Understanding Risk Management and Ethanol Trading

In the United States, the Energy Act of 2005, which established the Renewable Fuels Standard (RFS), and the Energy Independence and Security Act of 2007, passed in December, mandated increasing use of ethanol from 9 billion gal in 2008 in increasing increments to 36 billion gal in 2022. Brazil has revolutionized its own industry with the expansion of the flex-fuel vehicle fleet; ethanol production levels have increased to 5.8 billion gal for the last crop year, according to UNICA, the sugarcane industry union of Sao Paulo State. Increasing corn acreage in the United States as well as increasing amounts of sugarcane in Brazil are being allocated for the production of ethanol; simultaneously, other international programs to produce and consume fuel ethanol are being developed. This combined with new bullish fundamental dynamics in the world’s commodity markets have contributed to a bigger, more volatile market for ethanol.

As a result, the need for risk management practices to manage commodity price risk for feedstock inputs and forward sales of ethanol are crucial to ensure the stable growth of the industry as well as security of supply. With the increased mandates in the United States, it is important to manage the price risk associated with feedstock and ethanol output. Using ethanol derivatives is important for producers to have maximum flexibility in marketing their ethanol, locking in prices on a forward basis and managing inventories – it is important to lock in revenue streams to secure project finance. The derivatives are also important for ethanol blenders and consumers who need to price and hedge supply needs. For many reasons the efforts at creating these instruments have been challenging and incremental processes. However, risk management instruments and practices have increasingly evolved in the ethanol industry.

To understand what is happening with the development and use of ethanol futures, options and over-the-counter (OTC) contracts, it is helpful to get some sense of how these instruments have developed with other energy products. The New York Mercantile Exchange (Nymex) introduced a series of energy futures contracts instruments to provide price discovery and the ability to shift risk associated with the energy complex during its extended period of deregulation. Heating oil, crude oil and gasoline futures were developed during the deregulatory period of the late 1970s and early 1980s. With the deregulation of the natural gas industry in the 1980s, natural gas futures, options and the OTC market in basis swaps are essential tools the industry used. Similarly, with the deregulation of the power industry in the 1990s, futures markets were introduced but ultimately a highly flexible menu of OTC locational swaps was developed to help manage the risk of freely fluctuating prices in power. Coal futures and options followed as well as the associated emissions and weather markets, created by the CME.

The success of these instruments is measured by the liquidity they attract. They are designed to identify a standardized set of specifications, including physical specifications, delivery location, timing and method to attract the widest number of market participants. The ability to settle contracts with a physical delivery assures a close relationship with the underlying cash markets and convergence of the two at the time of delivery. Exchange traded futures and options are distinguished by the fact that these trades are cleared by the exchange clearing houses; the other side of every transaction becomes the exchange clearinghouse itself, comprised of member financial institutions, guaranteeing performance on the contracts.

In some cases, standardization of these terms and conditions worked well. The Henry Hub futures contract for natural gas, where gathering facilities, pipelines and production facilities converged, provided an excellent delivery point for the natural gas futures contract, attracting liquidity from a number of sectors. In the case of power, however, which is more difficult to standardize and futures contracts did not work well, specialized OTC swaps were created for a number of different time blocks and locations. In other cases, a vibrant OTC market developed in conjunction with an existing futures contract, such as with natural gas basis swaps whereby various locations are traded against the Henry Hub benchmark. For each instrument, the exchange attempted to find hubs and specifications that could serve as a benchmark to aggregate liquidity. This was difficult in some markets, such as power, which is sold in specific locations in discreet time units. Impossible to standardize to one set of specifications, an OTC market developed in swaps for customized locations and time periods. These instruments were traded bilaterally, meaning that unlike futures that were cleared on the respective exchanges, these trades were transacted with counterparties and each were exposed to the others’ credit risk.

This worked well until the demise of Enron. One of the biggest counterparties in the OTC swap markets in energy, its collapse caused a ripple effect in the performance of bilaterally traded derivatives, incrementally damaging the creditworthiness of all its counterparts on these derivatives.

New York Mercantile Exchange
The New York Mercantile Exchange responded to this issue with a brilliant innovation. Through its Clearport platform, the Nymex allowed for hundreds of energy swaps, previously settled on a bilateral basis, to be cleared by the exchange’s clearinghouse. In effect, it enabled the development of flexible instruments that could be executed OTC but cleared by the exchange.

Against the backdrop of this history, ethanol has presented a number of challenges as far as developing liquid and effective risk management instruments for ethanol. The New York Board of Trade (now ICE) attempted to create the first ethanol futures contract by a U.S. exchange in 2004 with a contract that called for delivery of an indentured Brazilian specification for ethanol, deliverable FOB Brazil. The heavy protective tariffs imposed by the United States fragmented underlying trade, allowing for international trade only when the U.S. market was high enough and Brazilian prices low enough, usually in spring when the Brazilian sugar harvest depresses prices and the U.S. driving season supports gasoline and ethanol prices. These “windows” allowed Brazilian ethanol to enter the United States and to be competitive, even while paying the US$0.54-tariff. In some cases, market participants used other instruments as a proxy to price and hedge ethanol, such as gasoline. In 2004, banning of MTBE in key states stimulated demand. In 2005, Hurricane Katrina spiked U.S. product prices. In 2006, the implementation of the RFS and sudden effective banning of MTBE at the start of the driving season, and high prices in 2007 led to periods when Brazil exported to the United States. These intermittent periods when the export window opened, allowing for direct sales of Brazilian ethanol into the United States, hardly constituted the underlying physical traded needed to sustain a liquid futures market. Other challenges were the fact that international specifications were not standardized, infrastructure was undeveloped, leading to logistical difficulties, and even pricing methods for the underlying physical trade were not standardized.

It was with the powerful growth spurt in the United States associated with the passage of the RFS, and particularly with the increase of the RFS mandated by the Energy Security Act of 2007, that the demand for such risk management instruments really increased. Most previous attempts at creating futures were dominated by producers and not particularly attractive to the oil industry. It was when end-users in the oil industry began looking for risk management solutions that worked for them that the beginnings of a liquid ethanol derivatives market took root.

Chicago Board of Trade
In 2005, the Chicago Board of Trade (CBOT) launched a futures contract, also developed by producers for a Chicago delivery railcar contract, structured like an agricultural contract (delivery period before last trading day).

It was for 17,000 gal (64,325 L), matching the delivery of a railcar with a Chicago destination.

This contract design, while familiar and attractive to producers, was alien in design to refiner and blender consumers. Its heartland delivery point and design did not catch on and volumes languished. Its structure called for a delivery period, during which the expiring contract traded did not correspond well to the way the gasoline futures markets worked and against which ethanol was often traded. However, the CBOT supported the futures contract with a market maker, which assured a regular settlement price for the contract.

What resulted was the invention of energy traders who began to trade ethanol calendar swaps, which would be the equivalent of buying or selling 12 consecutive months of a commodity forward, using the CBOT futures settlement price to settle calendar swaps. These swaps matched the Nymex energy contracts in design – full month of trade settled on last trading day – settled with a futures price. Volume in these swaps took off in the OTC markets, and a viable market for risk management of U.S. ethanol began to develop basis Chicago. The Chicago Board of Trade was wise to recognize the development, embrace it and eventually began to clear the swaps on the CBOT as Nymex had done with other energy swaps on Clearport. Currently, the CBOT futures contract has open interest of about 2,000 contracts of open interest, while the cleared swaps contract, which is a subset to the total market, is more than 20,000 contracts of open interest.

Brokers who match buyers and sellers execute these cleared contracts and then “give up” executed trades to brokerage companies that are clearing members of the CBOT to “clear” the contracts, like futures contracts. Traders enjoy the security of having the CBOT as counter-party, and trades are margined as ordinary futures transactions.

This is the first major success in the creation of risk management products, which work for ethanol, and is the most liquid risk management instrument for ethanol to date. The swaps also trade purely on a bilateral basis, whereby buyer and seller enter into transactions with dealers, which become the counterparties (as opposed to the exchange) and are governed by the International Swap Dealers Association. The average swap size is for 20 contracts, 17,000 gal each. Bilaterally, the terms, tenor, location and settlement index can be customized.

Other swaps have become widely used to manage risks. The second most-active swap is the Platt’s settled New York Harbor calendar swap. These are calendar swaps, which use a daily index from Platt’s to settle the swaps. These swaps are used to price and hedge waterborne cargo trade into New York Harbor for material barged in from the heartland, cargos from the Caribbean Basin Initiative or from Brazil. Each transaction is generally for the equivalent of 25 futures contracts (42,000 gal - 158,987 L) and extends from one to 36 months. These are actively traded as well and able to be cleared on Nymex Clearport. The swap futures listed on the Nymex where these swaps are cleared are a series of one-month contracts. If one sells a three-month swap, such as April through June, one sells three futures on the Nymex Clearport – April, May and June. They are settled on a daily basis just like regular futures contract and as time progresses, each contract will expire, settled on a cash basis. Each typical swap size is 25 contracts, and each contract is 42,000 gal.

Reformulated gasoline blendstock
Ethanol traders also use reformulated gasoline blendstock for oxygen blending (RBOB) futures contract, or swaps, hedge ethanol as well, often pricing ethanol on a differential to RBOB and using the gasoline market to hedge. In addition to an RBOB futures contract, RBOB swaps trade as well and can be cleared on the Nymex (as the above New York Harbor Platt’s swaps). Other popular swaps are LA calendar swaps and ethanol vs. RBOB swaps.

Since ethanol is often sold on a price differential to RBOB gasoline, there is a need to hedge that differential. To solve this problem, one can trade an RBOB vs. ethanol swap, which is basically two transactions amounting to a differential swap. This transaction hedges the differential of RBOB to ethanol. To do this, trade the trader would execute two swaps – an ethanol swap vs. an RBOB swap. If one wanted to execute a CBOT-based swap vs. a Nymex RBOB swap, one would execute 36 CBOT ethanol – based on a 17,000-gal contract – vs. 25 RBOB – based on a 42,000-gal contract – because of the size differential of the contracts. Other active swaps are the Nymex RBOB calendar swap and an Opis LA calendar swap.

From a practical perspective, what has emerged for ethanol in terms of risk management instruments is an actively traded swap market, executed by brokers on a bilateral basis and often cleared on the CBOT calendar swaps using the futures prices for settlement, or Platts-based New York swaps, which settle on the Clearport platform, using Platts New York Harbor prices. For now, these instruments seem to provide the flexibility in terms of deal size, tenor and location traders need.

Exchanges are still trying to create a futures contract with a set of specifications that might serve as a broader benchmark for the industry. Because the market is still relatively young and fragmented, because of developing infrastructure, different pricing practices of the agricultural and energy worlds, or in the case of international trade or high tariffs, a single set of useful specifications have not yet developed. This is in contrast to other active energy commodities, such as crude, gasoline, heating oil or natural gas or active agricultural commodities such as corn or sugar. As the market grows and trading practices become more standardized (and trade barriers are dropped), this is more likely to happen.

On March 31, 2008, the Nymex launched an ethanol futures contract with a New York Harbor delivery based on the design of their RBOB contract. The contract size is for 42,000 gal and is hoped to integrate trade from the U.S. heartland, the Caribbean Basin Initiative where largely Brazilian feedstock is dehydrated and exported to the U.S. duty free, and Brazil. Volumes to date are still light.

Conclusion
The ability to hedge price risk associated with buying and selling of ethanol is important to ensure the stable growth of the industry going forward and enable the industry maximum financial options to manage risk and supply the country with its ethanol needs. The existing market for risk management instruments has developed with the size and scope of the industry, expanding the number of choices. As ethanol usage became mandated in the United States in increasing amounts, the inventiveness of traders and financial institutions emerged to create increasingly effective hedging instruments, which include futures, cleared swaps and customized swaps.
The lack of an international trade framework, the relatively undeveloped state of infrastructure, the preponderance of fixed price deals and the still emerging standardization of trading practices have provided challenges to creating one set of specifications which is useful for all producers and consumers of ethanol. However, as the market grows in size and the necessity for the United States to import and export pressures policymakers to adopt a more open trade approach, the market for ethanol derivatives should continue to evolve.

Patrica Hemsworth's background is in providing risk management services for commodity producers. Triland USA Inc. is a subsidiary of Mitsubishi Corp.