Ethanol Producer Magazine, ND
08-02-07
At the Corner of Jackson & LaSalle
After two years of offering services and products for ethanol, the Chicago Board
of Trade is helping stabilize the industry and hosting producers as they conduct
risk management operations, including long-term sales negotiations and grain
procurement. EPM visited the commodities market to the world in May to observe
the operation.
By Nicholas Zeman
There's energy in the air as one walks down LaSalle Street with trains speeding
by overhead and the statue of Ceres, the goddess of agriculture, perched fittingly
atop a magnificent building where the boulevard intersects with Jackson Street.
Named for the French explorer, Sieur De La Salle, who established important
trade routes on the Great Lakes and what is now present-day Chicago. LaSalle
Street leads right up to one of the world's leading commodities trade centers.
The Chicago Board of Trade's (CBOT) current home was built during the 1920s
and was the tallest building in the city for decades, symbolizing perhaps the
power of a company where agricultural commodities contracts from around the
world are still bought and sold. Inside on the trading floor is a sort of organized
chaos that goes on every weekday morning, a process that ethanol has been a
part of since March 2005. "Offering ethanol products was a natural extension of
CBOT's grain futures and options complex," says Jeff Campbell, CBOT ethanol
products manager. "We've established ourselves as a place the ethanol industry
looks to for a price-discovery mechanism."
In the spring, CBOT hosted a series of free seminars on risk management across
the Midwest to educate a diverse range of players in the ethanol value chain.
"We saw it as a very good way to provide information at a grass roots level,"
Campbell says. There was a good turnout with more than 180 registrants and a
lot of interest in the subjects discussed, indicating that some of CBOT's services
and the futures market are perhaps underutilized by the ethanol industry. "There
are really some misconceptions out there about some real basics, like how a
hedge works, or the specifics of the delivery process," Campbell says.
In order to increase risk management expertise, producers have a lot to gain
from learning how to play the futures markets. "Futures send a series of signals
that help ethanol producers manage their expectations," says David Swenson,
Iowa State University professor of economics. Ultimately, when playing the
futures market, plant managers, marketing agents and grain origination services
are making price bets based on certain factors inherent in supply and demand
economics.
This work was harder to do before CBOT began offering its services. CBOT
provides the process in which the price of a commodity is determined through an
analysis of various supply and demand characteristics. This is something that is
changing the industry. "It eliminates the strong gains and the sharp losses
[associated with the absence of strong price-discovery and sales mechanisms],
and is helping to stabilize the industry," Swenson says, referring to the extremes
that characterized ethanol deals in the summer of 2006.
Procuring Inputs, Ensuring Delivery
When it comes to corn, experts say the main factor to watch for is the weather
when attempting to predict future prices. Players like Greg Milkovich, a strategic
analyst for Lind-Waldock, a commodities brokerage firm in Chicago, are
constantly looking at precipitation across the Corn Belt and analyzing the USDA
estimates as they try to shield their clients from the volatility of the commodities
market. "Right now there's a lot of concern about drought in the eastern Corn
Belt," he says.
As many as 95 million acres of corn will be planted in the United States this year,
if current estimates are correct. Furthermore, with genetic improvements, the size
of the crop could dwarf other record years. But demand is expected to be strong
too, and the promise of high corn prices has lured acres away from other
commodities to supply the market. A variety of influences can affect corn futures
projections, including planting progress, drought and harvest conditions, all of
these are constantly tracked by commodities brokers.
While CBOT has almost always been the place to track corn prices, ethanol is a
relative newcomer to the trade floor. April was the biggest month so far for fuelalcohol futures trading at CBOT. Compared with corn, ethanol is a small market
as far as the number of contracts traded. If 53 contracts, however, are traded in a
day—at 29,000 gallons per contract—that is a significant number of gallons (1.1
million), Campbell says.
Contracts for different commodities trade in what are known as pits, in a process
called open outcry, which is essentially a public auction where bids are made
verbally. Ethanol futures are traded in a section of the corn pit. Not just pieces of
paper, futures contracts call for the arrival of the actual fuel on a specified date
agreed upon by the negotiating parties. Ethanol contract specifications call for
physical delivery by tank car, on track at a shipping origin with the seller
responsible for transporting the fuel to the buyer's destination. Once a deal is
reached, the buyer and seller have 48 hours to negotiate a freight rate. In other
words, ethanol is shipped directly from the buyer to the seller. Ethanol that's
classified for delivery as "regular" means that the plant supplying the renewable
fuel was inspected and approved by the exchange and the product is guaranteed
to meet ASTM specifications.
Ethanol facilities must meet several financial and physical requirements and be
inspected by CBOT officials that basically guarantees the legitimacy of the firms
that trade on its floor, or through its other electronic swap channels. "If you're
holding a contract [for an ethanol sale] and prices begin to fall, you don't have to
worry about performance because you have already been compensated,"
Campbell says, referring to CBOT's clearing services. "We're providing both
sides with more certainty." CBOT further observes that an effective delivery
process ensuring the orderly convergence of futures prices and cash values is
essential to the contract's risk transfer and price-discovery functions, and
eventually its success.
Tracking Trends, Linkages
Besides guaranteeing the legitimacy of ethanol firms, CBOT provides several
other important services that increase the strength of risk management
operations. The futures market, for instance, is where a plant can lock in prices
for inputs like natural gas and corn, so the plant isn't as susceptible to the
volatility that characterize commodities trading. "This allows plants to manage
supply without having to consistently bid on inputs through a spot basis, and from
being strictly tied to sales on the wholesale market," Swenson says. "Ultimately,
these guys are watching the weather and looking into the future and hoping they
are making the right bets."
Article Continues After AdvertisementBFA AA 6-21-07
Risk managers are usually looking for trends and associative factors that
influence the price of corn on the front-end and ethanol on the back-end.
Because ethanol is growing past its role as an oxygenate-blend component, its
price correlation with reformulated blendstock for oxygenate blending (RBOB) is
not as strong as it once was. Obviously, there are opportunities for growth, but
there are some problems too. "In the upcoming energy bill they're going to have
to step-up mandatory levels of ethanol usage or these next 18 months are going
to be a very interesting time for the ethanol business," says Jerry Gidel a grain
analyst with North American Risk Management Services Inc.
The aggressive build out of the industry is the main factor that could impact
ethanol prices as early as this fall. The overall absorption rate is much less than
10 percent, and with capacity soon to exceed that number, producers could be
looking to lock in long-term sales contracts as quickly as they can, thinking the
price will decline. "This is because they are anticipating supply to outstrip
demand," Swenson says.
In the past, producers have hedged against the price of unleaded gasoline or
crude oil but that is becoming more difficult. "With cheap corn and high ethanol
prices last year, running an ethanol plant was like running a printing press of
money," Campbell says, referring to the period when methyl tertiary-butyl ether
was being phased out as an oxygenate- blend component. At that time, the
ethanol industry had less capacity and the fuel was in great demand. The
circumstances have changed, however, considering the speed at which gallons
are coming on line.
Swenson argues that ethanol has never been tied to the price of gasoline. "It's a
very simple calculation, the price of ethanol is determined by the forces of supply
and demand [economics] as well as its energy value as a fuel," he says.
Theoretically, ethanol is worth two-thirds that of a gallon of gasoline, because of
the fuels respective British thermal unit content, so ethanol needs to be
considerably cheaper than its petroleum-based competition to realistically
compete in the market. If unleaded gasoline is priced at $2.40 and ethanol is
priced at $2.10, for instance, the oil companies are going to make more money if
they are blending higher percentages of ethanol for sale in retail markets.
"Energy firms don't do things that don't make them money," Gidel says.
In addition, the price of ethanol is not strongly tied to the price of corn, an opinion
which refutes a common misconception, Swenson says. In the end, the price of
corn is the producers' problem. The fact is, regardless of the price of the inputs,
ethanol has to remain cost competitive as a transportation fuel. This means that
it's hard for ethanol producers to pass on the costs of rising raw materials, which
often occurs in other sectors of manufacturing.
Nicholas Zeman is an Ethanol Producer Magazine staff writer. Reach him at
nzeman@bbibiofuels.com or (701) 746-8385.