May 23, 2023
What is the Ethanol Margin Management tool?
Ethanol margin management is the commodity hedging process of analyzing financial risk exposure from the perspective of an overall profit margin approach, considering costs and revenues together as a single unit of risk in the ethanol industry. This differs from a more traditional approach which focuses on minimizing plant expenses and maximizing revenue from ethanol and co-product sales independent of one another. A margin management process in the ethanol industry involves modeling forward projected costs and revenues using the futures market as a price discovery mechanism. As an example, corn prices would be the main cost of producing corn ethanol, which along with natural gas to fuel the plant consists of a large share of total inputs. On the revenue side, ethanol, DDG’s and corn oil would constitute the outputs of the plant.
Acceptable Profit Margins
Holding certain fixed cost assumptions static in ethanol production and using futures market prices to represent both input costs and revenue values together, forward profit margin opportunities can be identified in deferred time periods to indicate how profitability is projected to change from one period to the next. This is beneficial by itself in providing greater visibility to an ethanol company on how the market as an unbiased estimate of price is valuing both input costs and revenue value in a profit margin context. In addition to this though, because the futures market also provides a risk transfer function, an ethanol plant can contract both input costs and revenue values simultaneously using exchange-traded derivatives to lock-in or protect a profit margin level in a forward time period.
This can significantly add value to a corn ethanol production facility by improving planning and budgeting, assist with lender discussions and smooth out volatility in returns over time. Moreover, it may sometimes be the case that a projected forward profit margin opportunity identified in advance may turn into an actual loss in the spot marketing period as market conditions, like corn price risks, change over time. In other words, should input costs increase from what is projected today and/or revenue values decline it may be beneficial to capture or protect the opportunity in advance.
Risk Management Strategies
As an example, if it is currently Q2 and an ethanol plant is concerned about margin deterioration toward the end of the year in Q4 after the summer driving season ends with a potential slowdown in demand, the plant could proactively manage Q4 margins ahead of time by locking in or protecting forward values in the futures market.
December corn prices futures would represent the benchmark spot corn prices in Q4 and be the reference price for corn input costs to the plant during that period. If the plant were concerned that input costs might spike over the summer through the fall due to poor weather negatively impacting crop yields, stronger demand or other reasons, the price could be secured ahead of time by purchasing futures contracts on the exchange. Similarly, call options might be used instead of futures to protect against higher corn prices while preserving the opportunity to benefit from lower spot corn prices should market prices decline into Q4. These strategies could also be considered to protect natural gas prices as an input cost to the plant.
On the revenue side, October, November, and December Chicago Platts ethanol futures would be the benchmark prices for spot ethanol in Q4, and thus the reference price used to establish sale values for the plant in that part of the year. These forward sale prices could be protected by selling futures contracts to lock in those prices ahead of time and eliminate the risk of potentially lower prices through the fall. Alternatively, the ethanol plant might choose to purchase put options to protect against the possibility of lower prices while preserving the opportunity to participate in higher prices should ethanol prices increase through year-end. While futures contracts do not exist for co-products such as DDG’s and corn oil, forward sales could potentially be established with local counterparties to lock in prices ahead of time for Q4 to secure those revenues.
To determine whether it may be beneficial to establish or protect plant margins and profitability in advance, a margin model needs to be built so profit margins for a given ethanol production period such as Q4 can be followed, and then ranked within a historical context. This allows an ethanol plant to evaluate the profit margin opportunity within an objective context by analyzing how relatively strong or weak the opportunity is from a historical perspective. This can help give direction to the contracting choices an ethanol plant may want to consider in potentially locking in or protecting a margin opportunity.
For example, if the projected margin opportunity for Q4 ranks very high historically, perhaps at the 95th percentile or higher within the past 10 years, it may be prudent for the plant to simply lock in revenue and input costs simultaneously using futures contracts. If instead projected plant margins are profitable but not as historically strong, maybe ranking at the 80th percentile within the past decade, the plant may instead choose to protect profitability by using option contracts to preserve the opportunity for margins to hopefully improve over time.
In addition to price considerations, basis represents another risk that could negatively impact forward plant margins and profitability. If for example a drought were to impact corn yield over the summer, particularly within the local area of the plant’s draw, cash prices may spike beyond the movement of the futures board, adding increased cost for the plant sourcing corn from local producers. The ethanol plant might choose to proactively secure supply ahead of time from local growers by establishing a grain origination program to encourage forward sales and supply commitments from that supply pool. Offering growers myriad contracting alternatives with flexible pricing features could potentially overcome resistance to contract ahead of time and reduce the plant’s exposure to the spot market.
While many ethanol plants may choose to remain in the spot market and realize margins as they are discovered from one period to the next, ethanol margin management presents a unique way of analyzing financial risk and should be seriously considered as part of a strategic business plan.