November 27, 2008
Corn prices went to record highs then plunged 50 percent, leaving ethanol maker VeraSun Energy Corp tangled in a maze of hedges which made it vulnerable when prices dropped.
The ethanol maker was seeking bankruptcy protection by October.
Don Roose, president and analyst for US Commodities of West Des Moines, Iowa said VeraSun's plight is a lesson in risk management for other ethanol makers. He said that VeraSun pitched their hedges and at the same time through different strategies tried to take on ownership of corn going down. So they caught it from both sides, and that is left-footed risk management.
Roose said VeraSun, possibly to avoid margin calls, lifted its hedges, leaving it vulnerable to losses as corn prices kept falling.
Once VeraSun abandoned its hedges it took ownership of expensive corn that was rapidly losing value. That contributed to the bankruptcy, said Roose, who holds investments in ethanol producers.
An ethanol maker's income is derived from sales of ethanol and distillers dried grain (DDG), a byproduct of the ethanol production process which is used as an animal feed.
A pure hedge for an ethanol producer would be the purchase of corn and natural gas accompanied by the sale of ethanol and DDG.
With 16 ethanol plants in the Midwest, South Dakota-based VeraSun is the largest publicly traded U.S. ethanol maker. It has admitted that expensive corn contracts and the credit crunch led to its bankruptcy filing.
Charlie Sernatinger, analyst for Fortis Clearing Americas said that the general strategy that was sold to VeraSun was to buy an upside call (in corn options) and at the time the calls were so expensive they sold two downside puts to pay for it.
But when they put their hedges on for corn they never locked in a price for the ethanol or DDGs at the same time, he explained.
Buying calls is a long or bullish options play and so is selling puts, so VeraSun was hurt by both their call and put positions when corn prices collapsed.