Futures, Swaps Market Can Help Manage Risk

An array of new financial instruments helps the industry overcome financial challenges and thrive.
By Robert Esposito | December 27, 2010
My first exposure to the business of corn came 15 years ago at Lehigh University, where I played on the varsity soccer team. During our preseason workouts, we would go on hour-long runs through the many cornfields of Bethlehem, Pa. Fast-forward to the present, and those corn fields I trudged through are now the main focus of my everyday life. When I think back to my days in college I realize that there are many parallels between running through the cornfields and managing the ethanol industry today: endurance through difficult conditions, adapting to one's surroundings, and the rewards of hard work. Over the past four years, the industry has been bombarded by adverse publicity, wild price swings, and activists questioning our very existence. Politicians and citizens alike had spirited political debates over the merits of using corn for food or fuel when prices rose to $7 a bushel. Gasoline prices traded a dollar below ethanol, decreasing discretionary blending. A few producers faced cash flow problems, yet demand continued to increase. Despite all these growing pains, the industry has endured and is showing signs of prosperity ahead. One place where the industry has shown signs of progress is in the growth of financial instruments to service its practitioners. Four years ago, ethanol futures only had 2,000 lots total open interest, and financially settled ethanol swaps were not yet cleared on an exchange. Only banks and companies large enough to have an ISDA agreement could trade ethanol swaps. The International Swaps and Derivatives Association Inc. has created an ISDA master agreement which sets guidelines for privately negotiated over-the-counter (OTC) swaps. In such a short time, much has changed. Today, ethanol futures volume has increased to more than 10,000 lots of open interest. Chicago Board of Trade ethanol swaps have over 50,000 lots of open interest and are now clearable through NYMEX Clearport. This makes trading financially settled ethanol swaps available to anyone who has a futures trading account and takes away the counterparty risk of nonpayment associated with ISDAs. Due to the volatility of commodity prices, hedging by producers is necessary, prudent and vital to their existence. For ethanol producers, this means hedging the price of inputs (corn), costs (energy) and outputs (ethanol). Just a few years back, producers could only easily hedge their inputs and costs, but not their output. In addition to hedging, the most crucial lesson learned over the past four years is the importance of managing cash flow. When buying inputs and hedging outputs in a rising market, producers face a double drain on their cash. They buy corn and at the same time make margin calls to support an ethanol hedge. In this case, one needs enough cash to maintain this double drain until the final product is sold and income is received. While hedging sounds simple in theory, some ethanol companies have not done the best job in streamlining their hedging activities. Different departments do not always communicate with each other and as a result a company can over hedge when they could just trade internally. Hedging managers need to start looking at the company's overall exposure and not just individual department risks. Part of the ethanol industry's current success is due to its ability to adapt to the current financial environment. The greater financial system is still based on trust that a counterparty will deliver, but these days one cannot be too sure. As such, in the past year, ISDAs have lost their appeal. No longer will companies accept being exposed to counterparty risk when it is unnecessary and the majority of OTC ethanol products are cleared through exchanges. Although ethanol futures volume has increased over the years, the majority of ethanol trading still happens in the OTC swap market. Types of Swaps The most liquid ethanol product in the market today is the CBOT Calendar Average Swap (or simply CBOT swap), based upon next month's futures price. For example, a January CBOT swap settles at the same price as the February ethanol futures contract. A standard contract is 14,500 gallons per lot, half the size of an ethanol futures contract, and is based on Chicago area pricing. Since this swap settles financially, there are no concerns of delivery. Since its settlement price is based on the futures contract, the price is easy to track. The next most liquid contract is the Chicago Platts ethanol swap, which also settles financially. The settlement price is based on the average price of Chicago Platts for each day, and the contract size is 42,000 gallons per lot. It is often traded as a differential spread to RBOB swaps since they are the same contract size. The NY Harbor ethanol swap is also 42,000 gallons per lot contract and is based on the daily average pricing of NY Harbor Platts. Generally speaking, the NYH swap trades approximately 10 cents over the Chicago-based swap, accounting for transport cost. That spread has traded anywhere from 4 cents to 14 cents, however. There are often arbitrage opportunities to be found in the locational spreads as the prices are sometimes well below or above the transport cost. Over the years this was the contract of choice for exporters (especially from Brazil). Currently, with high Brazilian sugar prices and U.S. ethanol prices in the $2.30 range, it is not economically feasible for Brazilian producers to export ethanol to the U.S. The ethanol/RBOB differential is perhaps the most common trade in the industry, though it can be a very volatile trade since ethanol and RBOB do not often correlate. There is a lot of activity in the market when RBOB trades at 50-60 cents over ethanol, and profit taking when the differential flattens out. This trade allows end users (blenders) to lock in their ethanol price at a discount to RBOB while they receive the 45-cent ethanol blenders credit. Another very popular trade is the ethanol/corn crush spread. The CBOT ethanol swap is an equivalent size of one corn contract. One corn contract represents 5,000 bushels of corn, which produces approximately 14,500 gallons of ethanol, good for a corn/ethanol ratio of 2.9 bushels per gallon. This makes the CBOT swap easily traded versus corn as a crush spread. The simple crush formula is the price of corn divided by 2.9 and then subtracted from the price of ethanol. This basic formula does not account for the dried distiller grains, which are also produced during the crush. An example of the simple crush spread is if Q4 CBOT swaps trade at $2 and Q4 corn swaps trade at $5, then the crush spread is 27.5 cents. ($2 ($5/2.9) = $0.275) The most popular way to trade corn is still the corn futures market, which is very liquid, although more and more ethanol hedgers are using calendar average corn swaps to hedge the crush. Similar to the ethanol swaps, corn swaps are traded OTC, settled financially and clearable over Clearport. A third way to hedge corn is through an exchange traded fund called the Teucrium corn fund (NYSE symbol: CORN). The corn fund is the closest equivalent to corn futures in the market today and trades as an equity. This provides a new way to hedge corn without having to open a futures account. For the first time, anyone with a stock account can trade a corn-tracking fund. Fifteen years have passed since my Lehigh soccer days. I now run along New York City's Central Park Reservoir rather than the cornfields of Bethlehem. Although I am a little slower, a little heavier, and I miss the days of running through cornfields, I am very proud to be part of an ethanol industry that continues to endure, adapt and revolutionize the global energy markets. Author: Robert Esposito Head of Latium Capital, a division of GFI Securities LLC (212) 968-2745 R.Esposito@latium-capital.com