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The Importance of Working Capital and its Relation to Crush Margins
By Nathan Burk | April 01, 2006
The Web site www.investwords.com describes "working capital" as current assets minus current liabilities. Other definitions describe working capital as a measure of how much a company has available in liquid assets to evolve its business. This figure, working capital, can be positive or negative. In general, a plant which has it-that is, has enough of it-will have an advantage to grow quicker than a plant that doesn't.

That said, however, what does working capital really mean to a new biodiesel plant? To help articulate an answer to that question, I asked Jeremy Wilhelm of Farm Credit Services of America for his input. Wilhelm described a biodiesel plant's current assets as cash, inventory and accounts receivable. On the other hand, he said liabilities include current debts or accounts payable. What is left over, if anything, after deducting liabilities from current assets gives you your working capital, Wilhelm said, adding that most biodiesel plants are financed with 50 percent equity and 50 percent debt. This means that for every dollar of equity the plant sets aside for working capital, the bank will most likely match.

Given that advice, what is the "right" amount of money to allocate toward working capital? Is there a "right" amount? Every plant will have different equations for this number; however, Wilhelm said Farm Credit Services of America likes to see 15 cents- to 20-cents-per-gallon of capacity set aside for working capital. Therefore, $4.5 million would be a good working capital target for a 30 MMgy biodiesel plant.

Now that we have established the "how much" question, it is now important to explain why working capital is necessary. In having working capital, a biodiesel plant is able to take advantage of forward pricing (when favorable), protect against price swings and, most importantly, lock in crush margins. Without working capital, a biodiesel plant becomes a "market taker" (i.e., the plant purchases soybean oil or other feedstocks at current cash prices and is either open to biodiesel sales or possibly has sold priced biodiesel out forward). Simply stated, the market decides the plant's margins when it fails to lock in crush margins. Some months will return a high margin, while other months might not return any margin. A biodiesel plant operating like this can experience big swings from month to month.

With working capital in place, a producer can become a "market crusher" (i.e., establish favorable margins when the markets warrant) and effectively narrow the market swings. Instruments used to help establish margins out forward include exchange-traded futures and options, or derivatives via the over-the-counter (OTC) market.
What's at risk for producers that don't lock in crush margins? The two major risks which are feedstock prices-essentially virgin oils, animal fats and greases-and the sale of biodiesel. Being two completely different commodities, these ingredients of the crush are disconnected. This places extreme importance on margin management.

As you can see in the chart, "market takers" are at large risk to margin swings. In Example 1 (the black circled area on the left), market takers saw their margins being squeezed. In Example 2 (the black circled area on the right), market takers were very profitable. What if Example 1 had been much longer lived? Would some U.S. plants have had to shut down? Working capital helps establish a steady rate of return and minimizes risks.

The final question that should be addressed is cost. In other words, what is the cost of establishing margins? The capital to establish margins can vary considerably depending on the market dynamics. Costs fluctuate depending on what strategies are used. It would cost less to buy a "1-cent-out-of-the-money" (OTM) soybean oil call versus an "at-the-money" (ATM) call. Although the OTM call requires less capital than the ATM call, the ATM call offers greater protection (i.e., an ATM call would offer 1 cent more protection than an OTM call). Every biodiesel plant has its own specific margin risks. What are yours-and how will you go about minimizing them?

Nathan Burk is a risk management consultant for Des Moines, Iowa-based FCStone LLC. His primary focus is the renewable fuels industry and processing margins. Reach him at nateb@fcstone.com or (800) 422-3087.
 
 
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