Plant Profitability: Back to Basics

Considering the factors that impact margins in a changing industry
By James K. Schmidt | June 10, 2011

The natural question for a business of any kind to ask their accountant is, “What can we do to increase the profitability of our operations?” Members of the ethanol industry are no exception, and we receive this question often from clients and others in the industry. We could provide all sorts of fancy formulas or suggestions, but the answer to the question is really quite simple: Maintain your margins.

Unfortunately, the only thing simple about this is the answer. As those who have worked in the ethanol industry for many years know, implementing procedures, processes and management philosophies to actually do this is quite complex. Managing the expectations of investors and board members, especially during the past several years, is a challenging, on-going task.

There are methods that can be utilized to help plants maintain their margins and thereby, the profitability of their operations. Knowing your costs and matching purchase and sales cycles are two of the most critical things management and the board must do to ensure that a plant achieves its desired margins.

Cost Factors
Know your input costs, your processing costs and what you can sell for. Again —sounds simple, but this is one area where many plants can make enhancements that will result in more positive margins. During the latter part of the past decade, many plants—buoyed by several years of strong growth, product demand and the ability to contract sales into the future, and expecting more of the same—unknowingly engaged in greater speculation as part of their previously successful hedging strategies. These factors, coupled with the unexpected changes to the world and national economies, contributed to significant decreases in profitability for many ethanol plants. 

Obviously, corn and natural gas prices play a significant role in managing costs; however, two other factors that should be taken into consideration are transportation costs and the ability to sell distillers grains locally as wet distillers grains. If corn is readily available within a reasonable geographic distance, a plant’s corn costs related to transportation can be reduced considerably. As the availability of corn diminishes, and corn is imported from a larger geographic area, the price needed to induce sellers to transport that corn increases to offset the seller’s transportation costs. Inversely, the further the market for distillers grains is from the plant, the more transportation cost and potential drying costs are incurred for distillers grains. Additionally, as natural gas prices rise, the costs of drying distillers grains increase, thus reducing overall margins. By selling the wet distillers grains into the local market, ethanol plants can reduce natural gas and transportation costs, and depending on the difference between drying costs and transportation costs, and the sales price of wet versus dry distillers grains, can increase their margins.

In addition, markets have changed related to how ethanol is sold and marketed. During earlier years, there was the ability to market and lock in a substantial portion of a plant’s production with a fixed price contract. This, when combined with fixed-price contracts for purchasing corn (and perhaps fixed-price distillers grain contracts), provided the ability for a stable margin within the production process. As markets have become driven by other economic factors such as world oil prices, fluctuations in the value of the U.S. dollar, perceived or real shortages of corn and other commodity price fluctuations, to name a few, the ability to contract at fixed prices has diminished. More and more contracts for the purchase of corn are not fixed, such as basis contracts, hedge to arrive, etc. In addition, contracts to sell ethanol tend to be shorter term and can also be tied to other market factors including crude oil prices, RBOB, or other futures markets, that are not converted to a fixed price until delivery of the ethanol. With these multiple moving targets, and markets that do not always move parallel to each other, plants face increased risks to maintaining their margins.

Match Purchase, Sales Cycles
Increasing globalization, along with changes in supply and demand, has forced plant risk management committees to re-evaluate many of their risk strategies. These committees are now actively discussing such topics as the level of speculation the plant should be involved with and what levels of risk are considered to be “acceptable.” 

It has always been a challenge to balance the appropriate levels of risk to maintain the desired margins for the plant. We are finding that today, many plant owners and their lenders have lower risk appetites than they had in prior years. Many of these plants are now utilizing a “back to basics” model, where they match the purchase cycle and sales cycle simultaneously.

While matching the sales cycle and the purchase cycle are noble causes, there are still risks, even when you can manage your costs and selling prices. Let’s look at an example.

An ethanol plant is in the fortunate position that it can lock into purchase contracts for corn each month, get a fixed-rate natural gas contract for the next year, plus fixed-contract selling prices on ethanol negotiated each month. Contracts for corn and ethanol are entered into two months in advance of production. Plant managers know how much other production costs are and can calculate a reasonable margin based on this information. The sale of distillers grains, however, is based on the local spot market. To minimize this risk, the plant managers enters into contracts to sell their distillers grains for a price based on a trailing monthly average that uses the price of corn as its base. Overall, the plant managers have done a good job of locking in their margins. In periods when the price of corn is rising, they will have greater margins on their distillers grains than if they had priced the distillers grains when the corn contract was entered into. In periods where corn prices are falling, they will have reduced margins. As long as there are no large swings in corn prices that impact the distillers grains margins, there should be no surprises. As history has shown, volatile markets create situations that are not anticipated, and which can have devastating financial impacts, even to the point of bankruptcy.

Different strategies, pricing mechanisms and hedge scenarios either reduce or enhance the risk that an ethanol plant takes in the marketplace. Identifying potential risks in the process, managing those risks, and setting risk management tolerances are the first steps to providing a profitable future.
When identifying risks, plants should take numerous factors into consideration. These include the obvious, such as regulatory issues, mergers and consolidations, rate risks and natural disasters. Many plants are now also considering the “what-ifs” in their risk assessments and discussing such issues as lawsuits and damage to reputation, socio-political issues and potential terroristic threats involving the food supply. Additionally, plants are considering risks associated with internal factors such as fraud, financial issues and maintaining strong leadership.

By reviewing both internal and external risks, as well as the relationships between these two, management and boards have the opportunity to discuss how risk is currently being managed and opportunities for managing it in the future. In-depth risk discussions should occur at least annually at the board level and be an ongoing part of other management discussions.

Over the past several years, boards and plant management have learned—in some cases, the hard way—that it can be very challenging to outguess the market and, as a result, have reverted to strategies successfully employed in the past. It may be tempting for boards and management to make the above-noted changes now and, once things get better with the economy and the state of the ethanol industry, revert to more speculative behavior. The strategies noted above have stood the test of time and have been utilized since well before the ethanol industry’s birth.

Author: James K. Schmidt, CPA
Eide Bailly LLP
(952) 918.3599
jschmidt@eidebailly.com