mill ethanol plant would need $6 million to $8 million on hand at start-up to implement an economically sound strategy of risk management looking forward.

Babler says there are three broad classes of tools that risk managers use to control margins: the cash market, the exchange-traded futures and options market, and over-the-counter (OTC) derivatives. Cash markets, in which most ethanol and all distillers grains pricings occur, involves spot and forward-pricing activities that are directly tied to the physical products. Nessler says cash market prices are established through the gathering of data—specific cash prices paid at a given time in a particular location—to establish a reference price. "Normally, cash contracts don't go past one year in duration," he says. "In the futures market, we have executed contracts that have been two-plus years in duration. [A futures price] looks at the underlying fundamentals to establish a price at that given point in time. This price is established by supply and demand, and market participants' expectations of prices in the short and long term."

According to Tucker, the CBOT ethanol futures contract will benefit accordingly from the ongoing, increased focus on the distribution infrastructure for ethanol. "More storage coming on line helps the success of the contract," she says. Although ethanol futures contracts aren't traded in significant volume yet on the board, most experts believe this will improve. Babler says the contracts present opportunities in terms of price discovery, transparency and hedge effectiveness.

"Likewise, the OTC market for ethanol swaps and options has grown considerably," Babler tells EPM. "For those with adequate balance sheets and sophistication, these tools can certainly complement the cash contracts available in the ethanol market. OTC hedging tools allow producers to lock in fixed prices, minimum prices or a range of prices for their ethanol within a financial, settled hedge position."

OTCs include the trading of commodities like corn or ethanol outside of an exchange or clearing house. OTCs are riskier but, like any financial investment, big risks can bring big rewards. One of the benefits to utilizing OTCs as opposed to options is that OTCs can be bought or sold by the penny, whereas options may only allow puts or calls in 10-cent increments. This allows the ethanol producer more flexibility. "All of our clients utilize OTCs from day one," Nessler says. "We follow the ethanol market every day. We utilize every market we can to maximize revenues for the client. This gives us great latitude in making forward crush margins." The word "crush" is borrowed from the soybean crushing industry, where soybean crush volume is driven by the demand for meal in the livestock industry. An ethanol plant's revenue from ethanol and distillers grains, minus its corn and natural gas costs past spot or current cash value, is a plant's forward margin.

"We constantly look at forward curves," Nessler says. "We utilize the over-the-counter market to do financial hedging against the CBOT ethanol market for 2007 at much higher values than they are presently, yet still giving them the cash outlet for their product through the marketer." Nessler says FCStone's decision on which structure to use for a particular client—cash, futures and options, or OTC products—boils down to one ultimate goal, which focuses on how such a decision affects the bottom-line margin that FCStone is crushing for. According to Markham, the marketplace's rising level of sophistication supports that mentality. "There's less of the cowboy mentality now," he says. "It used to be that producers would make their ethanol and [distillers grains], and sell them wherever. Now it's becoming more of a business mentality. Producers today care what their margin is."

Ron Kotrba is an Ethanol Producer Magazine staff writer. Reach him at or (701) 746-8385.