By Robert Boslego
Ethanol accounts for around ninety-four percent of the renewable fuel market in the United States. Average daily production and consumption is over one million barrels per day. This represents more than ten percent of the U.S. gasoline market, the largest in the world.
Ethanol is a renewable resource primarily produced from corn in the U.S. In another large market, Brazil, ethanol is primarily made by processing sugarcane.
Producing ethanol is similar to oil refining in the sense that a raw material is processed into a final product. In the case of oil refining, crude oil is processed into petroleum products such as gasoline and heating oil. Because ethanol is produced from plants, both the agricultural and oil commodity markets are involved, creating a more complex risk exposure.
The end result is that the ethanol producer’s gross margin is risky and subject to sharp changes. A strategy in which to manage that risk is to use commodity hedges. However, they must be carefully constructed to be sure that the risk will be reduced.
Note: Corn cost per gallon ethanol.
Note: Corn prices received by farmers. Ethanol is rack prices (wholesale truckload sales or smaller of gasoline where title transfers at a terminal) F.O.B. Omaha.
In this article, a case study of VeraSun’s is presented. It is an extreme example underscoring what may happen due to a lack of developing a proper hedge strategy. This discussion is followed by a six-step process properly developing and testing systematic hedge strategies to meet management’s strategic goals.
Case Study
In 2008, VeraSun was the largest ethanol producer in the United States. However, in the summer, it found itself exposed to rapidly declining ethanol prices due to the oil price crash and rapidly rising corn prices due to extreme weather conditions. It described the actions it took to protect its gross margin in a September16th announcement:
“In July 2008, after corn prices had risen from approximately $6 per bushel at the end of May 2008 to almost $8 per bushel due to extraordinary weather conditions in the Midwest and broader market commodity trends, we effectively priced our corresponding physical purchases of corn at the then-current market price, which proved to be significantly higher than today’s market prices for corn. In addition, based on market forecasts that prices would continue to rise, we entered into a number of “accumulator” contracts relative to corn requirements for the third and fourth quarters that, in each case, allowed us to purchase a specified volume of corn at prices below then-prevailing market rates, but also required us to purchase that same volume of corn (in addition to the initial purchase) at one or more lower prices per bushel should market prices decline to or below those lower levels over the duration of the contract. Shortly thereafter, corn prices commenced a sharp decline from almost $8 per bushel to a low of under $5 per bushel in mid-August 2008. As a result, we were required under the accumulator contracts to purchase additional amounts of corn at prices that proved to be higher than prevailing market prices.”
VeraSun concluded that it expected “to incur a net loss for the third quarter of 2008 in the range of between $63 million (40 cents per share) and $103 million (65 cents per share).” Market conditions worsened and VeraSun declared bankruptcy on October 31, 2008.
This episode highlights the need for a systematic hedging strategy that is designed in advance and implemented to follow hedging principles. Had VeraSun correctly analyzed the correlation between corn prices and the gross margin for ethanol, it would have found very low correlation.
The corn exposure is only one-half of the risk, and the hedge must also include ethanol to guarantee that the margin is correctly hedged.
Systematic Hedging Strategy Development
As illustrated by the case study, VeraSun was ill-prepared for the commodity market crisis in which they found themselves. To prevent such a catastrophe and to maximize success, Boslego Risk Services (BRS) utilizes a six-step process:
Step 1: Define Objectives and Performance Criteria
Hedge program objectives should be linked to achieving the firm’s strategic plan and operating budgets. Therefore, it is critical to understand management’s business and development goals for the firm by reviewing and discussing the Strategic Plan and Annual Budget. For example, is the firm planning to expand production and in need of bank credit? In such a case, hedging may enable the firm to obtain a larger credit line because its future profits are subject to less risk.
It is also important to understand if and how profit margin risks and losses have interfered with meeting budgets and goals in the past. Have past losses prevented the firm from moving forward with expansion plans?
In addition to defining the objectives of the hedging strategy, specific hedge performance evaluation criteria need to be established. In this regard, it is important to measure how hedge gains and losses will be measured in the context of profit margins for each period.
At the conclusion of this step, a memo documenting the selected hedging strategy objectives, and how performance is going to be evaluated, should be prepared.
Step 2: Perform Unhedged Risk Analysis
After setting the objectives and evaluation criteria, the second step to determine an effective hedging strategy is to perform a risk analysis. For hedging purposes, risk is defined as the sensitivity of income to market price changes.
The most effective method to measure the risk is to use linear regression analysis to build a model that links the company’s historical prices to market prices. The model can then be used to project the company’s future margin using futures prices.
The risk to the margin can be objectively calculated using historical frequency distributions. For example, the distribution below summarizes a monthly gross margin and provides frequencies of experiencing a margin at a given level or lower.
At the conclusion of this work, a memo should be prepared summarizing the unhedged risk to margins. A spreadsheet model should be built to use the company’s budget data to predict future margins, given current futures prices.
Step 3: Assess Risk Tolerances
Based on the hedging goals defined in Step 1, and the level of unhedged risks defined in Step 2, management should quantify their risk preferences. This quantification will provide the basis for making tradeoffs between risk and return, so that they can be consistently applied without a need to “reinvent the wheel” every time.
The question is how much (percentage) does management want to hedge if a particular margin is being forecast by the model built in Step 2? Generally speaking, managements prefer to hedge the most when the forecasted margins are high and prefer to hedge the least (or not at all) if forecasted margins are low.
However, market conditions may dictate a more conservative approach. For example, it is now clear that the ethanol market is in a glut and production capacity has to be reduced to get supply back in line with demand. That implies margins may be negative until this happens. Therefore, it may be preferable to hedge at low levels because losing a little is better than losing a lot.
The result of this step is to define a table with the percent hedged for each hypothetical gross margin. This risk-return tradeoff will be used in the hedging simulations in Step 5.
Step 4: Define Hedge Instruments and Strategies
Ethanol margins can be hedged with the “corn crush.” In this example, the inputs to the spread are the corn price (nearby CBOT corn futures price) and NYMEX natural gas futures. The output is the ethanol Platts Chicago price one-month forward. (The data and calculations below were provided by INTL FCStone.)
The hedge strategy will be to “lock-in” the spread by simultaneously purchasing corn and natural gas and selling ethanol. The variables for the strategy are how many gallons to lock-in at what price levels, and for what future period (e.g., 1 month, 2 months, etc.).
An alternative strategy that may be considered is to use gasoline futures to hedge future ethanol sales since the long-term correlation between gasoline and ethanol is very high (80%). One advantage of that strategy is being able to hedge for more future months because gasoline futures are liquid whereas ethanol futures are not liquid more than a month into the future. Another advantage right now is that the spread difference (basis) between gasoline and ethanol prices is at or near an historical high such that an additional hedge gain could be earned if the basis were to narrow in the future to a more normal level.
Step 5: Perform Hedged Risk Analysis
Daily hedge trading simulations over past periods are the best way to assess the effectiveness of a hedge strategy over different market conditions. The risk analysis framework and assumptions developed in Step 2, the risk preferences defined in Step 3, and the specific hedge strategies defined in Step 4 are combined to create the simulations. The gain or loss from the hedge, together with the unhedged profit/loss, may be used to calculate the hedged profit/loss for each period.
As an example, data from Iowa State University’s Center for Agricultural and Rural Development (CARD) was used to calculate a Return Over Operating Costs for a sample ethanol plant in Iowa. (All the assumptions behind the calculations are defined on this page.)
As illustrated in the graph above, the Return Over Operating Costs was often below capital costs, resulting in a net loss. Calculating the Net Margin assuming a 240 million gallon per year plant, the net return from the beginning of 2015 through September 14, 2018 was -$28.735 million.
A hedge strategy was simulated that locked-in margins when they were in they were relatively high and took off the hedge when margins were relatively low. Hedging volumes amounteto production and sales of 60 business days into the future, about three months.
Such a hedge would have produced a hedge gain of $30.154 million over the same period. Thus, the combined (hedged) result would have been a net gain of $1.381 million, instead of the loss of $29 million.
Note: This hedge simulation is for illustrative purposes only and uses certain simplifying assumptions, such as no transaction costs. It was also created with the benefit of hindsight.
When all of the simulations are completed, a memo should be written summarizing the results of each strategy tested, as well as referencing the spreadsheets which detail the calculations and results.
Step 6: Compare Costs/Benefits/Risks of Hedged vs. Unhedged Strategies
As a result of completing Steps 1 to 5 above, a comprehensive quantitative and qualitative comparison of the strategies tested may be completed. Part of the assessment should also include implementation issues, such as developing internal capabilities or on-going monitoring requirements. From this assessment, the best overall strategy may be selected.
Conclusions
The gross margin for ethanol producers has been volatile historically because it is a function of the spread between prices in two different commodity markets, agricultural and energy. Moreover, this margin has dropped to low levels recently, squeezing profitability in this sector.
Hedging ethanol margins can better enable producers to meet their budgets and goals. Attempting to hedge during a crisis or on an ad hoc basis could prove to be disastrous, as it was in the case of VeraSun.
Developing and simulating results from a systematic strategy can better enable management to make trade-offs between risk and return. It also provides insight into how the strategy would have performed under different market conditions in the past. It gives management confidence that it has selected a strategy that makes the most sense for the company.
It is wise to begin with a “pilot program” of hedging a portion of the volumes, as opposed to the total. That allows management to build confidence that the program is operating as expected and yielding the appropriate results or to correct any problems that it discovers while they are small.
About Boslego Risk Services
Boslego Risk Services (BRS) has extensive knowledge and experience in providing risk analysis and in developing hedging strategies and programs for corporations and hedge funds. Beginning in the early 1980s after NYMEX crude futures began, BRS began advising oil and gas companies on how to hedge their income. Clients include major oil companies such as Exxon, Mobil, Texaco, Chevron, Shell, and Phillips; national oil companies such as Agip, PDVSA, Total, Statoil, Pemex, and PetroCanada; major refiners such as Citgo, Marathon, Ashland and Hess; major end-users, such as Burlington-Northern Railroad, Canadian National Railway, United Airlines, and Delta Airlines; and large trading companies, such as Phibro, Enron, Vitol, Louis Dreyfus, and El Paso. BRS has also developed hedging strategies for hedge funds.
Robert Boslego has authored numerous articles regarding energy price risk management and wrote the chapter on risk management for Energy Futures, published in 1990 and 2000, and edited by the former president of the New York Mercantile Exchange (NYMEX).
As strictly an advisor, BRS has no conflict of interest in making recommendations since it will not profit as a result of which transactions occur.
Robert is an accredited member of Lee Enterprises Consulting (LEC), the world’s premier bioeconomy consulting group. Robert offers hedge strategy services through LEC to the renewable fuels industry.
