Six Traits of Successful Ethanol Producers: Keys to Effective Risk Management

By Tom Wapp | August 04, 2008
Today's economic environment is filled with soaring corn prices, a heated food-versus-fuel debate, legislative uncertainty and other factors dramatically affecting market prices and stability. These market conditions require greater attention to risk management than in the past. No one can predict the markets' behaviors, but chance favors the prepared mind—and so do profits.

Ethanol profitability depends on outstanding commodity price risk management. The most effective risk management program is custom-tailored to an individual plant, taking into account its actual corn purchases, ethanol and distillers grains sales, the local market conditions for corn supply, the cash positions that a plant has or will have, and the impact of broader energy markets. Additionally, plant managers should avoid comparing their plant's strategies to those of another plant as if they are comparing apples to apples. Without knowing the underlying motives for their positions, it's difficult to decode any significant meaning from someone else's risk management strategies.

The overall goal of any risk management program, of course, is to maximize profitability and competitiveness—not only in calm markets but, more importantly, among waves of extremely volatile market conditions. Several factors influence a successful risk management strategy, but I've identified six common traits present in successful (that is, profitable) ethanol plants.

No. 1: A producer needs a willingness to use a variety of tools to manage adverse price moves.
Not every strategy or tool works the same in every situation. Using a variety of hedging and risk management tools gives the plant the flexibility to match its own needs with the needs of the marketplace. Some of the tools ethanol producers use to protect against adverse price moves are traditional, such as futures and options contracts. These are particularly useful for managing corn positions. Tools available for ethanol hedging have arisen more recently, which limits some of the comfort that comes with familiarity. Futures and options for ethanol can be thinly traded, if at all, making them difficult to use.

Many ethanol producers have instead turned to over-the-counter hedge structures that are less well known. In many cases, the liquidity in the over-the-counter market can be many times greater than traditional futures markets. Chicago Platts ethanol swaps are an example of an over-the-counter trade that is actually placed in the ethanol company's hedge account and cleared by the New York Mercantile Exchange. This clearing function reduces the counter-party risk that can be available in over-the-counter transactions.

Some plants may find over-the-counter transactions to be unfamiliar and therefore are reluctant to use them as part of a disciplined hedging strategy. The first thing these plants should do is diligently learn all they can about any unfamiliar tool or strategy before it's time to utilize the trade. Decide beforehand, based on a working knowledge of the strategy, if it is a tool that plant managers are comfortable using. Don't wait until decision time to become educated about the tools available to the plant. Doing so means running the risk of severely limiting the plant's risk management options.

No. 2: Know that one can't outguess the markets. Modesty is a virtue when it comes to managing financial risk.
To effectively plan for and protect against certain undesired outcomes, acknowledge that even having years of commodity market experience does not mean that one can successfully outguess the markets. Admit that you don't know what you can't know, and find a way to hedge against negative circumstances that might arise from changing weather, unforeseen factors affecting demand for inputs, changes in
legislation and subsidies, and so on.

No. 3: Acknowledge the unpredictable.
Similarly, avoid saying things such as: "In my experience, whenever X event occurs in the marketplace, the result is always Y." The word "always" can get even the best risk managers into bad positions. When one starts thinking in terms of absolute reactions, he or she blocks out the potential to protect against perhaps uncommon but unavoidable adverse reactions. Be prepared to react to a surprise that changes the market's dynamics. No plant will always be perfectly positioned for every unpredictable event, but any plant can be prepared to quickly acknowledge and analyze changing circumstances to judge whether they require a change in the plant's hedging plan.

No. 4: Know the role of the risk managers.
Define the roles and responsibilities of the decision makers in a plant's risk management implementation. Self-doubt about authority to enter positions leads to reluctance, which leads to missed opportunities. It's good to have oversight, as no one person should have complete authority and responsibility for a plant's risk management strategy and execution, but decision makers need to have well-defined parameters within which they can work well and avoid second-guessing. Those defined parameters can include price, time, volume or some combination of the three.

No. 5: Decide to act, even if it means doing nothing.
Making no decision at all is the same as passively deciding to do nothing. In some situations, doing nothing is the best course of action, but doing nothing should never be the result of failing to make an active decision. Sometimes, a market-changing event will occur that leaves plant managers uncertain about what the impact will be from a price standpoint. A passive approach would be to wait and see how the market responds before discussing the change in the market with fellow decision makers within the organization.

A more responsible approach would be to raise the concern with those who should be involved in making decisions as soon as the market-changing event is discovered. If the decision is then made to do nothing, at least an open dialogue and discussion were encouraged. You won't always make the right decision, but successful companies do not
generally succeed on passive approaches.

No. 6: Get an opinion from an outsider.
Plant personnel have a vested interest in the success of the plant, which is generally a good thing. However, when it comes to risk management, that vested interest can often get in the way of making good decisions. Often an individual outside of the plant has a clearer picture of what needs to be done and can make a more rational decision. This also helps to avoid the mentality of "looking out your window" to make a decision. When you do this for yourself, all you see is what is right in front of you, and the bigger picture is often overlooked.

Conclusion
Managing commodity risk in the ethanol industry can be incredibly challenging. The two primary commodities—corn and ethanol—have historically had low correlation to one another. This increases the need for a risk management structure that is fluid and able to quickly adjust to the changing market dynamics.

In managing the commodity price risk that is inherent in the ethanol industry, first acknowledge the unpredictable nature of commodity prices and that you will not be able to outguess the markets all of the time. Do not let personal ties to the business cloud the view of the issues driving the market.

One of the most important keys in commodity risk management is for the decision makers involved to clearly know their roles and responsibilities. Many times, this is where an effective risk management program will break down. When the time comes to make decisions and execute, be familiar with the tools available to make quick and efficient decisions. The above six traits of successful risk management for ethanol plants can increase the likelihood of achieving goals in this difficult environment.

Tom Wapp is the commodity price risk manager at United Bio Energy, a company that provides risk management consulting and market advisory services for ethanol producers. Reach him at twapp@unitedbioenergy.com or (316) 616-3558.