Academic journal article Agricultural and Resource Economics Review

An Insurance Approach to Risk Management in the Ethanol Industry

Academic journal article Agricultural and Resource Economics Review

An Insurance Approach to Risk Management in the Ethanol Industry

Article excerpt

The vast majority of crop and revenue insurance policies sold in the United States are single-crop policies that insure against low yields or revenues for each crop grown on the farm. But, increasingly, producer income is based more on the value of crops that have been converted into a value-added product such as ethanol. Moreover, the recent increases in energy and commodity price levels and volatilities emphasize the importance of risk management to ethanol investors. This paper uses an insurance approach to outline a risk management tool which mimics the gross margin level of a typical corn-based ethanol plant. The gross margin, premium, and indemnity levels are calculated on a per bushel basis to enable producers/investors to utilize the product based on their ownership share in the production facility. The fair premium rates are shown to be quite sensitive with respect to corn and energy price levels and volatilities.

Key Words: corn-based ethanol, insurance, risk management, correlation, Monte Carlo

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Value-added enterprises, such as ethanol production, have recently gained interest as tools that farmers can use to create new markets for their products. According to the Renewable Fuels Association (RFA 2007), there are currently more than 100 plants producing ethanol in 26 states in the United States.1 These facilities comprise a total production capacity of more than 5.5 billion gallons per year, nearly three times the production capacity in 2001. More than 80 plants, with the potential to double the production capacity in the United States, are reportedly under construction. In 2006, 4.9 billion gallons of ethanol were produced in the United States using nearly 1.8 billion bushels of corn, roughly 17 percent of total U.S. corn production (RFA 2007).

The majority of ethanol plants use corn as the feedstock in the production process, increasing demand for corn by creating new markets for corn producers. Generally, investors in ethanol production are required to provide an initial investment to purchase ownership rights in the facility and then receive premium payments based on plant profitability in addition to any payments they may receive for corn marketed to the plant. In the case of farmer-ownership, membership "shares" are often sold on a per bushel basis, potentially tied to a designated delivery requirement, with premium payments made based on each producer's proportion of ownership (share of total bushels processed). These new investment opportunities help to boost corn prices by enhancing demand through market creation. However, ownership in an ethanol production facility also exposes the investor to global and domestic energy market risk.

In March 2005, the Chicago Board of Trade (CBOT) introduced one of the first market-based risk management tools designed specifically for the ethanol industry in the form of a futures contract for denatured ethanol. However, the short trading history of the ethanol futures has shown relatively low trading volumes2 and little price volatility relative to ethanol cash markets. Moreover, the market still lacks an exchange traded options contract on ethanol, further limiting the risk management options available to both plant managers and farmers invested in ethanol production.

It is estimated that ethanol production in the United States will reach over 12 billion gallons by 2010, with ethanol prices declining over the same period, as growth in production outpaces demand (FAPRI 2007). Ethanol's increasing demand for corn is expected to lead to higher corn prices and to more acres being devoted to corn, an effect already being seen with an estimated 90 million acres planted to corn in 2007. The dual effects of higher corn prices and lower ethanol prices will tighten profit margins in the ethanol industry and slow investment (Elobeid et al. 2006). Moreover, high price volatility for both corn and ethanol are expected over the next few years as the industry continues to rapidly expand (Hart 2005). …

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