Hedging Overcapacity, Mandate Economics: Strategies for Managing Biodiesel Commodity Risk

July 14, 2008

BY Will Babler

In a few short years the biodiesel industry has experienced an evolution that takes many commodity industries decades to realize. Constantly changing domestic and international policy, tremendous investment in production capacity, and extreme fluctuations in commodity prices have driven both opportunity and stress in the industry. Industry observers and market participants are painfully aware of the often negative consequences presented by commodity price risk in the biodiesel market. The only certainty in biodiesel is that uncertainty will continue, even as new policies such as the biodiesel mandate take effect.

The new renewable fuels standard (RFS) signed into law in December 2007 establishes a domestic biodiesel mandate. The mandate requires the domestic consumption of 500 million gallons of biodiesel in 2009 and expands to 1 billion gallons of biodiesel use by 2012. The final EPA rulings that will dictate specific details of the mandate have yet to be finalized. Just as these rules are uncertain, so too is the ultimate impact the mandate will have on the industry.

This article will review the current challenges faced by biodiesel producers, the expectations moving into the 2009 biodiesel mandate, strategies for mitigating commodity risk in this environment and steps for moving forward with a structured commodity trading and risk management program.

Current Market Situation, Mandate Outlook
Global demand for food and fuel is causing supplies of biodiesel feedstocks to dwindle and prices to rise to new highs. Additionally, the high gross margins that incentivized investment have disappeared and left a glut of global biodiesel production overcapacity in their wake. In the current environment, only the least-cost producers are able to produce fuel at a positive margin. The market is rationing demand for oils and fats by keeping feedstock prices high and biodiesel margins low. Margins are kept low enough that idle biodiesel capacity can't be put into production. If this demand destruction weren't taking place it would take only a short time until biodiesel producers depleted global feedstock supplies by way of their substantial processing capacity. Assuming biodiesel policy stays constant for the balance of 2008 it is reasonable to conclude that this rationing process will continue.

At least 500 million gallons of domestic biodiesel consumption is assured in 2009 by way of the RFS biodiesel mandate. Although this mandate infers a level of certainty for the industry, barring policy safety valves, mandate economics and capacity utilization can be expected to look much like the 2008 situation. At press time, changes were expected for the biodiesel tax credit as well as for international trade of biodiesel. These policy changes could severely limit U.S. exports of biodiesel and make the domestic market much more vital to the ongoing operation of U.S. biodiesel producers.



Figure 1. Expanding margins with call options
source: WILL BABLER, FIRST CAPITOL RISK MANAGEMENT LLC



Figure 2. Expanding margins with put options
source: WILL BABLER, FIRST CAPITOL RISK MANAGEMENT LLC


Producers who succeed under mandate economics will be in the same category as those producing fuel today in the difficult non-mandated market. The mandate will be met by least-cost producers and all remaining production beyond the mandate will be subject to rationing. This rationing is a function of overall global feedstock supply and demand where the market still must curb demand and incentivize supply in order to initiate the multi-year process of rebuilding ending stocks.

Several common characteristics define the least-cost producers expected to succeed today and in the future: large capacity and economies of scale, the ability to process multiple feedstocks, and superior logistics including substantial storage and access to truck, rail and water transportation. The bulk of biodiesel production is expected to come from these players while a small amount may originate from well-positioned, small-scale niche market producers.

Regardless of production capacity, it is also critical that biodiesel producers have expertise in commodity trading and risk management in order to be a competitive least-cost industry participant. The ability to successfully execute on physical and financial commodity transactions allows producers to make incremental cost savings on feedstock purchases and realize incremental value on biodiesel sales. Further, executing on financial hedging strategies is necessary to control costs and optimize pricing and planning decisions that would otherwise be impacted by rapidly fluctuating commodity prices. If commodity price volatility is not controlled it can result in financial losses and leave producers uncompetitive and priced out of their market.

Hedging Strategies
Many characteristics of least-cost producer status are constrained by initial investment decisions related to the scale, capabilities and location of the biodiesel production asset. On the other hand, managing commodity price risk is a management issue which is only constrained by available transaction types, expertise and working capital.

Fortunately for the biodiesel industry there are many hedging tools available in the physical and financial markets to manage price risk. The available hedging tools for feedstock and biodiesel include futures and options, swaps, and cash-forward, index and basis contracts. This article will not discuss these tools in detail, but suffice it to say that transactions allowing fixed, minimum or maximum price or any combination thereof are available to a biodiesel producer who understands financial hedging tools and makes appropriate deals in the cash markets.

From a management standpoint, the primary objective of any hedging strategy is to capture opportunity and minimize risk. In a market undergoing rationing, or in a market subject to overcapacity and mandate economics, hedging is required to limit risk on basic physical transactions as well as to strategically take advantage of price volatility.

Under current conditions and future mandate economics it is reasonable to assume that biodiesel prices will remain relatively correlated to feedstock prices. This is also likely to only allow for a small margin for least-cost producers. However, both the feedstock and fuel markets are prone to dislocations in correlation. Volatility events can drive short- to medium-term changes in individual commodity prices and consequentially in biodiesel profit margins. Past events have been driven by credit market crashes, investment fund liquidation and weather. In the future many other unknowns will drive price volatility and associated breakdowns in correlation. Any breakdown in correlation, where feedstock and biodiesel prices move in opposite directions, can present an opportunity to increase biodiesel profit margins or alternatively put producers at risk of substantial financial losses. Hedging tools can be used to lock in opportunity as well as mitigate losses during these events.

The most direct way to gain favorable exposure to un-correlated events, or other significant price moves where prices remain correlated, is through option hedging. Options are price risk management tools that give the purchaser the equivalent of minimum or maximum price insurance. For example, a biodiesel producer purchasing a call option on soybean oil has paid a premium today to ensure that their feedstock price doesn't move higher than a certain level in the future. Conversely, a producer purchasing a put option on diesel fuel price has paid a premium today to ensure that their biodiesel price (via an index or basis contract) doesn't fall below a certain level in the future. In the context of correlated input and output commodity prices, Figures 1 and 2 demonstrate how option hedging may be able to expand margins when markets become volatile. Figure 1 shows how margins can be expanded in an environment of rising prices and Figure 2 shows how margins can be expanded in an environment of falling prices. In both cases it is assumed that feedstock and fuel left un-hedged would remain correlated.

Diversification in hedging with options can help mitigate the risk that premium will be lost if markets move sideways or in the opposite direction of the hedge. By balancing and diversifying hedge positions to take advantage of favorable volatility on both fuel and feedstock it may be possible to increase the frequency in which margins can be enhanced. This is an important consideration when looking to implement strategies with the profit and loss profiles demonstrated in Figures 1 and 2.

Next Steps
Managing commodity price risk is a complex topic. There are many economic, strategic and technical issues that must be understood prior to implementing a hedging program. Therefore, we believe it is of the utmost importance that biodiesel producers work to understand their commodity risk, take steps to structurally position their plant to be least cost and develop in-house expertise and/or work with partners who can develop and execute on a structured commodity risk management program.

Today's biodiesel market is a difficult one for producers and even the 2009 mandate doesn't drastically change the underlying fundamentals. The future outlook for biodiesel is likely to remain challenging and in our view the most competitive industry participants will be those who actively seek to mitigate price risk and expand margins through a structured commodity trading and risk management approach.

Will Babler leads First Capitol Risk Management LLC's biodiesel commodity risk management operations. Reach him at wbabler@firstcapitolrm.com or (815) 777-1129. Trading in futures and options entails significant risks that must be understood prior to trading. This article is not a solicitation for the purchase or sale of any futures or options instrument and past results are not indicative of future performance.

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