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Biodiesel Magazine

From the September 2008 Issue

A Hedging Exercise in Biodiesel

by Jess Hewitt
This isnt just another hedging article. Most business people cannot muster the strength to read a textbook How To article about hedging. However, businesses want to sell more products and make more money. Therefore, the following is a specific example of one hedging strategy that can increase sales and improve profits. Most biodiesel producers take enormous risk every month selling biodiesel on fixed price contracts or on a price that they post daily. They may not see the risk until the market price suddenly decreases. Every producer also knows that his or her customers may not want a fixed price but a price that is related to diesel fuel. These buyers want prices related to index or average prices for diesel published in newsletters or electronic services. Most producers do not receive these publications and consider the subscription costs to be prohibitive to make another sale. There may also be some lack of knowledge about diesel prices that makes producers uncomfortable with offering a biodiesel price that floats with diesel fuel. A producer may also pay a fixed price for his or her feedstock, so why should he or she take any risk on a floating price? Due to these excuses producers decline to sell on floating price and end up using only a fixed price strategy.

However, one hedging strategy allows a producer to cover the fixed feedstock cost and also cover his or her profits and sell on a floating price related to fuel prices. Lets use an example of a biodiesel producer who uses soybean oil or tallow as its feedstock. Lets assume that the producers feedstock prices change weekly. For simplicity, lets also assume that the cost of producing the biodiesel is 50 cents per gallon. For the first week of the example the feedstock price is 40 cents per pound of tallow and 60 cents per pound of soybean oil. We will further assume a 1:1 yield of feedstock to biodiesel. By this point the typical business direction would be to set a price at a point above the costs and market the product as best as possible. But lets take a different tact. A number of other buyers would rather buy on a floating price contract related to the price of diesel fuel. This floating price is seen as a risky endeavor. What if the floating price declines? Isnt there risk in any event? If the market price for biodiesel declines, the producer is really taking the same risk. So, now my job is to show how to hedge the risk and make even more money.

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The secret to hedging is using a commodity that approximates the price we will be selling (the floating price). The commodity is a proxy for biodiesel prices. For example, lets use the heating oil contract on the New York Mercantile Exchange. The contract is for No. 2 heating oil, which is not much like an over-the-road diesel but the contract approximates the price of diesel fuel. In the theoretical example we will set up a new biodiesel sales contract with a new customer. The price is based on an index price for diesel fuel, and three publications list market prices for the imaginary producer. The publications are Oil Price Information Service, DTN and Platts Oilgram. Each publishes local rack prices and refinery or pipeline terminus prices. The rack prices represent the wholesale price of diesel fuel and the pipeline prices represent the refinery prices. The example plants buyer is a petroleum distributor, so it is most likely that the customer is able to buy above the pipeline price or below the rack price. We can use either index as long as the premium or discount is set at a point that the customer will have demand for the product. Analysis shows that the price of NYMEX heating oil on the first day is $3.15 per gallon. The published rack price is 15 cents above NYMEX price and the pipeline price is 15 cents above NYMEX price. To complete the example, the price of biodiesel B99 is $3.20 per gallon after the blenders credit. The new customer is excited to offer that they will buy a lot of B99 at a price that is 3 cents under the rack price, so long as the biodiesel price can float with the diesel rack price. The rack price is $3.30, so 3 cents less yields $3.27. Thats a great deal but with a floating price there is a chance that the price can decline quickly and eliminate all the profit and result in monetary loss. Commodity Order In the example, the customer buys 40,000 gallons of biodiesel per weekday at rack price less 3 cents per gallon. The following will discuss one week in order to simplify the calculations. Now comes the hedging. An institutional commodity trading account is opened with the help of a commodity broker. Five thousand dollars is placed into the account to get it started, and the broker is already sending multiple e-mails everyday with new market and weather information. The commodity hedge orders are now placed. We will essentially be selling the equivalent volume of heating oil contracts on NYMEX. Each days biodiesel sales to the new customer is about the same volume as one NYMEX heating oil contract, which is 42,000 gallons. Five contracts will be sold for the week. Its time to call the commodity broker and place an order to sell the equivalent volume of heating oil on a future contract. An option contract could also be used, but that would require even more math and the use of funny symbols. The conversation might go something like this: Producer: Hello broker, I would like to place a limit order. Broker: Excellent, go ahead with your order. Producer: Sell five September heating oil at $3.15 or better. Broker: OK. To confirm, you are selling five Sep heat, 315 or better? Producer: C onfirmed. The broker then sells the heating oil hedge at a value of $3.15 per gallon. The producer sends in a margin payment equivalent to 26 cents per gallon. Finally, order a free trial subscription to the pricing publication. The broker will send a statement requesting a margin deposit of $60,000. The deposit must be placed on an account with the broker within the time specified or the position will be liquidated and the hedge eliminated. The producer will also receive daily statements from the broker updating the account position. Executing the Plan C ontract deliveries begin the next week and the news is not favorable. C rude oil prices decline as the market opens and the price of heating oil drops 8 cents per gallon. The sales price for diesel also declines 8 cents per gallon for the first day to a price of $3.22 per gallon. The new customer begins taking delivery of his contract quantity. Now the contract calls for an average of the

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daily prices for the week. The average will be calculated from the closing price on NYMEX. The customer can be billed on the daily price but at the end of the week we will have to adjust to the average for the week. Essentially, one-fifth of the contract is sold on the first day. Now that sales have started, we have to start unwinding the hedge. The commodity broker is asked to buy back one of the contracts. He executes the order and closes out one contract of our position and charges a small brokerage fee. Here is how the producer enters the order to close out the position for the first day: Producer: Heres my order for today: Buy one September heating oil at market on close. Broker: C onfirming, buy one Sep heat MOC (market on close)? Producer: C onfirmed. The price the broker executed is $3.07, or exactly 8 cents under the NYMEX sales price. Since we are now buying back at a price less than the sale price we will receive a credit to the brokerage account of 8 cents. Thats 8 cents multiplied by 42,000 gallons, or a credit of $3,360. Each day thereafter the price will adjust and we have to continue buying back one-fifth of our position until it is liquidated. The prices that can be achieved for the week are listed in "The impact of hedging" chart on page 93. At the end of the week, the hedge is reviewed to see if it made sense. The B99 biodiesel sales price at the beginning of the hedge period was $3.20 per gallon and we hedged a price of $3.27, which was 7 cents higher than the typical biodiesel price. The producer sold approximately 40,000 gallons per day to the new customer at an average price of $3.26. The hedge produced a gain of 1 cent per gallon over the entire volume thereby bringing the price of the sales up to $3.27 per gallon. The margin deposit was $12,000 for each contract or $60,000 total margin for about one week, which can be expressed as a time value of money of $115. The brokerage commission was about $75. The cost of the hedge was a $190, or about $38 per day (less than one-tenth of a cent per gallon). Now when we look at profitability we get a good answer: the producer made much more money. The producer sold 200,000 gallons more than usual and made a gross profit of $14,000 before considering the costs of the hedge. Overall the hedge worked well. The producer can continue this hedge program every week when he buys his feedstock. If the producer adds just four floating price customers, his monthly profit has the potential to increase by more than $200,000. Now there are things that can go wrong with hedges and the producers broker should prepare the producer for all possibilities. I am hopeful that this hedge exercise made sense and you will seek out more education about commodity contracts. A producer can also hedge their feedstock with the same type of hedging strategies. Jess Hewitt is president of Gulf Hydrocarbon Inc. Reach him at jess.hewitt@gulfhydrocarbon.com. 2010 BBI International

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