Making the Most of Every Dollar

Despite record-high corn prices, most ethanol producers have managed to stretch their dollars to keep operating at or near break-even. Now that corn prices have started to come down to a more manageable level, producers' margins could start to improve.
By Bryan Sims | September 08, 2008
The recent bombardment of information, or misinformation, by the mass media about what's behind high food prices spurred a spate of global indictments. Politicians blame speculators. Speculators blame the Federal Reserve and a weak U.S. dollar. Free traders blame countries with agricultural subsidies. Countries with agricultural subsidies blame free traders, and then there's everyone's favorite scapegoat the ethanol industry. Although ethanol producers would like to see their industry get more positive press coverage, they have more pressing issues to attend to, such as the volatile corn market.

Just when ethanol producers thought corn prices could get no higher, summer floods ravaged the central Midwest in mid-June—the worst in 15 years—damaging crops and causing corn prices to again spike to historic levels. Chicago Board of Trade July corn futures closed at a record $7.42 per bushel, which was up 25 percent from less than $6 per bushel that same month the previous year. At press time, however, prices had started to come down significantly, trading on the CBOT at about $5.28 per bushel. December corn contracts in June were locked in at $7.86 per bushel, which equaled a decline of $2.68.

According to Robert Wisner, biofuels economist for Iowa State University's Ag Marketing Resource Center, the decline in corn prices indicates just how the commodity directly affected operating margins for ethanol producers and their products. "That's a reduction of 89 cents per gallon in the cost of producing ethanol versus what we encountered in mid- to late-June," Wisner tells EPM. Lower corn prices were accompanied by lower prices for ethanol's coproduct distillers grains. "We've seen about a 28 percent drop in the value of dried distillers grains and that's going to vary a little bit depending on where the ethanol plant is located," he says. "So we've seen on the value side, with the ethanol and the dried distillers grains together, about a 73 cent drop in value there and 89 cent drop in corn prices; in other words, per gallon of ethanol from the lower corn price."

With the steady decline in corn prices, operating margins showed signs of stabilizing and producers experienced slight break-even to marginal profits. "Clearly, the crush spread has improved since bottoming earlier this summer and certainly right now ethanol economics are no where near as bad as they were at their lows," says Pavel Malchanov, alternative energy analyst for Raymond James & Associates in Houston. "When we look at the crush spread evolving from its levels of early June—this is of course with corn prices hitting the $7 per bushel level—it reached almost zero at one point and as of [August], it's actually north of 80 cents per gallon. So, clearly the economics have improved."

Input, Output Prices Are Favorable—For Now
According to Malchanov, the price of ethanol today is about as high as it has been since 2006, as prices have seen an upward trend in the spot market. According to the CBOT, July ethanol futures contracts closed at $2.89 per gallon, up approximately 20 percent from $2.40 a barrel before the flooding occurred. Ethanol futures contracts moved slightly higher following additional buying interest in corn futures markets in August. September contracts posted a 4.4 cent gain, closing at $2.18 per gallon, but the sharpest gains have been posted in the October contract, which is the production levels that will be affected most by corn price increases, according to Rick Kment, biofuels industry analyst for DTN. "A lot of that has to do with the rally in the corn market," he says. "We're actually seeing a disconnect between the gasoline price and the ethanol price now and more of a reconnect between the price movement in corn and the price movement in ethanol."


This summer's high oil price environment did help increase the demand and subsequently the production of ethanol. According to the Energy Information Administration, U.S.
ethanol output in May jumped 10 percent; from 1.7 million barrels in April to 18.5 million barrels in May. The EIA also noted in its monthly August "Petroleum Supply Monthly" that refinery utilization dropped to an astounding 85.9 percent of capacity compared with a year ago when the utilization rate was 91.8 percent of capacity. "The blenders are very aware of the economics behind ethanol production," says Tom Wapp, ethanol market analyst and risk management advisor for United Bio Energy, which provides risk management consulting and market advisory services for ethanol producers. "They need the ethanol and it's very profitable and economical for them to use the ethanol in their blending but they don't want to pay any more for it than they have to. So they're following that corn market closely to make sure that there's enough margin in the market for the ethanol producers to be able to continue to produce it," he says. In addition to the decline in corn prices, discretionary blending by oil refiners and the recent decline in gasoline and crude oil prices have contributed to ethanol's steady price.

National average gasoline prices at the pump fell to $3.86 on Aug. 6 from its record high of $4.11 on July 16, according to data compiled by the American Automobile Association. Experts expect a further retreat in gasoline prices because of the demand issues.

But there are still some challenges for ethanol producers, Malchanov says. "Obviously, corn prices remain at historically elevated levels," he says. "Meanwhile, the price of ethanol, while quite high in absolute terms, remains below gasoline. So the spread between the two remains negative as it indeed has been for nearly a year now."

Couple this with the price volatility of natural gas, which fires most ethanol plants, and operating margins are compressed. However, there is a silver lining behind that cloud as natural gas prices were starting to fall in August based on stronger U.S. supplies.

Hedging, Swapping Key to Survival
Industry analysts and experts agree that for ethanol producers to survive in a volatile market climate, producers must employ hedging and/or cash swapping strategies to protect themselves against price fluctuations in the corn and ethanol markets.

"It's definitely been a rollercoaster ride," Malchanov says. "Depending on where companies were hedging their corn costs across that commodity price curve over the past six months, will of course influence their profitability."

According to Wapp, producers have been in the midst of a "mentality shift" from attaining length on the corn side while selling ethanol to lock in margins to protecting themselves against the long corn exposure as they did during the flood in June. "On the way up, people got enamored with long corn positions and it obviously worked well for them," Wapp says, adding that current ethanol producers should have enough corn coverage to be profitable through the third quarter of this year, although profitability will likely start to drop off sharply as they enter the fourth quarter and work through their remaining corn coverage.

"You wanted to have long corn positions in place as this market was going up. Ethanol was going up with it so as long as you had those long positions in place you felt pretty good," Wapp says. "But, it was very easy to lose sight of the fact that the higher we went and the longer your corn position got the more downside exposure you were all of a sudden picking up on the corn and when this market turned over that became a key factor to start paying attention to."

When corn prices were at their peak in the early summer months, there was speculation that it might have been more profitable for ethanol producers to sell their corn on the open market rather than using it to make ethanol. According to Wapp, there were limited occurrences of that, but it didn't happen on a wide scale. "Ethanol plants are generally reluctant to do that," he says. "Most independent plants feel they are there to produce ethanol. A lot of the plants aren't even set up to sell corn out of their plant."

On the ethanol side, Wapp encourages plant managers to carefully analyze fixed and variable expenses to accurately assess break-even requirements and to coordinate grain purchasing with ethanol sales and cover all necessary expenses to ensure protection against temporary price swings.

"Cash sales on ethanol have been pretty difficult to accomplish on this decline in prices," he says. "The buyers are well aware of what has been transpiring and they want to see a bottom formed in the corn before they're willing to step out and commit anything on a priced basis on the ethanol side. That's pretty much left plants looking at a swap market or over-the-counter environment to hedge that ethanol against."

Looking ahead to the close of this year, experts believe risk will be an inevitable element to the business of ethanol production. However, proper due diligence on hedging approaches will ultimately lead to successful operations.

"The presence of volatility and risk are becoming a fact of life for ethanol producers and the importance of preparing to handle that risk will only continue to increase," Wapp says "There's going to be plenty of risk moving forward for plants in the next year, but if you're prepared and positioned correctly it also gives you an opportunity for reward as with high corn prices because—if you're ready for them—higher ethanol prices also come with it."

Bryan Sims is an Ethanol Producer Magazine staff writer. Reach him at or (701) 738-4950.