Hedging Against Rising Corn Prices using Corn Futures

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Hedging Against Rising Corn Prices using Corn Futures

In the world of biofuels, ethanol is king–the alcohol fuel is predicted to account for a full 9% of total US fuel usage within ten years. If this trend pans out, not only will ethanol production have met and surpassed Bush’s proposed goal of 14 billion gal/year of ethanol (enough to replace 75% of oil imports from Middle East in 2025), it will have done so one decade ahead of plan. After the 9% benchmark, however, the future becomes more uncertain. A likely discontinuation of government ethanol subsidies will mean that ethanol’s price must drop to remain competitive against gasoline (which has about 40% more energy content per gallon).

Although the alcohol fuel can be produced from a number of different biomass stocks (including wheat, sugar cane, and beets), in the United States, corn-based ethanol remains the most prominent possibility. (Brazil remains the world’s largest producer of ethanol, distilling it from sugarcane for use within the country.) Strong corn-growing conditions in the US breadbasket and relative familiarity with the corn-ethanol production process mean that corn is probably the most efficient and feasible staple biomass stock for the fuel. But corn ethanol is not without its challengers–recently, cellulosic ethanol has also been receiving increasing amounts of media attention (and research dollars). Bio-butanol is anther up-and-comer that threatens the corn-based camp’s hold on American biofuel.

Who wins?

  • ADM and Bunge are among the biggest winners from the ethanol boom: agricultural processors and agribusinesses. With massive resources at their disposal, ADM and Bunge can easily shift their focuses to corn planting and processing to maximize the effects of a coming ethanol glow.
  • Pacific Ethanol (PEIX), Andersons (ANDE), VeraSun Energy (VSE), and MGP Ingredients (MGPI) are all big players in the ethanol industry. (Some of these companies do have operations in other biofuel areas as well, however.)
  • Deere and Agrium (agricultural supply products), and Mosaic, Potash Corp, and Terra (fertilizer/nitrogen products) may also find their products in higher demand if corn prices hike.
  • Monsanto and other agrochemical/genetically modified seed companies that target corn crops may also feel the positive effects of an ethanol boom. GM giant Monsanto is already engineering strains of high-starch corn that will maximize ethanol yields; if corn ethanol truly takes off, Monsanto’s ethanol-maximizing corn will be sure to come along for the ride.
  • AGCO (AG) and Deere & Company (DE) who make agricultural equipment which is used for farming corn.

Who loses?

  • Delta and Pine Land Company (DLP) and other American companies that rely heavily on soybean demand will suffer, processors and seed companies alike. The sharp spike in US corn acreage due to corn ethanol’s growing popularity would come at the expense of existing agricultural acreage–most likely the soybean crop. (The US is currently the world’s leading producer of soybeans, at almost 40% of total soybeans produced.) So while agribusinesses themselves can switch crop emphasis and move into the lucrative corn business, companies which rely exclusively on soybeans (processing, products etc.) will find themselves in a more difficult situation as the soybean slack is picked up by Brazil.

  • DuPont and other companies that have invested heavily in other biofuels may also suffer. With its extensive investment in both bio-butanol and cellulosic ethanol research, DuPont is one such example (despite having its own strains of pest-resistant corn).
  • Ford, DaimlerChrysler, and other Auto Makers who have missed the boat on flex fuel or alternative fuel cars may find themselves in an increasingly difficult market, as consumer trends turn more and more towards biofuel-capable vehicles. In general, American automakers seem to be trailing the most (possible exception: GM, struggling with possible bankruptcy but currently leading the US drive for flex fuel cars).
  • As with the development of any renewable energy source, companies engaged in the exploration and production of oil will lose as ethanol becomes increasingly competitive. This includes companies engaged in exploration, production, and refining such as Exxon Mobil (XOM) and BP (BP) and also companies engaged in contract drilling such as Transocean (RIG) and Hercules Offshore (HERO).
  • Companies that purchase large amounts of corn will have to bear the steep (and still rising) price of corn, especially if corn ethanol catches on worldwide. This could affect the bottom line of producers of everything from meat products (livestock) to cereals.

Introduction to corn ethanol

Ethanol production

Corn ethanol is produced in two different kinds of mills, dry and wet:

  • Dry corn mills are generally less expensive to build (about $1/gal of annual production capacity less than wet mills). However, dry mills also uses more energy than wet mills, and also spend more in net corn costs. Dry mills account for 75% of all current US ethanol production (and nearly all of recent ethanol growth), and many of them are owned by small cooperatives of independent farmers. Marketable byproducts include dry distillers grains (DDG, used as animal feed), flakes, grits, and captured CO2.
  • Wet corn mills are more expensive to build, but generally spend less on energy (largely because they don’t have to dry distillers grains for DDG livestock feed production) and recapture more of their initial corn spending by selling higher-revenue byproducts like high fructose corn syrup. (Other byproducts include dextrose, starches, corn meal/feed, and corn oil.) Wet corn mills are owned almost exclusively by large corn processing companies, with most wet mills belonging to Archer-Daniels-Midland Company (ADM). As corn ethanol production’s emergence as a high-profit and high-profile industry attracts more big-business participation, wet mill production may pick up.

The energy costs of ethanol production vary depending on whether natural gas or coal is used. Mills are increasingly turning to coal in an effort to cut themselves free from fluctuating/rising natural gas prices.

  • In order of production cost efficiency, with least expensive (most profitable) first: dry mill with coal, wet mill with coal, wet mill with gas, and dry mill with gas.

With corn prices through the roof, VeraSun Energy has delayed the opening of two completed ethanol plants, citing concerns shrinking margins. [1]

Is corn ethanol a net energy loss?

If you’ve read about ethanol, you’ve probably heard it before–apparently, corn ethanol’s energy content is “negative,” due to the amount of gasoline and other energy sources consumed in its production. But the 1995 USDA report cited [1] for this discovery has since been very decisively corrected.

The original authors of the 1995 report published in 2002 a second USDA study [2] which reversed the results, showing that even from conservative estimates (excluding energy credits from reselling CO2, for instance), ethanol was a net energy gain–for every Btu used for ethanol production, 1.34 Btu of ethanol energy is created. Furthermore, liquid fuels actually make up only 17% of the energy used to produce ethanol; for every 1 Btu of liquid fuel used, 6.34 Btu of ethanol energy is produced. The Pimental studies of ethanol as “subsidized food-burning” have been similarly disproved, with the inaccurate results attributed to data 20+ years old. [3]. Two studies published in early 2008, in Science, however, have rekindled doubts about ethanol. According to the studies, ethanol can actually drastically increase CO2 emissions, when land use is taken into account. Farmers have been clearing grass lands and rain forest in order to grow additional corn crops. In doing so they release large quantities of CO2, enough to outweigh the C02 savings of burning ethanol, by a factor of hundreds.

A 2008 report by the University of Nebraska shows that ethanol production now has a net energy gain of 1.5-1.6 units of energy out to every unit in. Furthermore, it shows that 13 gallons of ethanol are produced for each gallon of petroleum put in. [2]

Understanding fuel types

Ethanol fuels are available in a number of different mixtures, but are rarely used pure. Ethanol is most commonly used as an additive (2-10%) in fuel mixtures; not only is government-subsidized ethanol cheaper than gas, but it also reduces harmful emissions when included in gas mixtures.

  • E10 fuel uses ethanol as an additive (10%) to unleaded gas. At this concentration, most consumers can’t notice any difference in the performance of E10 and normal gasoline fuel.
  • E85 fuel is 85% ethanol. It can be used both by flex fuel vehicles (“flexible fuel vehicles,” capable of running on E85, E10, or normal unleaded gasoline) and by “alternative fuel vehicles” specially equipped to run on E85 and E85 only.

Pricing and Dependencies

In 2006, ethanol was selling for $4 a gallon, considered to be far too expensive to used as a gasoline substitute. Now, the price has dropped to $1.50 a gallon, and detractors claim that the low price makes it unprofitable for producers. The price fall can be attributed to investment money pouring into the Midwest and causing production to skyrocket. While prices have fallen to levels where production appears unsustainable, the new price in comparison with oil prices could help drive the fuel to gain greater market acceptance, as government subsidies and continued investment attempt to develop a shift in vehicular fuels.

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A great deal of ethanol’s current success can be attributed to governmental subsidies of ethanol, making each gallon used by refiners for gasoline blends eligible for a $0.51 tax return. This means that ethanol can be sold at a sizable premium to regular gasoline as long as the premium is still less than the subsidy (most ethanol sells at a $0.46 premium). This situation will likely persist until ethanol hits the 9% dilution benchmark and most gasoline sold is an E10 blend. After that point, for ethanol to make further gains, higher-ethanol content fuels like E85 must make sizeable progress as a standalone gasoline substitute. But ethanol’s significantly lower energy content and thus lower miles per gallon means that consumers will be willing to pay significantly less for E85; when these lower profits are passed from gas stations to refiners and from refiners to ethanol producers, the ethanol-to-gasoline premium may narrow or even disappear. At the same time, since ethanol is highly corrosive, many cars are not equipped to run on E85, and special storage tanks and transportation systems must be built for the distribution and use of high-ethanol content fuels.

As long as ethanol remains primarily an additive fuel, its price will probably remain premium-driven and thus heavily dependent on the price of gasoline. But while higher gas prices may mean higher revenue for ethanol producers, many producers’ need for gasoline energy in the distillation process could minimize or eliminate these benefits. So if gas prices soar, ethanol companies with heavy investing in coal-based mills would have the most to gain.

Corn ethanol production also relies on having massive amounts of corn. With current corn ethanol production already pushing corn prices up, a ceilingless increase could be problematic for ethanol producers, making ethanol production less appealing for new entrants and dropping or slowing corn demand until possible price seesawing settles into sustainability.

The “corn crush” is the difference between earnings from ethanol and the price of corn. It can be measured using the equation

In June 2006, when ethanol sold for nearly $4 per gallon and corn cost $2.35 per bushel, the crush was $8.42. The crush is now around a dollar, only because ethanol prices are rising; at its lowest in the past few years, it was just $0.53. [3] The crush represents profitability; because corn is so expensive and ethanol is rather cheap, the crush is low, albeit rising.

Hedging Against Rising Corn Prices Leaves Ethanol Companies Vulnerable During Commodities Downturns

Many ethanol companies, ironically, are also exposed to falling corn prices, because of hedging against price cuts. VeraSun Energy went bankrupt in October 2008 because the company placed bets on rising corn prices once they hit $8 in June 2008. During the financial crisis of 2008, however, when commodities prices fell and the value of corn dropped by half, the company was left illiquid, unable to pay off its derivatives. [4]

Weather Can Hinder Development of Corn Ethanol

Corn production is heavily dependant on the weather which eventually determines the price of Corn Ethanol. For example, heavy flooding after a summer storm in Iowa wiped out a tenth of the state’s corn crop, sending July corn futures up nearly ten cents to $7.425/bushel and December corn futures up 11 cents to $7.76/bushel. [5]

The option of replanting corn that was damaged in May is dwindling as farmers are deciding whether they should replace their corn with a shorter growing season crop like soybeans. All ethanol producers can do now is desperately pray for sunshine as there is already a tight supply of corn available.

Government Intervention

The ethanol program is heavily subsidized by the government which mandates taxpayers support ethanol. It isn’t a surprise that food prices are rising when more than 25 percent of the corn grown today is taken out of the food supply and instead used for subsidized ethanol production. This subsidized program has the blessings of the Bush Government, which might not last with the advent of the new incumbent come 2009, with both McCain and Obama recognizing that government support for Ethanol has contributed heavily to increase in demand for corn.

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Declining White Sugar & Hogs; Rising Corn Futures

White sugar dropped to two-week low in London as prices tumbled in New York yesterday, signaling slowing demand. Prices also fell after the dollar rebounded, decreasing the attractiveness of commodities as a hedge against inflation. December delivery for white sugar dropped $13.10 (2.2 percent) to $571.40 per ton on the Liffe exchange.

Section II Basic Pricing Tools Chapter 10: Selling futures to hedge

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