If the relationship between natural gas and ethanol prices is strong enough, one can assert that there is natural hedge. The practical meaning when a natural hedge condition exists is that no forward pricing for either commodity is required to cover price risk or price exposure. The increase or decrease in natural gas costs are offset by increases or decreases in ethanol revenues. Therefore, forward pricing of one commodity without the other actually increases margin volatility.
The chart shows weekly ethanol and natural prices over the past year. Clearly, natural gas and ethanol price movements are strongly related over this period. In order to assess the strength of the relationship, we developed a linear regression model specifying ethanol prices as the dependent variable and natural gas as the independent variable. We specified the model in this manner since ethanol prices are more likely influenced by the fossil hydrocarbon complex, which includes natural gas, than ethanol prices driving the fossil hydrocarbon complex.
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The analysis shows that more than 80 percent of changes in the ethanol prices can be explained by the change in natural gas prices. More than 70 percent of changes in ethanol prices can be explained by the change in natural gas prices over the past two years.
If this statistical relationship holds in the future, it may be prudent to only hedge significant natural gas volumes for deferred months when and if forward ethanol prices are also set. To do otherwise jeopardizes the value of the natural hedge between natural gas and ethanol prices.
Casey Whelan, vice president of strategic initiatives, can be contacted at cwhelan@usenergyservices.com.
