Risk Management Issues and Challenges in Ethanol Production
AgMRC Renewable Energy Newsletter
Professor of Economics and Energy Economist
Ag Marketing Resources Center
Iowa State University
After a few years of extreme growth and large profit margins, the U.S. fuel ethanol industry has transitioned into a more mature stage. Growth opportunities are still present, but with the industry’s current size and potential impacts on the corn market through added demand from expansions, it has become a commodity processor. The era of double and triple digit returns on ethanol investment for significant periods of time appears to be behind us. As a result, cost and careful attention to risk management strategies have become essential for survival, profitability and growth of individual firms.
Ethanol refineries typically convert two commodities, corn and either natural gas or coal, into two value-added commodities, ethanol and distillers grains (DGS). Unlike industries whose products can be differentiated from those of other producers, ethanol processors use the same type of corn and natural gas as everyone else in the industry and produce the same type of ethanol, and for the most part, the same kind of DGS as everyone else. Accordingly, individual plants have little or no opportunity to influence the prices they pay for inputs or receive for their products, except through risk-management strategies. In this environment, risk-management considerations dictate that individual companies become managers of their processing margins rather than focusing on prices of individual components of those margins. That’s a sharp change from the 2004 to early 2007 period, when strong ethanol prices and low corn prices brought large returns.
In this article, we will provide an overview of the components of ethanol processing margins, a history of the margins, a partial view of the co-product (distillers grains) history, similarity to risk-management needs of the soybean processing industry and tools available for managing margins. Financial management is a closely linked element in this process; however, space does not permit us to touch on that aspect of risk management in the current article. We anticipate having more articles relating to risk management in future newsletters.
Recent History of Industry Size and Ethanol Processing Margins
Accelerated growth of the ethanol industry began in the 2002-03 corn processing year, as indicated in Figure 1 below. The industry’s growth accelerated sharply in 2005-06 when Methyl tert-butyl ether (MTBE) production was halted and ethanol processing margins increased sharply. MTBE was the petroleum-derived oxygen-enhancing additive used in gasoline to meet clean-air regulations. With the halt in its production, ethanol became the main oxygen-enhancing additive, thus opening up a large new market. Before 2005, corn use for ethanol was small enough that the industry could expand without being concerned about its own tendency to increase feedstock costs. During the pre-2005 period, fluctuations in ethanol prices were the most important variable influencing net returns and return on investment. With the industry expansion of the last few years, that is no longer the case. In the four-year period beginning in the fall of 2005, ethanol increased its share of total U.S. corn use including exports from 14.2 percent to 30.5 percent. Greatly increased corn price volatility has accompanied the increased processor demand, thus leading to large potential volatility in ethanol processing returns.
Figure 2 shows Ag Marketing Resource Center estimates of ethanol processing costs for a 100 million gallon per year dry mill plant in northern Iowa that converts corn to ethanol and dry distillers grains and solubles (DDGS). Costs shown are based on spot corn prices. The feedstock is by far the largest cost element in producing ethanol and was a relatively stable cost until 2006. For example, the feedstock cost was $0.62 per gallon in January 2005 and increased to a peak of $0.71 in July of that year.
From April through July of 2006, feedstock costs ranged from $0.71 to $0.73 cents per gallon, after reaching a low of $0.53 in October 2005. These are not insignificant feedstock cost fluctuations, but they pale in comparison with those of more recent years shown on the chart. From September 2006 to February 2007, estimated feedstock costs ranged from a low of $0.73 per gallon to a high of $1.37 – a range of $0.64 cents per gallon -- before falling back to a low of $1.10 in July 2007. Since that time, feedstock costs have fluctuated from a high of $2.30 in July 2008 to a low of $1.20 in December 2008. That is an incredibly large range of $1.10 per gallon.
Shift in Profit-Management Perspective
These large and unpredictable fluctuations in feedstock costs create a need for careful management of input and output cost risks. Soybean processors have faced a similar environment for many years and have focused on managing the crush margin. The crush margin is the difference between the cost of soybeans to the processor and the value of the soybean meal and oil. For the soybean processing industry, well-developed risk-management tools have evolved over many years in the form of soybean, soybean meal and soybean oil futures contracts and futures contract specifications that help to limit the extremes in basis fluctuations.
Basis is the difference between local prices paid by and received by the processor and the futures market prices. The basis can be influenced by local and regional supply and demand conditions that are not reflected in futures markets. It also can be influenced by transportation costs and other infrastructure developments, and may vary seasonally.
Management of the soybean crush margins does not guarantee continual profitability for processors. However, it narrows the risk exposure to basis fluctuations that historically have been much smaller than those for soybeans and soybean product futures prices. Basis changes also tend to be much more predictable than the level of prices.
The crush-management concept is beginning to emerge in the ethanol industry. Ethanol merchandisers and risk managers may find it increasingly necessary to “lock in” acceptable profit margins when they are available through swaps, forward contracts, the futures markets or some combination of these tools. If net margins offered by these tools are negative, the ethanol plant risk-management and merchandising team faces the difficult choice of (1) minimizing losses, staying open (unpriced on inputs and outputs) and taking whatever net result occurs through spot market prices for corn, natural gas, ethanol and distillers grain and waiting for an improvement in forward returns that will be offered later by the market, or (2) locking in negative returns to protect against the possibility of worse losses later on. This decision requires careful assessment of market risks and the ability of the ethanol firm to absorb short-term losses. Banks and other institutions financing ethanol refineries may also provide constraints that will dictate the need for well -designed risk-management policies. In some circumstances, it may be preferable to lock in a small short-term loss rather than expose the firm to risks that might put it out of business.
Historical Ethanol Net Margins
Figure 3 shows historical net ethanol processing margins as estimated by the AgMRC model for an example 100 million gallon per year plant in northern Iowa and corn costs, based on monthly average spot prices. The chart demonstrates that managing the corn cost without simultaneously managing other costs and returns does not stabilize profits. For example, the sharp decline in corn cost from August 2008 onward was actually accompanied by a decline in ethanol net margins that were based on spot market prices. Similarly, the sharp rise in corn prices in the first half of 2008 by itself did not produce the severe decline in profit margins that might have been expected intuitively.
Complications in Managing Forward Processing Margins
Managing ethanol processing margins involves managing (1) corn prices, (2) natural gas prices – unless the plant uses other energy sources, (3) ethanol prices and (4) distillers grain prices. This is a complex process, especially considering that pricing mechanisms for the two products of ethanol refineries are not as well developed as those for the inputs.
Futures markets have provided buyers with an effective tool for managing corn costs for decades, although futures do not precisely follow local cash or spot market fluctuations. The differential between these markets (the basis) has generally been much less variable than fluctuations in the level of prices. t also is generally easier for grain merchandisers to anticipate changes in the basis than in the level of prices. The corn basis has a distinct seasonal pattern, although its behavior and timing varies regionally. As a result, handlers and other corn users have relied heavily on futures contracts to manage risks of corn costs. Natural gas futures also are widely used in the gas, electric power and other industries to manage costs for that input. In contrast to management of input costs, management of price risks in markets for the products of ethanol plants can be a bit more complex.
Issues in Managing Distillers Grain (DGS) Price
In managing the price risk in the co-product market, one important question is whether DGS prices follow corn prices closely enough that they can be cross-hedged in corn futures contracts. Figure 4 shows 2006-09 marketing year Iowa and Illinois weekly prices for dry, modified (partially dried) and wet DGS, in dry-matter equivalent of corn. The prices are averaged across the four marketing years and the two states to give a single price for each month for each type of DGS. They are calculated as percentages of spot corn price paid by ethanol plants in the same region. Prices were obtained from the USDA Agricultural Marketing Service ethanol price reports. The chart shows a distinct seasonal pattern, with prices higher relative to corn early in the marketing year and tending to decline as the marketing year progresses. At first glance, it looks as though these price relationships might easily be used for cross-hedging DGS with corn futures. However, some cautions are appropriate.
First, this is a relatively short time period for comparison and is one in which output of DGS was expanding rapidly. The rapid expansion could be a factor in the seasonal downward pattern. The pattern may look a bit different in future years, with slower growth of the industry.
Secondly, it is important to look at individual-year variability within the three-year average. The dry distillers grains (DDGS) prices for individual years are shown in Figure 5. The chart in Figure 5 shows a great deal of variability in the relationship with corn prices. For example, in the 2007-08 marketing year, this co-product ranged in value from about 2.5 percent above corn on a dry-matter equivalent basis to 30 percent less than corn. The following year showed a range in values from about 6 percent under corn to about 39 percent less than the dry-matter equivalent of corn. For the portion of the 2006-07 marketing year for which data are available, prices for DDGS in a dry-matter equivalent of corn ranged from about 2 percent under corn prices to about 33 percent under corn. These individual years thus show somewhat more variability than the average pattern in Figure 4. With the combined years in Figure 4, DDGS prices ranged from a high of about 4 percent under corn to a low of about 25 percent under.
Implications of DGS price variability for risk management
This preliminary analysis of the relationship between DGS and corn prices identifies that control of DGS price risk is a serious challenge to risk managers of ethanol refineries. The large fluctuations in DGS prices relative to corn suggest that hedging DGS prices with corn futures is likely to leave more than desirable exposure to price risk. The preferred tool for managing risks in co-product prices in many cases appears to be forward contracts with users, when these are available. If the ethanol management team decides to hedge DGS with corn futures contracts, extremely careful attention to factors affecting the DGS basis will be required. Even then, this analysis suggests considerable risk will be involved.
In later articles, we plan to look at DGS price relationships by type of DGS and by individual states. It is likely that states with a large number of large cattle feedlots such as Nebraska and Kansas will have different wet DGS price behavior than areas where the predominant type of agriculture is cash grain farming. We also will examine potential cost savings from using milo (grain sorghum) vs. corn in areas where it is available, the relationship of milo prices to corn and the feasibility of protecting milo price risk with corn futures contracts.
With the evolution of the corn-based ethanol industry into a more mature stage, risk management has become critically important to individual firms and their investors. The large number of bankruptcies in the industry attest to this fact.
Risk management requires a shift of focus from prices of individual inputs and outputs to a focus on managing and protecting net margins. Possible tools for managing these risks include futures contracts, swaps and forward contracts with suppliers and users of the products. The tools for managing corn and natural gas price risks are well-developed and widely used by other firms, but management of price risks for the finished products is more challenging. This preliminary analysis suggests that substantial variability of the differential between corn and DGS prices will limit the potential for managing DGS price risks with corn futures contracts.