Mitigating Ethanol Market Risk by Monitoring Opportunities

Brokers play an important role in effectively using swaps, other risk management tools
By John Harangody | November 15, 2011

Whether it’s incessant growing demand for commodities from Brazil, Russia, India and China or Middle East turmoil, changes in U.S. federal energy policy or a drought in the plains, all these events have one unique thing in common: a significant impact on the price of ethanol. In fact, there is no market existing today that may be more acutely affected by such a broad array of factors.

At first glance, the ethanol business appears elementary. One acquires corn, ferments it, and co-produces alcohol and distillers grain. The industry refers to this as the “corn crush.” If the acquisition cost of corn and the cost of production are less than the market value of ethanol and distillers grain, the business is profitable.  

If only it were that simple. The ethanol market has many diverse participants that view price from different perspectives, including relationships to corn, basis locations, reformulated gasoline blendstock for oxygenate (RBOB) blending, renewable identification numbers (RINs), sugar, crude oil, the U.S. dollar and even equity markets. To complicate matters more, while most of the relevant forward commodity price curves are in contango (that is, futures prices are above the expected spot prices and the two converge), some are backwardated (futures are generally below the expected spot price, desirable for net long positions), and some have elements of both imbedded in their structure. This translates into price alignments that are extremely dynamic, requiring constant monitoring for opportunities to lock in profitable margins.

What It Takes

Ethanol risk management is not for the faint of heart. It requires a strong intellect, nimbleness, decisiveness and the ability to respond quickly to changing conditions. Possession of all these talents and skills is not sufficient for success, however.   

To be effective, one needs well-designed financial products and physical markets to manage price risk. In addition, the market needs to be structured in a manner that pools liquidity and facilitates rapid dissemination of price information. Fortunately, notwithstanding the fact that the ethanol markets are still in their nascent stage of development, many financial risk products have been developed to accommodate the most demanding of managers.  

The list of exchange-cleared risk products that can be employed is impressive. CME Group’s product suite includes Chicago Board of Trade ethanol swaps, options on CBOT ethanol swaps, Chicago Platts swaps, NY Harbor Platts swaps, RBOB calendar swaps and corn calendar swaps. CBOT ethanol futures, ethanol block futures as well as corn futures are also available. About 80 percent of all exchange-cleared ethanol contracts are over-the-counter (OTC) swaps. In addition, RINs and distillers dried grains with soluble (DDGS) are traded as physical products.

By nature OTC swap markets do not have strong institutional structure. Consequently, a final ingredient necessary for the markets to function effectively are good brokers who constantly monitor changes in conditions, quickly communicate that information and assist their clients in understanding the impact on price.

Advantages of a Broker

In the physical and financial ethanol markets, a broker is a neutral intermediary that matches buyers and sellers at the best price in the market. A good broker will keep company names anonymous until an actual transaction that meets the client’s requirements is executed. Because a pure broker does not leverage a balance sheet or take actual ownership of the underlying asset, transacting parties are assured of getting the best price without risk of bias.

Some ethanol brokers utilize a refined hybrid approach that melds voice brokering with electronic trade to produce the deepest, most efficient OTC ethanol swap markets. Mike Bridges, founding member of Atlas Commodity Markets LLC states, “We have found benefits to both forms of execution. Our selection is predicated by customer preference and our internal assessment of which venue will produce the best results for our customers. While a majority of today’s OTC ethanol swap trades are transacted via voice and instant message, there is a growing contingent of market participants that want to execute on our electronic trading platform.”

A proposed Commodity Futures Trading Commission rule governing swap transactions would require commodity swaps that are mandated to be exchange cleared to be executed on a designated contract market or a swap execution facility (SEF). Swaps that are not mandated to be exchange cleared may be executed bilaterally. This requirement may result in the migration of many swap contract transactions to SEFs. It remains to be determined which, if any, ethanol swap contracts will be mandated for clearing.

Some may ask why a broker is even necessary given the bilateral nature of OTC swap transactions and the ability for parties to trade directly. There are several ways that a broker can enhance a trader’s performance. The first is efficient utilization of time. A full service broker employs the optimum number of knowledgeable professionals to provide complete coverage to each counterpart in the marketplace. Within seconds, a well functioning desk can respond to a request for a quote with confidence that every relevant market participant has been queried regarding price and volume. This insures maximum liquidity and best price.

A skilled broker also provides market intelligence and completely understands where price values are in each geographic location across the time curve. This insight frequently results in the ability to combine disparate markets where interest is expressed, to create liquidity in a different market. The best brokers are market neutral and have exceptional market insight. This enables traders to always transact at the most competitive terms and frees their time to focus on ways to create additional value for their business.  

Chris Yarrow, the anchor on Atlas Commodity Markets’ financial products desk, says “a broker should serve as your eyes and ears for the market, helping to determine value by monitoring inter-market and intramarket spreads and to alert you to market opportunities.” An intermarket spread is a price differential between two distinct markets such as RBOB and ethanol, whereas an intramarket spread is a time spread such as first-quarter versus second-quarter ethanol.

The execution of the “corn crush” is an excellent example of a broker adding value to the trade process. An experienced broker can source the relevant markets, calculate the crush, communicate the bid and offer in cents per gallon of ethanol produced, and execute the trade in a matter of seconds.

DDGS traders face a unique set of challenges. For one, no liquid DDGS financial risk products are available for hedging purposes. In addition, the growth in the number of ethanol plants has not only increased DDGS production, but has created a wider variance in product from a nutritional perspective. Specific nutritional knowledge relative to different quality grades of DDGS needs to be disseminated. As nutritionists become more comfortable utilizing DDGS in feed rations, corn and other feed ingredients will experience some displacement in the formula.  

The increased number of ethanol plants provides merchandisers arbitrage opportunities that previously didn’t exist. Bart Vance, Atlas’ physical grains desk, says “a knowledgeable physical broker is an asset to both transactional parties. Whether as an extension of a company’s sales force or as a part of a procurement team, both get the benefit of another employee without the direct overhead.

Brokers that have trading experience understand the challenges that confront today’s market participants. Their tacit knowledge is invaluable to solving problems that may arise. For example, this year in drought stricken Texas, local buyers desperately needed alternative feeds. We were able to quickly locate DDGS supply from nontraditional regions throughout the U.S. while also creating new distribution points for processors.”

In summary, a reasonable person might think that corn, ethanol and DDGS comprise three distinct, somewhat untethered markets, each with a different array of risk products, liquidity, execution venues and methods of communication. Some may find it a clumsy arrangement that impedes efficient trade. These markets should represent great opportunity. The key is to invest the time to research and understand each market’s nuances, and risk products. If one then identifies and employs the most experienced brokers with the broadest market reach, the structure will be in place to simultaneously monitor all three and capture pricing opportunities as they occur.

Author: John Harangody
Chief Operating Officer, Atlas Commodity Markets
(312) 854-0400


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