Increased use of alternative fuels and low commodity prices have contributed to the recent expansion of the U.S. ethanol industry. As with any competitive industry, some level of output price risk exists in the form of volatility; yet, no actively traded ethanol futures market exists to mitigate output price risk. This study reports estimated minimum variance crosshedge ratios between Detroit spot cash ethanol and the New York Mercantile Exchange unleaded gasoline futures for 1-, 4-, 8-, 12-, 16-, 20-, 24-, and 28-week hedge horizons. The research suggests that a one-to-one cross-hedge ratio is not appropriate for some horizons.

Key Words: cross-hedging, ethanol, gas

JEL Classifications: G13, Q13, Q42

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. …