A Need for Discovery

There have been complaints that the only way to find the rolling spot price for biodiesel is to check with individual distributors, a tedious process at best. Some say those who lack price discovery expertise lack experience, so as the industry growsand more market players look to purchase the fuel, a legitimate discovery mechanism will be needed.
By By Nicholas Zeman | August 19, 2009
It's no secret there is serious volatility in commodities markets. The fact that no biodiesel futures contracts are offered in the United States further adds to an extremely perplexing situation for those in sales, purchasing and risk management. Industry insiders also note that the mechanisms in place for pricing biodiesel are not fully compliant with supply and demand fundamentals.

For one, the price reported by biodiesel marketers is considered the "advertised" price, and is viewed as higher than either the amount a load sold for or a party might be willing to sell it. It's a negotiation tool, as the advertised price is usually not the real price, and anyone can report any price at any time. "The biodiesel industry is very small and very fragmented regarding the number of participants and the different grades of quality," says Will Babler of First Capitol Risk Management LLC in Galena, Ill. "So developing a homogeneous methodology to determine what traders on the buy or sell side are incentivized to report, is very difficult."

Some parties will say that they bought fuel at a certain price-and it's a lie, says Michael Cooper, vice president of Ultra Green Energy Services LLC. "It's a few pennies more or a few pennies less, so there can be some fudging in the numbers, he says. "You have to view these prices like they are negotiable, and you need to be ready and willing to do some dealing."

Of course, biodiesel traders can track prices of pervasive feedstocks along with the price of crude oil and diesel, all of which influence the price of bio. But Chicago rack values aren't the same as they are in Tulsa, Okla., or San Francisco, so there are regional discrepancies that can be confusing for marketers and buyers. "There are different underlying diesel markets, so many different grades of fuel and so many logistic scenarios, and this makes it very difficult to trade biodiesel from one to another," Babler tells Biodiesel Magazine.

Supply and demand economics dictate prices in virtually all markets but with biodiesel policies and mandates involved, particularly the renewable fuel standard, it's sometimes hard to discover a consistent rolling spot price. "I think we will have a better chance once the mandate kicks in because there will be more certainty about what the obligated parties have to consume," Babler says. "Once the industry is big enough, and the mandate is issued, then the petroleum industry will be surer about what it has to buy and what it's willing to pay. I don't know if that is going to happen at 600 MMgy or if it will happen at a billion gallons per year."

There are companies investigating the possibility of offering a biodiesel price index, but developing that product could be very difficult. "Right now it's not clear whether prices are driving the market or if the market is driving prices," says Chris Draper of the Green Fuels Exchange in Des Moines, Iowa. Currently, GFEX offers trading on recycled oils and has developed a successful verified-seller program to guarantee that parties who offer product for sale can guarantee delivery. "Our objective is to expand into biodiesel and renewable identification numbers (RINs) within the next six to 12 months."

Differing Grades, Markets
To have all of the wholesale biodiesel producers trade under a single index is unlikely to happen any time in the near future. "Would that be based on FAME-0, or Soy Methyl Esters, or some type of generic FAME contract that is a listed derivative?" Babler says. "There are a lot of questions to be answered, and I think that until a particular cash price benchmark becomes financially settled as a swap, it will be hard to have a single product for biodiesel price discovery."

Transactions happen faster than reporting, so it is unclear what the mechanism behind the reporting is. Movements in the market can also happen in the period between bid and delivery. "That means you have to peg your sale on the base of a hedge related to heating oil," Babler says. "If you sold at heating oil plus 'X,' you don't know what the price will be at delivery unless you hedge it using the futures market." If a buyer purchases a load in Chicago and has to get it to New Jersey, which takes several days, the bottom might fall out of the market and a lot of money could be lost, but a buyer could also negotiate a deal gambling that price will go up. "If you reduce your risk, you also reduce your upside," Cooper says.

"There is a price discovery for biodiesel-it's the price of diesel fuels and home heating oil on the New York Mercantile Exchange," Cooper says. "We're diesel fuel producers and we're home heating oil producers. Yes, we might have a premium product, but people are not willing to pay a premium price for it-and if you know anybody who is, tell them I've got some biodiesel for them. Some producers just have too many expectations about what price they should be getting, and they're just unrealistic. This isn't about history. It's about what works now."

The Chicago Board of Trade, the leading spot for commodity price standards in the United States, has no biodiesel product, meaning it does not track biodiesel deals because the volumes are not high enough for the Board itself to make money. "There is a clear European product on NYMEX that is based on the price reported by Argus," Babler says.

One of the problems for biodiesel is that it is not a fungible product. Fungibility is defined as the interchangeability of things that are identical or uniform. "Biodiesel from one producer is not the same as biodiesel from another producer," Cooper says. There are different feedstocks, different fuel packages with different additization technologies, and biodiesel varies in quality from one refinery to another. That means that it's not fungible, not interchangeable. "There are too many different types of biodiesel to concentrate enough liquidity for a single biodiesel futures contract at the moment," Babler says.

Renewable Energy Group Inc., headquartered in Ames, Iowa, advertises that it is "serving up the highest quality biodiesel available," which is sold in a product line billed as REG-9000. There are three different fuels in this line all with different cloud points and different cetane levels. This system put forth by REG effectively states that the lower the biodiesel's cloud point, the more value it has-despite higher cetane numbers associated with biodiesel possessing higher cloud points. Some producers, however, do not like this situation and see it as creating a class system for biodiesel. Babler though does not feel this way. "I think it's a good thing, and they are trying to rightfully develop a pricing system that is based on specs and not on feedstocks because you have different buyers, different seasonal demand," he says. "It's an effort to concentrate liquidity."

Petroleum Terms
The New York Mercantile Exchange offers a trading platform for heating oil and diesel fuel, and press time prices for September heating oil futures were hovering between $1.82 per gallon and $1.87 per gallon. The projected price was rising steadily into February 2010. While there are no futures contracts for biodiesel, several different organizations-Platts, Argus, OPIS-collect spot prices daily for traders and risk managers to discover.

The heating oil futures contract trades in units of 42,000 gallons (1,000 barrels) and is based on delivery in New York harbor, the principal cash market trading center. "We translate biodiesel into the terms of heating oil," Cooper says. "I've learned that's the best way to manage my risk after trading for 10 years-translating biodiesel into petroleum terms."

If the economics work for traders to treat biodiesel as an oil product, then the petroleum industry has an easier time dealing with biodiesel on the buy-side. This also makes the financials of handling biodiesel deals easier on its own traders. "Then you do have liquid tools for laying the price off, hedging and transparent price discovery," Babler says. Biodiesel, however, is usually not traded in 42,000 gallon loads but rather in sizes that are determined by railcar and truck capacities: 29,000 gallons, and between 6,000 and 7,000 gallons, respectively.

For instance, a biodiesel trader who's main market is the heating oil sector has to buy at below the price of heat. That is the touchstone. "This is hand-to hand combat," Cooper says. "You watch the market, you pick up the phone and you negotiate a price. This took years of failure on my part to finally learn how to do this, but that is how you learn-by making mistakes. I think our business is set to explode and I'm ready."

Nicholas Zeman is an associate editor for Biodiesel Magazine. Reach him at nzeman@bbiinternational.com or (701) 738-4972.
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