A Spotlight on Risk Basics

Most industry experts agree that protecting an ethanol producer's margins is at the heart of a risk management program. EPM looks at some fundamental concepts necessary to understand how producers manage their margins to remain profitable while processing commodities into liquid energy
By Ron Kotrba | October 26, 2006
Ethanol producers can face adversity while managing risk. Protecting the bottom line can be difficult in an industry where the single-biggest input is a futures-traded commodity, and outputs include a semi-futures traded energy and a cash-market feed. One also needs to keep a disciplined eye on the natural gas futures market.

Risk mitigation is a more appropriate term for the profession of managing risk, according to Julie Ward, assistant vice president of R.J. O'Brien & Associates' Commercial Ag & Energy Group. "It's a better way to begin to define risk management," she says. "You can't do away with all risks. Some risk is inherently unavoidable."

Although all financial risks can't be averted, a more consistent, predetermined profit margin can be preserved through sound policies and disciplined adherence to preset guidelines, even when rational or irrational "emotions" are stirred up by movements in the markets.

Ultimately, it's about knowing what can and can't be done with respect to costs paid for and prices gained from doing business in the ethanol production industry. Buying insurance is a good way to explain the fundamental justification for putting a risk management strategy in place. "People buy all types of insurance to prepare for the What ifs?' life so often throws our way," Ward explains. Just as people have assets to protect through insurance, ethanol producers have margins to shelter through risk mitigation. Not having some form of a risk management program in place is unthinkable, considering ethanol producers' bottom lines are so susceptible to the wavering of several volatile markets. Approaches to risk management differ in how the plan is developed, implemented and stuck to with discipline.

Tools and Language of Risk Management
Learning the basics of risk management is almost like learning a new language. The spoken and written words utilized in the field look familiar enough but have entirely different meanings when used outside the realm of brokers, traders and risk managers.
With terms like futures, options, calls and puts one needs to know the jargon used day-to-day, as specialists work toward protecting a plant's margins. Ethanol plant margins are maintained by knowing how much one's facility can pay for corn in relation to how much it can sell its ethanol for in order to remain within a preset profit margin. Locking in favorable energy costs and distillers grains prices is integral to this plan.

Therefore, it is the job of a plant's designated risk management team to keep watchful eyes on corn, ethanol and natural gas futures markets and corresponding cash markets to maintain desirable profit margins many months in advance.

Learning the language also means learning the framework in which these new words are used. According to Will Babler, risk manager with First Capitol Risk Management LLC, there are three classes of risk management tools. "There's the cash market, where you have forward-pricing activities (not to be confused with futures trading), which is directly tied to the physical product," Babler tells EPM. "Then there's the exchange-traded futures and options market. Then, depending on sophistication, balance sheets and operational history, there are the over-the-counter (OTC) derivatives." Many experts say as this industry becomes more sophisticated, OTC derivatives will likely become more utilized (see RISK on page 62-63 for more details).

According to Brenda Tucker, commodities group manager with the Chicago Board of Trade (CBOT), a single ethanol futures contract bought or sold on CBOT is an agreement to buy or sell a volume of 29,000 gallons (approximately one railcar) of ethanol for future delivery. A key concept to managing risk lies in the difference between a futures-market price and the cash-market price, referred to as the "basis." CBOT defines the basis as cash market price minus the futures market price. Ward says if ethanol is $1.70 per gallon on the futures board but an area in Iowa is selling in the cash market at $1.60 per gallon, then one who purchases ethanol in that specific Iowa market does so at 10 cents under basis ($1.60 $1.70 = -$0.10).

In an ideal world, futures contracts should be as close as possible to cash-market prices, Tucker says. She also tells EPM that while CBOT ethanol futures contracts can offer limited price discovery, the low volume of contracts traded to date don't offer market transparency. As with any emerging futures contract, it will take time for the volume of ethanol futures contracts traded on the CBOT exchange to increase, Tucker says.

Options allow for the opportunity to buy or sell futures at a specific price, Ward tells EPM. "You pay a premium to do that," she says. Ward also explains what "calls" and "puts" are and an easy way to remember which one does what. "A call is a four-letter word, and a put is a three-letter word," she says. "A call, the longer word of the two, is buying the option to go long with your futures, and a put is buying the option to go short (or sell)." An ethanol plant buying a call option on corn futures is protected from rising corn prices by having the option to stay locked in to its prearranged price.

Developing a Policy and Sticking to It
"As part of the overall business model, we advise our clients and prospective clients to include risk management as early as possible in their project development," Babler says. "We look at goals and objectives ahead of time, and provide the framework and staff to make decisions in a consistent manner."

Ward agrees that early development of a risk management policy is imperative. "First and foremost, an ethanol producer needs a [risk management] policy in place, and within that policy they need to set goals that answer questions like, What do we want to accomplish?' or What margins will make us profitable?'" she tells EPM. Much of this early focus should involve gathering the appropriate parties with an ethanol project's board of directors to answer such important questions.

This early approach to margin management allows for "a full understanding of the impact risk management has on financial requirements and financial results," Babler says. "It also guides the high-level financial and strategic management goals of the organization." Additionally, Babler says this early commitment to developing a risk management policy pulls equity investors and lenders into the planning, which helps because it lets those with the purse strings know how much working capital will be required as the project nears completion.

According to Peter Nessler, vice president of FCStone LLC's renewable fuels group, the amount of working capital necessary to ensure a plant's ability to maximize the pricing tools available through its risk management program is about 10 to 15 cents per gallon of production. For example, Nessler says a modern 50 MMgy dry-grind plant should hit start-up with dedicated working capital ranging from $5 million to $8 million. Including the needed operational capital up front when developing a policy will help a project manager adhere to that policy as the markets test emotions with low and high prices.

Operationally speaking, risk management is most closely linked to financial management, Babler says. "Commodity prices are the largest lever impacting financial performance," he says. "Actual day-to-day risk management practices also involve significant participation from the financial staff to make sure positions are accounted for and money is being moved around. Likewise, it is linked to daily activities, including grain merchandising, and ethanol and coproduct marketing."

Distillers-grains contracts can be purchased on the spot market or monthly, even up to 24 months out. Steve Markham, merchandiser with Commodity Specialists Co., says there's a lot of distillers grains available on the spot market, as well as up to 60 days out. "We're lucky if we handle up to 10 percent of an ethanol plant's revenue stream," Markham says, indicating that while 10 percent is important, producers shouldn't let this minority revenue stream distract from their core focus of producing ethanol at a margin-managed profit.

Babler says risk management strategies for distillers grains are focused in the cash market and with cash-forward contracts. Some experts have indicated CBOT is looking into the idea of futures contracts for distillers grains, but CBOT wouldn't confirm plans at press time.

The policy development is important because it establishes guidelines through which the implementation of a risk management strategy will come to fruition. "Producers can have their cake and eat it toofor a cost," Babler says.

According to him, this cost reflects opportunity cost, or the price one pays for limited participation in higher prices and premium costs. "By acting in a disciplined manner, it is possible to take advantage of attractive prices and attractive margins," Babler tells EPM. "Likewise, through a disciplined and consistent approach, it is possible to limit loss during periods of poor prices or poor margins and still participate in upside gains."

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