Mitigating the Unknown

As the ethanol industry grows, the rules of the game are changing. Along with positive developments, like increased interest by investors and ramped up demand for ethanol, comes more volatile grain markets, for example. That means risk management is a tool with ever-growing importance as ethanol producers strive to maintain steady profits at a time when growing pains could threaten to strike.
By Holly Jessen | August 01, 2006
Investorwords.com defines risk management as the "process of analyzing exposure to risk and determining how best to handle such risk." Jeff Kistner, BBI International's vice president of project finance, simply referred to it as a topic that keeps him awake at night. "You have to have a plan, you have to have a strategy," he said during "Risk Management: Looking into the Crystal Ball," a June 21 session at the 2006 FEW. Kistner, along with four speakers, discussed contracts, commodity forecasting and supply issues that face the ethanol industry today.

The speakers gave an overview of key risk management points of interest for ethanol producers. There are far too many risk management tools to mention each of them in a short period of time, explained Eric Perry, senior manager with The Scoular Company, an agricultural marketing business. However, those tools are a very important part of managing risk, such as the cost of inputs like grain and energy.

Jason Sagebiel, senior risk management consultant in FCStone's Renewable Fuels Group, talked about changing dynamics in the marketplace that make risk management strategies more important than ever before. "It's becoming more imperative that you implement sound, strategic strategies to establish [good] margins going out forward," he said.

One big change is the price and availability of ethanol's biggest inputcorn. "One of the things that we've seen change in the corn market, obviously, is the advent of ethanol and what it's done to demand and what it's going to do to demand as we move forward," Sagebiel said, explaining that because of ethanol, there's now a demand for speculative pricing information on corn futures into the 10-year time frame, much further than ever before. That's a significant change in the marketplace that has added some volatility that was not historically as intense within the grain industry.

The rapid growth of the ethanol industry has also altered the dynamics of grain flows, Perry said. "The change in demand is going to have a significant impact on where bushels movewhat areas are deficit, what areas are not deficit," he said.

Changes in demand have had the most "eerie" effects in the Corn Belt. With current demand for corn, even areas of the Corn Belt located near ethanol plants can be deficit in corn supply for part of the year. "That's something we haven't had to deal with in the Corn Belt proper, ever," Perry said.

The market has undergone rapid change in the United States, but also throughout the world, said Clayton Weiby, risk manager for Cargill. It's important for U.S. businesses to keep the changes to the global market in mind as well. "This is going to become a world market within fairly short order," he said.

In response to that, Cargill has spent a lot of time and money developing worldwide networks as a crucial component of its business. "What we have done is try to approach it from a worldwide perspective and develop the infrastructure to give us a strong information network," Weiby said, adding that the process was a challenge and not necessarily something he could recommend to every business.

Different Options
The price of corn and ethanol are certainly two important things for ethanol producers to keep an eye on, Sagebiel said. Of course, prices for ethanol's coproduct, distillers grains, is another variable. Producers should consider whether the market is more favorable for selling distillers grains into ruminate or monograstric feedcattle versus pigs and poultry. They also need to stay abreast of the prices of competing animal feed, such as soybean meal.

When developing risk management strategies, there is a plethora of different factors to keep in mind. For example, a newly operating plant will have a different risk profile than a plant that has been in production for four years, Sagebiel said.

There are a number of different ways for ethanol producers to procure corn, wheat or milo, Perry said. Working with commercial buyers gives the plant access to many different contract options to manage price risk.

Cash contracts are going to become a very important part of ethanol plants' risk management strategy, Perry said. Cash contracts are for the physical delivery of feedstock to the plant or a rail destination.

Rather than waiting for a 30- 60-day window of time when feedstock is needed, producers should look at cash contracts. They can be used to buy aggressively at the optimal time or when the basis is wider in a local area or region. "We think it's important that you don't overlook the flexibility of the cash contract, especially with the commercial grain suppliers when you are thinking about how to build a [risk management] program," Perry said.

The need to get control of corn bushels can't be underestimated. It's especially crucial in areas where a lot of ethanol plants are being built and as grain flows change significantly over the next two to five years. "Most commercial grain operators, in today's competitive environment, are more than willing to offer the end user quite creative solutions when it comes to cash contracts," Perry said.

The Yield Question
Prompted by a question from the audience, speakers also discussed what corn price could make ethanol production unprofitable. Although there are many factors to consider, Sagebiel said, in general, a 10-cent boost in corn prices impacts an ethanol plant's margin by approximately 3.5 cents per gallon of ethanol produced. Perry said he agreed with those figures. He added that if policyand energy and fuel pricesstay static, he feels corn prices could reach the $3 range before it drastically affects returns on ethanol plants.

Taking the increasing demand scenario into consideration, $3 corn would be a strong price incentive, Weiby said. U.S. farmers would grow more to fill the demand. On the other hand, he did add a few words of caution on the current corn market conditions. "I don't know if it's a new reality like some people would like to think it is," he said.

Another question from the audience centered on how much more acreage can be devoted to corn production. Perry said the answer to the question was in improved technology for hybrid corn. Yield could continue to grow aggressively, following the 15-year yield trend, if technology advances are maintained in the seed corn industry. "If the market signals are there, one would believe that you could continue to grow corn acres well up into the mid-80 million to high 80s," he said.

Energy
From the number of audience questions, energy was a hot topic during the discussion of risk management. Still, grain is a much higher input cost than energy, said Casey Whelan, vice president of business development for U.S. Energy Services, who spoke primarily about how energy inputs are associated with risk management.

That doesn't mean energy costs aren't meaningful when considering a risk management strategy, however. Energy costs at a 50 MMgy ethanol plant can range from $15 million to $20 million a year, he said.

A history of price increases on the natural gas side put producers' concerns in context. In the past seven years, natural gas prices increased from an annual average of $2.11 per MMBtu to $8.16 per MMBtu. Seven years ago, natural gas costs totaled about 7 cents per gallon of ethanol, rising to about 28 cents a gallon at current prices, Whelan said. Volatility is also a concern. Recently, there was a dramatic price spike of $10 within a six-month period.

From a risk management perspective, public and private forecasters expect continued softening of prices for natural gas. At some point, however, the prices will go back up, though probably not above the rate of inflation, Whelan said.

Electricity, which represents only about 20 percent of a plant's energy costs, is experiencing incredible upward pressure. U.S. Energy Services' industrial clients have seen about a 10 percent increase in the price of electricity, and that's not expected to back down soon. "We expect electric prices to continue to increase at a rate higher than the rate of inflation," Whelan said.
Responding to high energy prices, some ethanol projects have turned to coal or biomass power sources. Although that could result in savings down the road, things to consider when looking at alternative energy sources are the large up-front cost and the volatility of the future commodity price, Whelan said.

For example, coal prices have been low for the past 10 years as mines have been producing under capacity and rail lines have been delivering under capacity. As demand rises and that situation changes, Whelan predicted that coal production would increase, bumping up the pricelikely at a rate higher than natural gas, he said.

While natural gas prices can be high and volatile, there is a positive that is often overlooked as plants consider risk management strategies for energy costs. When energy prices rise, ethanol prices do as well, creating a natural hedge, Whelan said. An internal analysis of U.S. Energy Services customers showed that each $1 increase in natural gas prices generated $2 in additional revenue.
In the past, most clients used futures contracts in an effort to keep a handle on energy costs, he said. Today, an increasing number are going to options contracts as a risk management strategy.

Holly Jessen is an Ethanol Producer Magazine staff writer. Reach her at hjessen@bbibiofuels.com or (701) 746-8385.