Spot-on Strategies in Risk Management
Developing risk management strategies has been a challenge for ethanol producers in the past decade because ethanol and corn markets operate very differently. The corn market is liquid and futures prices gradually increase in the forward months, while ethanol futures are far from liquid and forward prices tend to be lower than the spot, creating a disincentive to forward price. That is primarily because ethanol storage is limited, with only about 18 days of inventory on hand to accommodate nearby demand. On the corn side, there’s ample storage, which typically creates a cost of carry or positive return to storage. Add to that a seasonality in ethanol plant margins, where the first quarter tends to be a difficult period, which would encourage hedging, while most often, the rest of the year sees better margins on the spot markets, although not always.
“The industry has been programmed not to do anything forward as far as contracting beyond the spot period,” says Chip Whalen, vice president of education and research at CIH Associates LLC. “Because what they’ve become accustomed to believe, although not necessarily accurate, is that it is best for the plant to simply stay open and realize margins on a spot basis.”
“Most everybody is a hedger today, especially in corn,” says Craig Ludtke, president, Commodity Marketing Co. On the ethanol side, he says not many are using board futures, but Platts and other markets are deep and have useful pricing tools. “Today when doing risk management, you’re doing something with ethanol pricing and corn in equal and proportional amounts so you have a crush margin on, rather than a singular commodity risk position.”
Working as a business analyst for Christianson CPA, Fred Gould says what many plants end up doing is protecting cash corn purchases by hedging and using other methods for product sales. “When they buy grain from a producer at a particular price, that locks in the price, but they don’t have the ethanol locked. So what their hedging is doing is putting themselves back in the market so both sides are floating. Most of the ethanol contracts are indexed, floating with the market.” The contracts, often indexed to Platts or OPIS settlements, result in a monthly average ethanol price.
Developing a plant-specific margin history is the first step in developing a risk management strategy, says Whalen. A history can show, for example, that in February a 7-cent margin was seen 80 percent of the time over the past five years, indicating a good opportunity to lock in a projected 7-cent margin in a period that often is negative. “But the problem is, the highest that margin’s been for that period in the past five years is 35 cents,” he says. “If I lock it in at 7 cents and the margin improves to 37 cents, I’m potentially leaving 30 cents on the table. So the question is, is 7 cents worth protecting so I at least break even or make a little bit of money? This is because at the other extreme, the low over the past five years for that same period is a loss of 28 cents.”
Using put or call options to hedge provides flexibility, Whalen says. During harvest, for example, corn prices are usually depressed and, lacking storage, the plant may want to protect the lower price for several months out. One strategy is to purchase a futures contract that locks in the price. A second is to buy call options that set a ceiling on the price. If the corn market goes up, the right to buy the corn at the lower price is protected. If the market goes down, the plant can pay a fee and forego the option and buy the corn at the lower price. Another strategy is to lock in the corn price, Whalen says, but stay flexible on the ethanol by purchasing a put option that puts a floor under the ethanol sale price.
The challenge is to weigh the risk protection against the possibility of improved margins, incorporating the comparative costs of using options versus futures contracts. “I think there’s been more willingness to look at those strategies and looking at flexible options to protect margins without necessarily committing to a specific price level,” Whalen says. “So a producer can say, in a worst case scenario, I’m at least going to make money through a period that historically has been difficult for profitability. But not give up my upside or ability to participate in really strong margins if things continue to improve.”
Ludtke affirms plants use variable hedging strategies. “No one does 100 percent. I would say they hedge varying degrees, from 25 to 65 percent for specific months. Plants have different cash flows. Some are tight, so they have more hedging—more protection is probably appropriate. Most, once you get to spring or summer are pretty wide open on the spot market.”
Ludtke adds it is also important to look at gross margins, and not just at the plant level. “In order to work through the noise of the margin, you have to really look at what the industry sees. It’s the industry margin that is trying to incent plants to slow down or speed up. If you don’t have a good predictive model of what the industry looks like, then these decisions get difficult. Some people are operating with a positive margin in certain time frames while others are negative, because their variable and fixed expenses are higher or their ethanol yields are poorer. In other words, there’s a lot of moving factors.”
Whalen spoke about risk management at the Christianson Biofuels Finance Conference in October, along with Gould and Steve Squibb from Christianson. Gould stresses communication is paramount. “A trader and accountant think very differently,” he says. “The terms are different. Even the same term is used differently at different companies.” For example, DPR—daily position record—is a common acronym that has multiple meanings when getting into the details. He acknowledges there’s a hesitancy among accountants and others involved in overseeing risk management to admit not understanding, but he suggests being inquisitive. “I find unless you boil it down to the common language, there’s so much that can be left for interpretation and guessing. And [the trader] will say, that’s not what I meant at all.”
Gould recommends accounting teams work with the risk management team to prepare useful reports for management. Generally accepted accounting procedures (GAAP), for instance, call for unrealized gains and losses on open hedges to be reported on the income statement. Gould recommends adding another report that moves the unrealized hedges to the balance sheet, making it easier to evaluate the income statement. The GAAP report, he says, “has to be presented for the banks and financials, but more importantly, we need to evaluate how we’re doing. I call that business intelligence.” It isn’t widely done, he says, adding he gets a lot of questions. “Board members will say, ‘I don’t get this, why are things gyrating up and down so much?’”
Risk management must be approached in a thoughtful way, with best management practices, says Steve Squibbs, business development and solutions analyst at Christianson. That includes things like separation of duties, cash management and documentation. It’s also important that the key information gets to the people needing it. “I’ve seen it happen over the years,” Squibb says. “All the data is being collected but it never goes anywhere. Trading doesn’t flow it to accounting, or accounting is producing all this information but isn’t distributing or isn’t explaining it well enough when distributing.”
It’s important to work at continuous improvement, Squibb says, paying attention to failure points in the information exchange. “How do you make sure everybody in the plant that needs to be on top of it gets the information in a timely manner? That’s not just the traders, but senior management and accounting.”
Whalen recommends plants create a margin management committee that has a plan spelling out specific commodities, how much to hedge and how far out, along with who is responsible for what. “We first saw this at a Fortune 500 food company—a roadmap or guideline to spell out specifically what was trying to be accomplished through the risk management plan and how it was going to be executed.”
“What people have learned in the industry is that even though, historically, the spot margin has tended to be strong, it isn’t always that way,” Whalen says. “And when it’s not, it can really work against you and be very negative. In that sense, it’s probably worth exploring other alternatives—forward contracting and protecting margins in advance. I definitely see the industry is more open to doing that now. Not only that, but eager to learn about it as well.”
Author: Susanne Retka Schill
Managing Editor, Ethanol Producer Magazine