Ethanol producers can hedge against falling ethanol price by taking up a position in the ethanol futures market.
Ethanol producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of ethanol that is only ready for sale sometime in the future.
To implement the short hedge, ethanol producers sell (short) enough ethanol futures contracts in the futures market to cover the quantity of ethanol to be produced.
An ethanol fuel producer has just entered into a contract to sell 2.90 million gallons of ethanol, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of ethanol on the day of delivery. At the time of signing the agreement, spot price for ethanol is USD 1.5800/gal while the price of ethanol futures for delivery in 3 months' time is USD 1.6000/gal.
To lock in the selling price at USD 1.6000/gal, the ethanol fuel producer can enter a short position in an appropriate number of CBOT Ethanol futures contracts. With each CBOT Ethanol futures contract covering 29,000 gallons of ethanol, the ethanol fuel producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the ethanol fuel producer will be able to sell the 2.90 million gallons of ethanol at USD 1.6000/gal for a total amount of USD 4,640,000. Let's see how this is achieved by looking at scenarios in which the price of ethanol makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the ethanol fuel producer will have to sell the ethanol at only USD 1.4220/gal, resulting in a net sales proceeds of USD 4,123,800.
By delivery date, the ethanol futures price will have converged with the ethanol spot price and will be equal to USD 1.4220/gal. As the short futures position was entered at USD 1.6000/gal, it will have gained USD 1.6000 - USD 1.4220 = USD 0.1780 per gallon. With 100 contracts covering a total of 2900000 gallons, the total gain from the short futures position is USD 516,200
Together, the gain in the ethanol futures market and the amount realised from the sales contract will total USD 516,200 + USD 4,123,800 = USD 4,640,000. This amount is equivalent to selling 2.90 million gallons of ethanol at USD 1.6000/gal.
With the increase in ethanol price to USD 1.7380/gal, the ethanol producer will be able to sell the 2.90 million gallons of ethanol for a higher net sales proceeds of USD 5,040,200.
However, as the short futures position was entered at a lower price of USD 1.6000/gal, it will have lost USD 1.7380 - USD 1.6000 = USD 0.1380 per gallon. With 100 contracts covering a total of 2.90 million gallons of ethanol, the total loss from the short futures position is USD 400,200.
In the end, the higher sales proceeds is offset by the loss in the ethanol futures market, resulting in a net proceeds of USD 5,040,200 - USD 400,200 = USD 4,640,000. Again, this is the same amount that would be received by selling 2.90 million gallons of ethanol at USD 1.6000/gal.
As can be seen from the above examples, the downside of the short hedge is that the ethanol seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling ethanol prices while still be able to benefit from a rise in ethanol price is to buy ethanol put options.
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