Do Ethanol Returns Serve as a Hedge Against Low Corn Prices?
AgMRC Renewable Energy & Climate Change Newsletter
Iowa State University
Two decades ago emerging corn ethanol production businesses were looking for investors. Many of them focused on local corn farmers. This was logical since corn farmers were in a position to benefit from ethanol production, not only as investors but from an expanded usage of corn. The processing of corn into ethanol would result in a reduction of excess corn stocks and increase corn price locally (improved corn basis) and nationally (higher futures prices).
An additional benefit touted by many farmer investors was that an investment in an ethanol production business could provide a “hedge” against low corn prices. Low corn price results in little returns from corn production. But low corn prices can result in high ethanol production returns because corn is the major feedstock for ethanol production. So, an investment in an ethanol production business may provide a mechanism for corn farmer investors to maintain a relatively healthy level of returns when corn prices are low. On the other hand, high corn prices will squeeze ethanol margins resulting in low returns from ethanol production. But high corn prices will result in high returns from corn production. So, there is little need to supplement corn returns with ethanol returns to produce a relatively high level of overall returns for the corn farmer investor. We might call this concept the “ethanol hedge”. But does it work?
A track record of the accuracy of the ethanol hedge is provided in Figure 1. The net return from corn production is shown along with the net return from ethanol production. Total net return is the combination of corn net return and ethanol net return. In other words, total net return represents the net return from the corn/ethanol supply chain.
Total return is the return to a farmer who raises corn but has also invested in ethanol production. More specifically, a level of ethanol production investment where every bushel of corn produced is matched by a bushel of corn processed into ethanol. By contrast, corn net return is the return of a corn farmer who does not have an investment in ethanol production.
During 2013 and so far in 2014 it can be seen that the ethanol hedge has worked as expected. As the return to corn production declined, the return on the ethanol investment rose, maintaining total return close to the 2012 level. Similar results can be seen during the 2006 through 2008 time period. Initial high return on the ethanol investment supplemented low corn returns. As the return from corn production increased, the return on the ethanol investment declined, leaving total return relatively strong.
However, the ethanol hedge failed during the 2009 and 2010 period. As the return from corn production declined in 2009, the return from the ethanol investment did not rise sufficiently to offset the decline. So, the corn farmer who made an investment in ethanol production did not fare much better than the corn farmer who did not made an ethanol investment.
The factor that determines the viability of the ethanol hedge is ethanol price. As long as ethanol price remains strong, the return to the ethanol supply chain (corn return plus ethanol return) is strong. Corn price determines whether these returns accrue to the corn farmer or the ethanol producer.
The ethanol price/ethanol hedge relationship can be seen with the assistance of Figure 2 which shows the revenue generated from ethanol production. The ethanol hedge worked during periods of generally strong ethanol price (2013 to the present and 2006 through 2008). The ethanol hedge did not work when ethanol price was low (2009 and 2010). During this period, the ethanol supply chain provided a low return. The return to both corn production and ethanol production was minimal regardless of the level of corn price.
Looking to the Future
So, the future viability of the ethanol hedge depends heavily on future ethanol price. A snapshot of the current ethanol situation is shown in Figure 3. Production and consumption of ethanol remain in relative balance with a slight increase in net exports. This has resulted in a gradual reduction in ethanol stocks which has helped support ethanol price. However, future ethanol usage and price remains clouded due to the “blend wall” and other transportation fuel issues. Future articles in this newsletter will address these issues and provide in depth analysis of the supply, usage, stocks and prices of ethanol, crude oil and other transportation fuels.
Source: Energy Information Agency
Supply, usage and price for corn are presented in Table 1. Corn price for the remainder of the current marketing year and next marketing year are expected to remain low relative to the previous marketing year. A rebound in corn yield is providing a large supply of corn, an increase in carryover stocks and lower price. However, a significant weather induced reduction in corn yield will result in a lower supply of corn and a higher corn price.
Table 1. Corn Balance Sheet
| Harvested Acres (mil.)
| Yield (per acre)
| Production (mil. bu.)
| Beginning Carryover
| Total Supply
|Total Usage (mil. bu.)
| Feed & Residual
| Ethanol & DGS
| Food, Ind. & Seed
| Total Usage
| Million Bushels
|Selling Price ($/bu.)
| U.S. Avg. Farm Price
From this information it appears that the ethanol hedge will work in the near future with ethanol production return staying strong and corn production return remaining depressed. However, the intermediate and long-term situation contains considerable uncertainty as indicated above.
Corn farmers who have a level of investment in ethanol production to match their corn production are surviving the current period of low corn price relatively well due to the “ethanol hedge”. Conversely, corn farmers without an ethanol investment are bearing the brunt of the low corn price. However, the ethanol hedge only works when ethanol price is strong. In situations where the ethanol price has declined, return to the entire ethanol supply chain (ethanol production and corn production) suffers and the ethanol return does not compensate for the low corn return.
There are probably few corn farmers who have their entire corn production covered by an investment in ethanol production. The more realistic situation is corn farmers who have only a portion of their corn production covered. So, a portion of corn production is hedged from an investment in ethanol production (the return is dependent on ethanol price) and the remaining corn is not hedged (the return is dependent on corn price). Actually this can be considered as another risk management strategy called diversification. Ethanol price is determined by factors in the energy market. Corn price is determined by factors in the food market (although corn as an ethanol feedstock has made corn price also responsive to the energy market).