Yesterday we learned that Big Ethanol was set to get its own bailout — prima facie laughable, since the whole industry owes its existence to government money. Ironically, it was the decline in input prices that hurt companies like VeraSun, which had hedged its corn at prices higher than the prevailing rate. What we couldn’t figure out from the initial report was whether the company had been hurt by normal hedging ops, or whether it was dabbling in trading, as well.
To help us out, the company pointed us to this 8-K from mid-September, which offers an explanation and timeline of its hedges. It helps answer the question of how they ended up locking in high prices:
…we effectively priced our corresponding physical purchases of corn at the then-current market price, which proved to be significantly higher than today’s market prices for corn. In addition, based on market forecasts that corn prices would continue to rise, we entered into a number of “accumulator” contracts relative to corn requirements for the third and fourth quarters that, in each case, allowed us to purchase a specified volume of corn at prices below then-prevailing market rates, but also required us to purchase that same volume of corn (in addition to the initial purchase) at one or more lower prices per bushel should market prices decline to or below those lower levels over the duration of the contract.
That at least answer this criticism, posed by a commenter: “…why do commodities users always act as if they had never heard of puts and calls? A call falls out of the money, you just don’t exercise it.” They didn’t have the luxury not to exercise this hedge.
So how big a deal is this?
As of August 29, 2008, the prevailing price of ethanol in the New York Harbor (the destination and pricing point for a significant share of our shipments) averaged between $2.35 and $2.45 per gallon. Should we price the remainder of our ethanol sales at these levels, we would expect our average ethanol selling price for the third quarter of 2008 to be between $2.45 and $2.55 per gallon.
Based on these assumptions, and excluding the impact of other factors, we would expect to incur a net loss for the third quarter of 2008 in the range of between $63 million ($0.40 per share) and $103 million ($0.65 per share).
So yes, these were some costly hedges, since the accomplished precisely the oppposite of what hedges are supposed to do. And yes, taxpayers will help bail out these companies, even though the decline in commodity prices has been one of the few silver linings of the downturn. Gotta love capitalism in a country where Iowa holds the first caucus in the nation.
Meanwhile, check out the quotes for companies like Verasun (VSE), Pacific Ethanol (PEIX), and MGP Ingredients (MGPI). Each one is off over 90% this year. That kind of performance makes bank stocks look good.