An Overview of Ethanol and Energy Hedging

By Leslie Barbagallo | August 27, 2007
At first glance, William Shakespeare's tragedy "Hamlet" may not seem very applicable to today's energy environment. After all, the famed English poet and playwright wrote the play more than 300 years ago, well before the discovery of crude oil.

However, Amegy Bank Senior Vice President Steve Kennedy put the literary masterpiece to effective use at a June 13 event in Houston that brought together a variety of energy producers from traditional and biofuels markets. He opened his presentation in the voice of Hamlet, positing that some firms are making the choice "to be or not to be" when deciding whether to hedge their energy development project. Kennedy's talk, titled "To Hedge or Not to Hedge," provided a balanced view on that overall question.

Kennedy and FCStone Senior Commodities Risk Manager Jeff Carpenter focused on hedging in the ethanol and energy markets at the event hosted by Kiodex, a division of global financial software services company SunGard. Amegy Bank and FCStone use the Kiodex Risk Workbench for pricing, risk management and financial reporting of commodity derivatives offered to their customers. The event provided a networking platform for corporations with exposure to commodity prices, and the financial services companies that provide services to those corporations.

Kennedy and Carpenter helped attendees answer whether it's best to hedge or not to hedge in today's changing energy environment.

Reasons Not to Hedge
There are several reasons a producing firm might not hedge against the chance of a market downturn in prices. Given the competitive energy job market, firms may find it difficult to maintain financial derivatives personnel to staff a hedging desk. Firm management may also be opposed to leaving some potential upside on the table due to a hedging program. This is perhaps based on the experience of executing hedges and then watching the market rise in their favor. Assuming the capabilities and objectivity to hedge exist, a remaining reason not to hedge is that the worst conceivable forecasted prices in a firm's market would yield an acceptable profit per unit of production. Producers with more experience in hedging use Monte Carlo cash flow at risk analysis in making this determination.

Oil producers could conclude that crude oil prices will remain relatively high in the foreseeable future, given current pricing relative to history as well as current and forecasted supply and demand. On an inflation-adjusted basis, oil is cheap, Kennedy said. Bringing all prices to a January 2007 basis, December 1979 prices were over $100 per barrel, July 2006 prices averaged close to $66 per barrel and January 2007 prices averaged $46 per barrel. (At press time, prices had risen to more than $75 per barrel). In fairness, inflation adjusted prices were only over $60 for a couple of years, but current supply is tight, Kennedy noted.

The current daily call on the Organization of Petroleum Exporting Countries (OPEC) is 30 million of the 84 million barrels consumed globally, with much of OPEC's minimal 13 percent spare capacity at significant geopolitical risk. In addition, should the 2.35 billion people in India and China increase their oil consumption rate to that of Mexico (still only 25 percent of U.S. per capita consumption), the 84 million barrels of daily demand would skyrocket to 115 million barrels.

Reasons to Hedge
There are many reasons to hedge against adverse market conditions, including a corporate psychology that struggles with leaving the firm's health to the gods should forecasts go against expectation. This is particularly true in markets with great price uncertainty. For example, ethanol is a much younger market than oil, so historical analysis to assess current pricing levels is not available. In addition, ethanol supply and demand forecasts are a subject of great debate.

Carpenter has as much experience in ethanol markets as anyone, given FCStone's early entrance and strong presence as a broker in ethanol markets, and his long history in corn markets at Archer Daniels Midland Co. and elsewhere. With excellent data on planned production and intimate knowledge of trades related to 30 percent of U.S. ethanol production, Carpenter said it was challenging to answer the question of whether expected ethanol production will exceed expected demand. In terms of demand, there are political considerations—will President George W. Bush's objectives for ethanol through 2017 become a reality? In terms of supply, meeting the Bush objectives would require new sources of ethanol, or devotion of nearly all U.S. corn production to ethanol.

It is uncertain whether the large amount of planned production, which is four times current production levels, can be brought on line. When the leading broker in a market is uncertain, that is a good time to hedge that market. In addition, while a year ago the convergence of historical low corn and high ethanol prices raised interest in ethanol to a boil, current corn and ethanol prices are trending against the producer, providing further motivation to hedge. It would be difficult for an ethanol producer to firmly conclude that future market prices would keep them out of the red.

There are also financial situations where the question "Is a hedging program going to erode my potential upside in rising markets?" becomes "Will hedging allow me to change the game in terms of the size of the investments and acquisitions I can make, exponentially increasing potential upside?" Where a company sees multiple or large opportunities for investment in producing properties, hedging can support the raising of larger amounts of equity at a lower cost of capital.

Why is this so? Kennedy provided an example from the oil markets. When a producer is providing oilfields as collateral, the bank will use pricing data which can be well below current pricing, resulting in a lower approved loan amount. However, if the producer puts a hedge on for some portion of production, the bank will then use that locked-in, higher price in valuing the asset, and will be able to provide a larger loan. The producer can then take on higher debt levels, acquire or develop more producing property and maximize return on equity.

With Whom to Hedge
If one decides to hedge, what are the options for liquidity? The main categories are trading on an exchange, such as the Chicago Board of Trade (CBOT) or the New York Mercantile Exchange, or trading with a counterparty off-exchange in an over-the-counter (OTC) trade. With one banker and one broker speaking, the June 13 event provided an interesting comparison for producers considering counterparty options.

At times, trading on an exchange can offer the best overall price per unit, but it limits the possible structures of the hedge. Also, each exchange requires daily payments, known as margining, to cover any increase in the value of a firm's trades. OTC markets offer more flexibility and can offer competitive pricing where there are significant large players. However, some brokers may still require daily margining.

Regional banks are likely to offer derivatives tied to bank lending with no margining, in addition to providing better terms and larger loans when hedges are associated with the loan. However, banks may offer fewer products than can be found in the full OTC marketplace. For example, Amegy Bank provides customers with better energy lending packages when combined with derivatives hedges, but does not yet cover ethanol markets. As a broker, FCStone does not have project finance capabilities, but does cover a wide array of ethanol trades.

With What to Hedge
If one decides to hedge, the available liquid markets may not meet the hedging objectives. Kennedy noted that several years ago, one could not easily trade very far out in gas and oil markets, which created a challenge to effectively hedging production. However, gas and oil producers can now hedge further out, create more long-term protection and take on more leverage. By contrast, Carpenter said that ethanol markets only trade out through the end of 2008, and it is difficult to find someone to take a position for 2009.

While there are limitations given the relative youth of the ethanol markets, it was interesting to hear Carpenter's perspective on the array of products that are available. Ethanol producers are naturally long, or sensitive to downturns, in ethanol and related products, and naturally short the corn and energy used to produce these products. The spread between ethanol outputs and inputs is referred to as the crush margin.

For producers working with FCStone, the most popular trade is an OTC swap indexed to CBOT ethanol. The trade has the benefits of avoiding margining on the exchange while enjoying price transparency combined with a high correlation with the physical market on the exchange. There are also a growing number of locational swaps that can be used to provide a more precise hedge to a given producer's region (e.g., the Gulf of Mexico, California or New York). Carpenter said these locational financial markets continue to show arbitrage opportunities, as the difference with CBOT pricing is often well above or below the cost of freight. While arbitrage opportunities can be seen to some extent in all markets, this occurs with more frequency and voracity in ethanol markets. However, Carpenter further noted that the ethanol markets are much more efficient than a year ago, with additional new entrants from producers as well as financial firms.

Carpenter noted the availability of European, Asian and, to a lesser degree, American options for ethanol. CBOT markets include a unique OTC European option that can be physically settled into the underlying physical CBOT future through a mechanism known as "exchange for risk" or EFR. CBOT transacted 300,000 EFR contracts last year, and FCStone sees this as one example of a continuing trend for exchange-traded and OTC markets to converge. Hopefully, this convergence will continue to improve the efficiency of ethanol markets, providing more choices and promoting financial stability for ethanol producers and their partners.

Leslie Barbagallo is a senior vice president at SunGard's Kiodex. The Kiodex Risk Workbench is the pricing, risk and reporting engine underlying the derivatives services at Amegy and FCStone. For more information on Kiodex, visit Reach Barbagallo at [email protected].

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