Well-managed hedge positions improve margins

A case study examines strategies that leave openings for upside opportunities while mitigating risk. This contribution appears in the February issue of EPM.
By Chip Whalen | January 21, 2016

Forward ethanol margins can be projected using the futures market as a price discovery mechanism. The risk transfer function of these exchange-traded contracts, including futures and options, allow an ethanol plant to lock-in or protect forward margins. One aspect of the margin management process involves identifying a forward margin opportunity and then analyzing that opportunity from an objective context to determine whether it is worth protecting. Assuming it is, positions might be initiated as part of a margin management strategy to protect the plant’s profitability. From there, prices will fluctuate over time, which brings us to the next step, managing positions. Effective margin management is a dynamic process that requires monitoring open positions over time as market conditions change, and takes advantage of making periodic adjustments to these positions with the hope of improving upon the margin opportunity.

As a case study of this dynamic at work, let’s explore a recent market period with a model ethanol plant actively managing positions around a margin opportunity for August, 2015. In early June, the plant is modeling its forward profitability around its projected costs and revenues and calculates an expected profit margin of 19 cents per gallon for August. Given that margins have recovered from around breakeven earlier in the spring, the plant finds this value attractive and wishes to take positions to protect its corn costs and ethanol revenue. They decide to initiate coverage by purchasing September corn futures contracts at the current price of $3.675 on June 5 while taking a flexible ethanol strategy using options. With August Platts trading at $1.51 per gallon, the ethanol plant decides to purchase a $1.50 put option for a premium of 6 cents and simultaneously sell a $1.70 call option for a premium of 2 cents. For a net cost of 4 cents, the resulting position provides the plant with a minimum ethanol price of $1.46 per gallon and a maximum ethanol price of $1.66 per gallon. Given the historically low prices for both corn and ethanol on June 5, the plant determines there would be more opportunity to participate in potential margin improvement through higher ethanol prices, thus the flexible strategy there.

Holding all other costs and revenues fixed, with a projected margin on the open market of 19 cents per gallon, the combined positions would provide the ethanol plant with a minimum margin opportunity of 14 cents per gallon and a maximum potential margin of 34 cents per gallon, should August Platts be above $1.70 per gallon at expiration. Ten days later, on June 15, prices have subsequently declined and August Platts ethanol is now trading at $1.44 per gallon. As a result, the put option that the ethanol plant has purchased has gained in value while the call option that was sold has depreciated. The $1.70 call option is now worth a half cent, which means that it has lost 75 percent of its value in two weeks’ time, and the ethanol plant decides to buy it back in order to remove the maximum price sales obligation above the market. Following this adjustment, the plant effectively now has just a minimum ethanol price or floor of $1.455 with no cap or ceiling so that they can have unlimited participation to higher prices. 

Advancing a few weeks to July 2, the corn market has rallied sharply in response to adverse weather with excessive rainfall in the eastern Midwest causing concerns over yield ahead of pollination. September Corn futures are now trading at $4.30 per bushel, up over 60 cents from where the long position was initiated back on June 5. Much of the run-up has been in response to short-covering by commodity funds, and the price increase has been very sharp in a relatively short period of time. While wishing to maintain protection against further price increases, the ethanol plant also desires to secure the gain that has built up in its long futures position. Replacing the futures position with an option strategy may make sense in order to allow for the opportunity of participating in lower prices should the market retreat while still protecting the risk of higher prices. This may be particularly true as prices approach the previous high from the beginning of the year, as shown in Figure 1.

They ultimately decide to reposition their hedge into an option strategy, buying a $4.30 call for a premium of 22 cents. Effectively, the ethanol plant now has a maximum September corn futures price of $3.895 which represents their right to purchase futures at $4.30 minus their net gain on the previous hedge (62.5 cents realized gain on closed futures position—22 cents cost of call option). Another way of thinking about this is that the plant spent 22 cents to protect 62 cents of gains, and under a worst case scenario will add that cost to their eventual corn purchase. The tradeoff, however, is they will benefit, should corn prices eventually decline by more than the 22 cent cost of the calls purchased, thus potentially lowering their corn price below the $3.675 level they started from. 

By the end of the month on July 28, the corn market has moved sharply lower as fund selling and reduced weather concerns have pressured prices. September corn futures are now trading at $3.75 per bushel, 55 cents lower from where the decision was made to adjust the long futures position into a call option. While the call option has now lost most of its value, the gain in the futures position was preserved by offsetting those contracts at the higher price level. As a result, the plant is significantly better off having effectively participated in a majority of the price decline. The decision is made to convert the hedge back into a long futures position to lock in the lower value the market is now trading at. Accounting for both the gain on the initial long futures position and the subsequent loss on the long call option, the ethanol plant has an effective net price on the new September corn futures contract of $3.33 per bushel. (see figures 2 and 3).

Putting everything together, the ethanol plant comes into the August marketing period with a net realized margin of 26 cents per gallon. This is not only better than the open market margin at that point of 16 cents per gallon, assuming the plant had done nothing, but also better than the 19 cents per gallon margin they initially projected receiving back in early June, as detailed in Figure 3. While there were other adjustments that also could have been made during this particular period to improve the margin further, the main point is to highlight how active management of positions can significantly improve upon projected margin opportunities as market conditions change. Profit margin management is not simply a “set it and forget it” process but rather a dynamic one of capitalizing on opportunities as market conditions change. 

The examples reviewed in this case study explored two particular types of adjustments, buying back decayed options previously sold and protecting equity that has built up in a hedge position. The corn adjustment was an example of the latter in converting the initial futures purchase into a call option, while the ethanol adjustment involved the former buying back decayed options. While many might leave a short option in place with the expectation of it expiring worthless, there have been examples where the market can blow up (or down) to cause what were previously decayed options to suddenly become very valuable. The first quarter of 2014 is a case in point when logistical bottlenecks caused ethanol prices to soar heading into expiration. Short call options that impose a maximum price and limit participation in higher ethanol value would have been an unwelcome part of a hedge position during this period, particularly when they could have been bought back for little to no value (see figure 4).

There is always a cost/benefit tradeoff between protecting the risk exposure of deteriorating margins on the one hand and retaining opportunity on the other to participate in stronger margins over time. In the case of the corn adjustment, spending 22 cents on the call option was the cost while the benefit would be participating in lower corn prices if the market were to drop by more than 22 cents. While some might not choose to adjust a long futures position under those circumstances, others might feel that after such a strong rally in a short period of time, there was a reasonable expectation that prices might retreat by that much to make the adjustment worthwhile. The ethanol adjustment is arguably an easier decision. By only spending a half cent per gallon to remove a limitation on participating in higher prices, the plant is not really affecting their bottom line that much from a cost standpoint while significantly improving their ability to benefit from margin improvement. Weighing the costs and benefits carefully is an important part of making any adjustment to a hedge position, but should always be considered as part of a dynamic margin management process in order to optimize profitability.

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