Cash Ethanol Cross-Hedging Opportunities

The high demand for fuel and the resulting fuel prices have contributed to the recent expansion of the U.S. ethanol industry. Additionally, government grants and subsidies have increased interest in producing ethanol.1 Ethanol production has reached record levels (Figure 1), becoming a substantial source of corn demand, with a potential for and expectations of further growth.2 As with any competitive industry, some level of price risk for ethanol exists in the form of price volatility. Contracting exclusively in cash markets could leave ethanol producers and purchasers exposed to price volatility, depending on contract terms. Contractual agreements are widely used in this industry and are often based on the New York Mercantile Exchange (NYMEX) unleaded gasoline futures (Gerhold). Industry expansion is likely to heighten the demand for price risk management tools. Ethanol plant owners (e.g., agricultural producers and industry) and purchasers of ethanol could benefit from various techniques to manage price volatility. For ethanol, however, no futures market is actively traded. Producers and purchasers of ethanol might find cross-hedging ethanol with unleaded gasoline futures contracts to be effective in reducing exposure to price volatility. The objective of this study is to estimate the cross-hedge relationship between spot ethanol and the NYMEX unleaded gasoline futures market for various crosshedging horizons.

A cross-hedge is performed by hedging the cash price of one commodity with the futures contract price of a different, but related, commodity. A hedger locks in a price for a cash commodity by cross-hedging that commodity with a related commodity traded at one of the commodity exchanges. Therefore, a crosshedge uses information in one market (e.g., the NYMEX unleaded gasoline futures market) to predict the price of a different commodity in another market (e.g., a spot ethanol market).

In order for cross-hedging to reduce exposure to price volatility, the prices of the commodities being cross-hedged must be related, so that the respective prices follow in a predictable manner (Graff et al.). The Detroit spot ethanol and the NYMEX unleaded gasoline futures markets historically have traded in similar patterns, but at different levels (Figure 2).

Most ethanol production is contracted on volume, but the price may be left open-ended for future negotiations depending on the preferences of the buyer (Gerhold). Ethanol trades at lower prices than other gasoline oxygenates, and its value is based on octane ratings. Ethanol producers typically contract ethanol from 1 to 6 months out. Ethanol price is either set at a flat price, using the average ethanol price at base hubs, or determined by an index based on a historical ethanol-gasoline price spread (Gerhold).

Data

Weekly average price data from January 1, 1989, to November 29, 2001, for NYMEX unleaded gasoline futures contracts and weekly average Detroit spot ethanol prices were compiled. NYMEX unleaded gasoline futures contracts are traded for each month of the calendar year, and the delivery location is the New York Harbor. Summary statistics are listed in Table 1. To conserve space, we reported only the summary statistics for a nearby month data series.

The NYMEX unleaded gasoline futures contract is rolled forward to the next contract on the first day of the contract expiration month. This method is used because cash ethanol long hedgers would avoid taking delivery of gasoline during the contract expiration month. Similarly, because the contract specifies a New York Harbor delivery location, many unleaded gasoline long hedgers will exit the market prior to the expiration month. Changes in futures prices over the cross-hedge horizon were computed for the representative contract month for when the hedge is to be lifted. For instance, if the cross-hedge is to be lifted during any week in February 2001, then the change in the futures price over the 1-, 4-, 8-, 12-, 16-, 20-, 24-, and 28-week horizons is in reference to the March 2001 contract. NYMEX unleaded gasoline futures prices were obtained from the Commodity Research Bureau. The Detroit ethanol spot price data were obtained from Kapell.

Results

As previously mentioned, the time series data used for this study could exhibit statistical issues (i.e., autocorrelation and heteroskedasticity), for which the EGLS process corrects. After transforming the data for first- and kth-order autocorrelation, an autoregressive conditional heteroskedasticity test of the errors was performed. The Harvey test statistic was used to test the null hypothesis of homoskedasticity. Tests failed to reject the null hypothesis for each cross-hedge horizon.7 The autocorrelation coefficients, constants, and the estimated cross-hedge relationships from Equation (4) are presented in Table 2. The autocorrelation parameter estimates are significant for each of the cross-hedge horizons, except the 1-week horizon, indicating the strong presence of autocorrelation. This result was as hypothesized.

The R^sup 2^ statistics reported for the price change models are a measure of hedging effectiveness. Leuthold, Junkus, and Cordier (p. 94) state, ". . . hedging effectiveness refers to the reduction in variance as a proportion of total variance that results from maintaining a hedged position rather than an unhedged position." The R^sup 2^ terms become progressively better for forecasts further out. The R^sup 2^ on the 1-week cross-hedge horizon, however, indicates relatively little hedging effectiveness. Thus, a hedger would be as well off to remain unhedged for a 1-week horizon.

The cross-hedge ratios are generally less than 1 and are statistically significant at the 1% level. The cross-hedge ratios are not statistically different from 1 for the 8-, 12-, or 16-week hedge horizons. Thus, a one-to-one hedge ratio is appropriate for these horizons. The appropriate quantities of ethanol to be hedged against one 42,000-gallon unleaded gasoline futures contract for each cross-hedge horizon are calculated by applying the cross-hedge ratios to Equation (5) and are listed in gallons across the bottom of Table 2. The quantity of spot ethanol to hedge declines from the 1-week to the 8-week hedge horizons, remains at 42,000 gallons for the 8-, 12-, and 16-week hedge horizons, and increases steadily beyond.

To cover 100% of production, an ethanol plant that produces 30 million gallons per year requires 619 futures contracts to cover a 4-week routine cross-hedge, 714 futures contracts to cover an 8-, 12-, or 16-week routine cross-hedge, and 509 futures contracts to cover a 24-week routine cross-hedge. Furthermore, the estimates indicate that the U.S. ethanol industry would require somewhere between 25,000 and 41,000 NYMEX unleaded gasoline futures contracts to hedge 100% of production, approximately 1.7 billion gallons in 2001.

Discussion

Cross-hedge relationships between the Detroit spot ethanol price and the NYMEX unleaded gasoline futures price were estimated for this analysis. With EGLS to account for autocor-relation and heteroskedasticity, cross-hedge ratios for 1-, 4-, 8-, 12-, 16-, 20-, 24-, and 28-week cross-hedge horizons were estimated. The cross-hedge ratios varied from 0.632 for the 28-week hedge horizon to 1.0 for the 16-week hedge horizon. The measure of hedging effectiveness (R^sup 2^) indicated that placing a cross-hedge could substantially mitigate price volatility for the 4-, 8-, 12-, 16-, 20-, 24-, and 28-week cross-hedge horizons.

Two results yield from this analysis. First, cross-hedging in the NYMEX unleaded gasoline futures market can reduce ethanol price uncertainty. Second, the quantity of spot ethanol to cross-hedge with one NYMEX unleaded gasoline futures contract was estimated to be 48,443 gallons, 42,000 gallons, 42,000 gallons, 42,000 gallons, 50,542 gallons, 58,989 gallons, and 66,456 gallons for the 4-, 8-, 12-, 16-, 20-, 24-, and 28-week cross-hedge horizons, respectively. Thus, sometimes it is appropriate to cross-hedge more than 42,000 gallons of ethanol per 42,000-gallon NYMEX unleaded gasoline futures contract, as opposed to hedging in a one-to-one ratio.

Although this study is limited to one location, the results might be applicable to ethanol prices at other locations. Figure 3 illustrates that Detroit spot (Kapell), Gulf spot (Davies), and Minneapolis spot (American Coalition for Ethanol) ethanol prices follow similar patterns. The correlation coefficients between the Detroit and Gulf spot ethanol prices and the Detroit and Minneapolis spot ethanol prices over the available periods are 0.859 and 0.981, respectively. However, the brevity of available time series data at other locations prevents further statistical testing to validate the above statement.

Although current capacity in the ethanol industry is far too small to sustain an independent ethanol futures contract, this study provides evidence to suggest that the NYMEX unleaded gasoline futures market offers price mitigation opportunities in the absence of a stand-alone ethanol futures contract.