Risk Management Issues and Challenges for Starch-based Ethanol Biorefineries, Part II
AgMRC Renewable Energy Newsletter
Professor of Economics and Energy Economist
Ag Marketing Resources Center
Iowa State University
Last month we reviewed the profitability of ethanol production for the last few years and looked at several issues related to risk management for corn-starch ethanol plants. We noted that in the early part of the recent rapid expansion in fuel ethanol production, corn prices did not follow a close relationship with ethanol prices. In part of that period, managers of ethanol plants reaped large profits by focusing on the ethanol market and doing little or nothing to manage corn price risks. Later in the expansion period, as ethanol demand became a very significant contributor to the demand for corn, the cost of corn tended to fluctuate with the volume of corn used by the ethanol industry and with ethanol prices. However, corn prices also are strongly influenced by weather, crop conditions, and other factors and at times are not closely related to the ethanol market.
Very high and upward-trending energy prices for several months as well as concern about late corn plantings, tight grain supplies, and possible below-normal yields for U.S. corn in 2008 led some management teams to focus primarily on locking in the cost of corn. Logic behind the decisions included expectations that further increases in energy prices would strengthen the corn market and that if corn prices were locked in, the plant would increase its profitability as crude oil, gasoline, and ethanol prices continued to increase. Concern about the possibility of low corn yields also was an additional motivation to lock in corn prices. This was done with traditional corn contracts based on the futures market, as well as new types of corn contracts that used sales of options contracts. Some of these new contracts were not well suited for or tested in extremely volatile markets.
At the same time, a number of other ethanol producers relied mainly on spot prices for the pricing corn, natural gas, ethanol, and distillers grains (DGS). These different risk-management strategies generated very different net returns. For example, later in 2008, as corn yield prospects improved and global energy prices declined sharply, the cost of corn fell along with the price for ethanol and natural gas. Natural gas is a commonly used energy source for ethanol plants.
Ethanol firms that locked in their corn costs at early summer 2008 prices were forced to absorb very expensive corn, were unable to benefit from the sharply lower cost of corn, and at the same time were faced with drastic declines in ethanol and distillers grains prices. In this environment, a large number of ethanol firms were forced into bankruptcy as their costs for corn greatly exceeded the returns available from ethanol and its co-product, distillers grains. However, a number of other firms remained financially solvent during this period and even generated positive returns. Typically, these were operations that had chosen to rely on spot markets for the inputs and outputs of their plants, or had chosen to lock in profitable margins for producing ethanol rather than locking in just one part of the profit equation. The extent of financial pressures also varied from one firm to another, depending on debt-equity levels, plant efficiencies, and other factors.
As the starch-based ethanol industry moved into a more mature stage of growth, and with the widespread bankruptcies of the past 14 months, it has become apparent that the era of extreme profitability was temporary, and that a shift of risk-management focus from managing the individual components of ethanol profit margins to management of the processing margin is necessary for survival and longer-term profitability. Also, it will be important to look very carefully at the risk-management and risk-exposure features of new pricing tools as they evolve in the future.
Important questions to ask when considering new pricing tools include;
- how might this tool perform with extreme price volatility?
- will it unexpectedly increase the volume of my purchase and/or sales commitments?
- what additional financial obligations might it incur if prices move up or down sharply?
- is it traded on a reputable organized commodity exchange?
- if another party is involved in the contract (in addition to brokers and a commodity exchange), how reliable might that other party be in times of extreme market volatility?
Similarity to Risk-Management in Soybean Processing
There are a number of similarities between the risk-management approaches that have evolved over decades for the soybean processing industry and the emerging needs of corn-starch ethanol plants. For soybean processors, beans are crushed and processed into two co-products, soybean oil and meal. Hence, returns for doing so have been given the nick-name, “crush” or “crushing margins”.
The soybean processing industry has long been accustomed to managing and protecting the crush, rather than managing individual components of the crush separately. That involves simultaneously managing soybean, soybean oil, and soybean meal prices rather than dealing with each market individually. Important differences between risk-management for soybean processing and ethanol production center around the more mature state of pricing tools available for the soybean industry vs. relatively new and still evolving pricing tools for ethanol and distillers grains.
Management of soybean processing risks also requires careful study and continual analysis of basis behavior (differential between local spot market prices for soybeans and products vs. the futures market). The basis typically is more predictable and less variable than either the spot market or futures prices.
Because most input and output pricing tools are linked to futures markets, the risk-management team for an ethanol biorefinery also is faced with the challenge of understanding and monitoring basis behavior in local corn, DGS, ethanol, and natural gas markets. The most important of these are corn and ethanol since they involve the highest cost and largest source of revenue for the bio-refinery. Management of DGS markets can be a significant swing factor in ethanol profitability at times. Also, in areas where milo is available as an alternative feedstock vs. corn, the relationship between the two grains and potential impacts on profits become important.
Financial Management and Pricing Considerations
With the potential for large volatility in the energy and corn markets, careful incorporation of an ethanol firm’s financial structure and cash-flow management needs into risk-management decisions is important. Firms with higher debt-servicing requirements and lower equity have less ability to withstand periods of depressed returns than those with little or no debt. The high-debt firms at times may find it necessary to lock in very modest but positive processing margins to avoid the risk of losses that might jeopardize the firm’s financial position. At the same time, a debt-free firm might decide to rely on spot markets and wait for better returns later on because its debt-free status enables it to withstand a short period of negative returns if prices should move adversely.
Charts of ethanol profitability in earlier articles were based on an accounting approach in which assets are depreciated and interest is charged on invested capital. This approach is very important for investment decisions and for tax purposes. From a risk-management perspective, it is also useful to use a cash-flow analysis. We use this approach to determine the minimum gross margin needed to meet all variable costs and debt repayment obligations. With this approach, focus is on cash expenditures needed to cover feedstocks, plant utilities, labor, salaries, taxes, other cash expenditures, and required debt payments. If these items are not covered, the firm’s equity will be reduced. In managing risks, this margin can then be compared with the margin being offered by the market for purchases of corn and delivery of ethanol at various future times.
Cash-flow break-even prices for ethanol will vary from one ethanol firm to another. They depend significantly on the amount of outstanding debt per unit of ethanol production capacity as well as interest rates, length of maturity of the financing, and any obligations for payment of dividends to stockholders. Because of the huge dominance of the cost of corn as the largest expense in producing ethanol, the financing impact is significant but not as large as some might expect. For example, a 100 million gallon ethanol plant operating at 120% of rated capacity with a $3.50 per bushel average corn cost would incur about $150 million in annual outlays for feedstock purchases. This same plant, with a debt of $106 million amortized with 10-year financing at 8.5% interest would have annual financing costs of about $16 million.
Net Cash Flow with Varying Debt Levels
Figure 1 shows the simulated net cash flow since January 2005 for an example northern Iowa ethanol plant with financing levels of 50%, 25%, and zero percent of the original plant cost, including operating capital. Details of this AgMRC model plant are available. Our model plant was built in 2006, has a name-plate capacity of 100 million gallons annually, operates at 120% of rated capacity, produces 2.8 gallons of ethanol per bushel, and uses 3.5 gallons of water per bushel. For additional details, check the web site. The net cash-flow is based on local spot prices for all inputs and outputs. For the plant with 50% financing, debt at the beginning of operations was $105,623,500. Net cash-flow results for actual operating plants may vary from those of our model plants, depending on plant efficiency, operating percentage of capacity, transportation cost and availability, local basis for inputs and outputs, and other factors.
Note that since January 2005, the lowest net cash flow, based on spot market prices was reached in May 2009. Our analysis shows a net cash-flow at that time of -$0.27 per gallon for the plant with 50% debt, vs. -$0.01 per gallon for the debt-free plant. The plant with 25% financing incurred a net cash-flow of -$0.14 per gallon. To put these differences in perspective, if the same returns had continued for five months, the plant with 50% debt would have reduced its equity by $13.5 million vs. $7.0 million for the plant with 25% financing. The debt-free plant would have incurred a $0.5 million reduction in equity. These differences are important and must be considered in developing a risk-management strategy and in making day-to-day risk-management and input-output pricing decisions. However, depending on market volatility, their impact may be significantly smaller than that from feedstock and ethanol price variations. For example, a $0.60 per bushel change in the corn price paid over the same period would generate a $10.7 million change in net cash-flow, provided all other profit-influencing factors remain unchanged. Over the past 18 months, fluctuations in corn prices have been much larger than this. As an example, corn prices fluctuated in a $1.07 per bushel range from September 9, 2009 to October 23, 2009, leading to a change in cash-flow of $0.38 per gallon of ethanol. (1) Over a 5 month period, if prices continued at the top end of this range, net cash flow at our example plant would be reduced by $19.1 million vs. the lower corn prices. A $0.50 per gallon change in the price of ethanol over a 5-month period would generate a $25 million change in net cash-flow for our example plant. Over the past 18 months, ethanol prices also have varied in a considerably wider range than this. For example, from early July to early December of last year, ethanol prices fluctuated in a $1.30 per gallon range. So far this year, they have fluctuated in a $0.52 per gallon range. (2)
In short, effective risk-management for starch-based ethanol plants involves both a thorough analysis of the firm’s financial position and careful management of the processing margin, with simultaneous pricing of inputs and outputs.
Debt Causes Leveraging of Returns
Debt financing has both positive and negative impacts on the ethanol business. It allows the management team to leverage the firm’s equity with outside dollars from lenders. When profits are good, the small amount of equity per gallon of ethanol output produces a very large return on investment. But conversely, when profits turn to losses, the rate of return on equity capital can quickly shift to a large negative figure. That is illustrated in Figure 2, which shows the annual rate of return on equity for three selected time periods since mid-2006. The results are shown for four different debt levels on our model plant: 50%, 25%, 10%, and a debt-free ethanol plant. In July 2006, ethanol prices moved to very high levels in response to a halt of MTBE production. Petroleum-derived MTBE had been the main oxygen-enhancing additive used in gasoline to meet clean air standards, and ethanol became the primary source of a replacement. At the same time, corn prices were low. For the firm with 50% debt, the rate of return on equity capital surged to a very impressive 177 annual percentage rate. In contrast, the rate of return for a debt-free firm was a more modest but still very favorable 103%. The other extreme in Figure 2 is May 2009. That was a time of moderately high corn prices – brought on partly by concern about 2008 crop prospects – and low prices for all types of energy, including ethanol. That combination sharply reduced the profitability of ethanol production. For the firm with 50% debt, the annualized rate of return on equity capital fell to a negative 31%. For the debt-free firm, return on equity was -0.6%.
Managing the Processing Margin
Figure 3 affirms the conclusion that, while debt levels must be incorporated in a risk-management strategy, an ethanol firm’s greatest risk-management challenge is management of its processing margin. The net cash-flows in Figure 3 are for the same model plant described above, with the same debt levels and with natural gas, ethanol, and distillers grains priced in the spot market. However, corn prices were locked in at the June 2008 level through March 2009. After March 2009, corn prices were shifted back to the spot market. For the firm with 50% debt, net negative cash-flows for December 2008 and January 2009 were $1.05 and $1.00 per gallon of ethanol, respectively. Net cash-flows per gallon of ethanol for the other debt levels and months of this period are shown in the table below. If our example plants had been able to operate at 120% of rated capacity over the entire June 2008-March 2009 period, their cumulative cash-flow deficits would have been $624.2 million for the plant with 50% debt, $564.5 million for the 25% debt example, and $491.6 million for the formerly debt-free plant. With the original plant cost at $211.2 million and with $105.6 million of equity, it is apparent that these magnitudes of losses would push the firm into bankruptcy within a very short period of time.
Net Cash-Flows/Gal. of Ethanol for North Iowa Model Ethanol Plants with Varying Debt Levels,
|Debt Level||Dec. 2008||Jan. 2009||Feb. 2009||March 2009|
Impact of Variations in Operating Percent of Capacity on Net Cash-Flows
Even though many ethanol plants have the physical ability to operate at 120% of rated capacity, there may be times when the plant is not operated that intensely. If so, fixed costs and cash-flow commitments are spread over fewer gallons of ethanol and the cost per gallon increases. Figure 4 shows the net cash-flows per gallon since January 2005 for our example northern Iowa 100 million gallon ethanol plant with 50% debt financing and producing at 100% and 120% of rated capacity. The difference in net cash-flow is five to six cents per gallon when the plant is operating at only 100% of rated capacity. That could be quite significant to the financial performance of the plant during periods of tight margins. However, it has less impact on the bottom line than other dimensions of risk management discussed above. From a leveraging perspective, operating at 120% of rated capacity rather than 100% increases the return (or loss) on equity, thus substantially enhancing the attractiveness to investors in good times.
Risk management for starch-based ethanol plants is a complex and extremely important challenge for the management team. It includes careful attention to maximizing plant operating efficiency, recognizing the extent of firm’s financial ability to bear negative returns if market conditions should bring that about, and carefully developing on-going strategies to protect the processing margin. Protecting the processing margin involves locking in favorable net returns with simultaneous pricing of all components of the margin when they are available and company finances indicate the firm is not in a position to absorb the risk of lower returns. The past two years have been an excellent illustration of the importance of risk management for ethanol firms. Many firms in the industry have found their risk management strategies to be woefully inadequate for the volatility of the corn and energy markets, and have been forced into bankruptcy. At the same time, a number of other firms have been able to adjust risk-management strategies to deal with extreme market volatility, avoid major financial problems, and move forward with a long-term growth strategy.
1 Price data are based on daily Chicago Board of Trade high and low prices for pit-traded December 2009 corn futures that were obtained from TFC Charts. Cash or spot market prices at individual ethanol plants may have varied slightly more or less than this, depending on basis behavior.
2 Prices were near-by CME Group ethanol futures prices obtained.