What are Ethanol Futures?
Ethanol futures give ethanol producers and marketers a useful tool to protect themselves against the risk of price fluctuations in the ethanol market.
An Ethanol future is a standardized contract that is traded on an exchange between two parties. The buyer of the contract agrees to take delivery of a specified amount of ethanol at an agreed upon contract price, with delivery and payment occurring at a future specified date. The seller agrees to supply such a quantity as per the contract.
Thanks to the drastic price fluctuations and delivery challenges of the physical ethanol market, ethanol futures have become tremendously important in recent times.
What is Ethanol?
Ethanol is a clean-burning renewable fuel, made from various plant materials and feedstock, collectively called “biomass.” Ethanol is also known as ethyl alcohol, and was used in the past as an alcoholic beverage. Today, it is widely produced in the U.S. and is used primarily as a transportation fuel.
Ethanol blended with gasoline is an excellent source of fuel. Ethanol is essentially produced by fermenting starch or sugar-based Biomass feedstock at an ethanol production facility. It is then mixed with gasoline by fuel suppliers before being distributed to fuel stations.
Brief History of Ethanol
Ethanol was first used to power engines in 1826, and first used as a lighting fuel in the 1850s. Enterprising folks even started using ethanol as a very strong alcoholic drink. It was taxed as liquor to help pay for the Civil War. Ethanol was then blended with gasoline in the early 1920s and became quite in demand during the fuel shortage in the Second World War.
The modern ethanol industry sprung up around 1970s, when demand for ethanol mixed with gasoline surged in the United States. Since then ethanol has been mixed with nearly all of the gasoline sold in the U.S.
Due to the rising costs of oil within the past few years, Government and private companies have invested millions into developing ethanol into a biofuel. Federal and state subsidies have spurred production of ethanol in the U.S. in a bid to decrease dependence on foreign oil, find a suitable oxygenate, and increase the use of eco-friendly fuels.
The Ethanol industry is set witness dramatic growth in the coming years as well. President Bush signed an act in 2007 mandating renewable fuel usage to increase to 36 billion gallons annually by 2020, and ethanol demand will surge in this decade largely due to this Act.
Where is Ethanol Produced?
Brazil and the U.S. account for nearly 90% of global ethanol production today.
The U.S. became the world’s largest producer of ethanol fuel in 2005. Initially, it took 20 years for the U.S. to produce its first billion gallons of ethanol. But today, the industry is growing at a rate of nearly a billion gallons per year. In 2011, the U.S. produced 13.9 billion gallons of ethanol. The US exported 622 million gallons of ethanol in 2013, while imports were around 306 million gallons.
Brazil, the world’s biggest ethanol exporter, uses sugar cane as the raw material for producing ethanol. However, Ethanol is largely produced from corn in the U.S. Around 80% of U.S. ethanol is produced by dry-mill processing where corn is ground into a flour and fermented into ethanol. The rest is produced by wet-mill process where starch, protein and fiber are separated prior to being processed into ethanol.
U.S. ethanol production is highest in the Midwest, lead by Iowa, which grows large quantities of corn. Other plants located near ethanol markets receive corn by rail.
Nearly half of the industry is owned by farmers, locally-owned cooperatives and limited liability companies. The other half is made of privately-held companies and some publicly traded ethanol companies.
How is Ethanol Used (United States)?
The largest use of ethanol is as a fuel additive for motor vehicles. Around 10% ethanol and 90% unleaded gasoline are mixed together to form the fuel E10, which is approved to be used in any vehicle sold in the U.S. and meets government regulations for oxygenated (pollution-reducing) fuels.
Ethanol is used in the blend because it is a high performance fuel which is cleaner than gasoline. It reduces harmful emissions from tailpipes by boosting the octane level of gasoline.
Almost 95% of gasoline in the U.S. now contains a low level of ethanol. In 2013, ethanol consumption reached 13.18 billion gallons, up from 12.88 billion gallons in 2012 and 12.89 billion gallons in 2011. With new federal blending requirements, the use of ethanol will become even larger.
Ethanol consumption is highest along the East and West Coasts, which throws up several distribution challenges for ethanol (largely produced in the Midwest). 90% of ethanol is transported by truck or train, the rest by pipelines.
Who Invests and Trades Ethanol Futures?
Corn traders can be broken down into two main categories: hedgers and speculators.
The price of ethanol is influenced by many factors. In order to reduce the impact of these price fluctuations on growers, producers or blenders, ethanol futures were introduced. Ethanol futures offer these market participants a way to hedge their risk and regain control over their ethanol investments.
Producers and Marketers of ethanol can minimize the risk of price fluctuations in the ethanol market by using a short hedge. This will set a fixed selling price for the ethanol that they will produce, so that they will get the specified amount in the contract, even if prices fall in the future. Consumers (businesses, like gasoline refineries, that need ethanol) can use a long hedge to set a fixed purchase price for a specified quantity of ethanol as per their need.
Ethanol futures are also traded by speculators. Speculators have no vested interest in the underlying asset, that is, they will neither deliver ethanol nor take delivery for ethanol. They trade in and out of ethanol futures only based on speculations about the price fluctuations of ethanol over the trading period. They take on the price risk that hedgers are trying to avoid, because they hope to profit from the price movements. Ethanol speculators buy ethanol futures if they believe that the price of ethanol will go up, and sell ethanol futures if they believe that the price of ethanol will go down.
Ethanol Futures Contracts
Ethanol is traded on the NYMEX, and the Chicago Board of Trade (CBOT).
NYMEX Ethanol Futures (New York Delivery) contracts are of 42,000 gallons each, with the minimum price fluctuation of $0.0001 per gallon. The contracts are listed for 36 consecutive months and are settled by physical delivery at the New York harbor.
CBOT Ethanol futures prices are quoted in dollars and cents per gallon. The standard contract size is 29,000 gallons (approximately one railcar) and their symbol is “EH”. The minimum fluctuation is $0.001 per gallon, so if the price moves from $21.107 to $21.108, the difference will be of $29.00 per contract. The Contract is for 36 consecutive months and is settled by a physical delivery.
How to Trade Ethanol Futures: Costs and Different Brokers
You can trade futures by opening a trading account with a trusted broker who handles futures trading. Starsupply Commodity Brokers, CME Globex, CME Clear Port and Etrade are some well known online platforms for trading futures.
Most brokerages will charge the National Futures Association fees, which is roughly around $0.02 per side, along with a commission (which can range from $0.025 to $3 and more, per contract per side). You will also have to pay an exchange fee, which will vary depending on the exchange and the specific contract you are trading. Be sure to look at the fine print and add up all the fees into your cost.
Ethanol futures trading is accompanied by several risks affecting the underlying commodities. Ethanol production, especially in the U.S. depends largely on corn, and an unpredictable damage to the corn crops due to floods or adverse weather can severely impact Ethanol value. Ethanol also faces several distribution challenges. These challenges can also cause huge spikes in Ethanol prices and go against the trader’s position.
There are also the risks typical to financial trading. Ethanol prices are known to be volatile, being governed largely by the supply by farmers and the demand by gasoline and octane companies in particular markets.
Furthermore, Ethanol futures have a lot of leverage, which allows traders to control a large amount of commodities for a small amount of investment. However, it also means that even a small, unfavorable change in the prices of ethanol can dramatically impact a traders’ entire equity.
Additionally, denatured Ethanol trading has a daily price limit—that is when prices move beyond this amount, trading comes to a stop. So it is possible for ethanol traders to lose their equity and still be unable to close their contracts, due to the stop in trading.
While Ethanol is a growing industry, accompanied by growing price volatility and price risk, Ethanol futures are highly liquid and offer traders a convenient way to minimize risks and make substantial profits.