Market Tools Help Identify, Manage Margins

Volatility, a function of fluctuating prices for corn and natural gas inputs, is changing revenue values for ethanol, DDGS and corn oil.
By Chip Whalen | May 20, 2015

Managing ethanol plant margins is a challenging endeavor as the factors affecting input costs and revenues are constantly changing and often pulling in different directions to the detriment of the plant’s profitability. Ethanol margin management is the process of analyzing financial risk and considering costs and revenues as a single unit of risk. This differs from a more traditional approach which focuses on minimizing plant expenses and maximizing revenue from ethanol and co-product sales independently of one another. Fortunately, there are tools available in the market to help identify and manage these margins. 

A margin management process involves modeling forward curve projected costs and revenues using the futures market as a price discovery mechanism. The daily interaction of a large pool of buyers and sellers in the futures market determines a forward curve of value for a host of commodities, including those impacting ethanol margins. Holding certain fixed cost assumptions static and using futures market prices to represent both input costs and revenue values together, forward profit margin opportunities can be identified in deferred time periods to indicate how that profitability is projected to change from one period to the next. 

This gives greater visibility to an ethanol producer on how the market, as an unbiased estimate of price, is valuing both input costs and revenue. It may be the case, for example, that current costs and revenues to the plant are generating a loss, while at the same time, forward values for those same costs and revenues are projecting a profit in a deferred time period. And, what was once projected to be a profitable marketing period for the plant may eventually be turned into a loss as the fundamental dynamics of the market shifts over time to the detriment of margins. The accompanying February margin graph displays such an occurrence for a model ethanol plant earlier this year. Profit margins in January and February were breakeven at best and negative for many plants as a function of slumping ethanol prices while corn costs held relatively steady. While the chart shows this negative profitability during that period, you will notice that the market was projecting a positive margin as high as 35 cents per gallon for the month of February during the fall of 2014. In fact, the market was projecting margins above the 90th percentile of the previous five years through November before profitability started to slip. 

Risk can be managed through the futures market when an ethanol plant contracts both input costs and revenue values simultaneously using exchange-traded derivatives to lock-in or protect a profit margin level in a forward time period. For example, an ethanol company projecting a positive margin last fall of around 25 cents per gallon for the winter time period of January and February could have locked that margin in by buying a corn futures contract and simultaneously selling an ethanol Platts swap. Alternatively, it may have used an option to protect a minimum margin while allowing the opportunity for improvement. 

Choosing a strategy will depend on how relatively strong or weak the opportunity is perceived to be. If, for example, the profit margin being projected is very strong historically and represents a good return, the company may be inclined to simply lock it in. If instead the profit margin is projected to be weaker or more average from a historical perspective, the ethanol producer might want to preserve the opportunity for improvement and incorporate more flexibility. The accompanying table of June 2015 statistics shows the ethanol margin and the underlying input costs of corn and natural gas against the revenue value of ethanol.

The red box in the table outlines each of the components of the June 2015 margin, along with the open market margin itself. Holding other fixed cost assumptions constant and factoring for local cash basis and ethanol index to the plant, the model is essentially looking at the variable costs of corn and natural gas against the value of ethanol to project a margin during the month of June. The ethanol price index and corn basis represent the difference between the local cash price and the swap or futures price that is being used to manage the risk of that price changing over time. Because cash prices and futures prices do not move in lockstep with one another, there is also a risk of a fluctuating basis or index over time.

The projected margin of 22 cents per gallon currently exists at about the 38th percentile of historical profitability when looking back over the previous five years of June margins. The strongest the margin has ever been over the past five years in the month of June was 71 cents per gallon, and the weakest value observed was breakeven. Scanning to the left of the margin column, you can see the individual components starting with the ethanol price at $1.57 per gallon. This value is at the 5th percentile of the previous five years, meaning that 5 percent of the time the June ethanol price has been lower than $1.57, and 95 percent of the time the price has been higher than this level. Moving further to the left, you will notice the input costs for natural gas at $2.74 per million Btu and corn at $3.86 per bushel. These currently exist at about the 6th percentile of historical prices over the past five years for their respective contracts.

In thinking about contracting alternatives, let’s assume that this particular ethanol plant is concerned about summer margins and believes that the 22 cents per gallon projected margin is worth protecting. Because it is only at the 38th percentile however, the plant would like to incorporate flexibility for this margin opportunity to hopefully improve over time. Considering the price levels for each component of the margin, the plant’s risk managers may deem corn and natural gas prices to be historically cheap and therefore wish to simply lock in these values. They may even choose to do this through the cash market with a local intermediary, whereby these costs are fixed and secured, including basis. Moving on to the ethanol piece, because that is also historically cheap, they may want to include flexibility here. Perhaps one contracting possibility might be to place a floor under the value of the ethanol to establish a minimum margin with their input costs now fixed. Another alternative might be to establish this floor under the current ethanol price while also incorporating a ceiling or maximum price above the market. 

This form of contracting involves two types of futures options. A call option provides the right to purchase a commodity at a fixed price level while a put option provides the right to sell. In exchange for this right, the buyer of the option pays a premium which fluctuates on a daily basis as a function of where the underlying futures price is trading relative to the fixed price at which the right to buy or sell that contract exists. The seller of the option who receives the premium from the buyer takes on the corresponding obligation should the buyer exercise the right to buy or sell at the fixed price level, which is referred to as the strike price. 

As an example, the plant’s risk managers could purchase a June 155 put option for a cost of around 7 cents, which effectively would establish a minimum price for their ethanol at $1.48 per gallon (the right to sell at $1.55 minus the 7-cent cost). Alternatively, for a cost of around 5 cents, they could purchase the same 155 put in June while also selling a 175 call option. This combination would give the plant a minimum ethanol price of $1.50 per gallon along with a maximum price of $1.70 per gallon (the right to sell at $1.55 and the obligation to sell at $1.75 minus the 5 cent cost). If we also assume that the input costs have been locked in at the values indicated, with no further fluctuations to the plant’s fixed costs and no changes to the index, this likewise would imply a minimum margin of 15 cents per gallon and a maximum margin of 35 cents per gallon. The latter maximum value would translate to a profit margin at the 80th percentile of historical opportunity, which the ethanol producer might consider attractive.

Obviously, a different matrix of prices and margins would suggest a different approach to contracting.  In any case, modeling and managing risk from a margin perspective can provide valuable insight on forward opportunities and help direct contracting decisions. 

Author: Chip Whalen
Vice President, Education and Research
Commodity & Ingredient Hedging LLC