Managing Ethanol Risk

By Jerry Gulke | March 05, 2009
The rise and subsequent demise of some in the ethanol business created an interesting ride. Bankruptcies were blamed on price volatility of corn and the demise of the energy markets. However, the apparent lack of price risk management and the adherence to sound management practices are likely the real culprits.

Had it not been for the price volatility of crude oil and its byproducts there would not have been the profitable opportunities witnessed in the ethanol industry. For many years, market analysts thought a 2 billion-bushel carryover of corn was a huge supply. However, as many sadly found out, we live and trade in the future. No longer can we assume that what worked in the past (seasonal tendencies, carryover stocks) are precursors of things to come. The market was looking ahead two years ago to what might happen if demand continued to outstrip supply of energy, foodstuffs and the resources used to produce them. Higher prices were a given, however the ethanol industry failed to consider that the world changed.

Economics 101 dictated that the rapid rate of corn use, Asian countries' appetite for calories and limited resources to respond quickly meant prices had to eventually reach a level to discourage demand.

There was ample time for limited risk coverages of the price of corn for use in ethanol production as recently as late 2007 at the early fall harvest lows of $3.20 per bushel and the breakaway price gap at $4.20. Corn prices rallied with crude as market participants realized the obvious. Price rationing was a given at some point. Farmers responded with more acres of corn, and fewer of soybeans.

Buyers were like deer in the headlights refusing to believe. Media soon suggested that corn could go to $10 per bushel if crude went to $150 per barrel. The $200 price forced buyers of corn to finally capitulate and cover costs at what turned out to be levels that the economy could not support.

What Could Have Been Done
Education in the process of a well-capitalized risk management program is a must whether it be in a corn producer's ability to hedge off risk by selling futures or buying put options, or the end user buying futures and/or call options while keeping in mind that they are in the business of making money for themselves and stockholders. Throughout the two-year bull/bust cycle there were opportunities for the end user to lock in inputs and hedge off production risk for multiple years, ensuring the viability of their business. Strangely, with the cooperation of the speculator, there was sufficient liquidity for both to have locked-in long enough to realize profits that could have been used to retire borrowed capital, rather than expand it into no-man's land. However, lack of adequate capital and the understanding of simple math, supply and demand, and our free-market global environment helped create the demise of what promised to be one of the best of times for agriculture.

As a student of risk management, it appears to me that energy is cheap again. However, producers may not get the chance to have missed selling $6 or $7 corn, nor may the producer of crude or ethanol be given the chance to hedge $120 crude, $2.50 ethanol, or $4 wholesale gasoline anytime soon. We saw in a mere six months what happens to a globally dependent economy with $6 corn or $4.50 gasoline. Risk management and return to investment have become a necessity.

Jerry Gulke is president of Strategic Marketing Services Inc. Kennedy and Coe LLC and SMS partner to deliver value to agricultural-based clients and ethanol plants. Reach Gulke at or (312) 896-2080.