Inventory and Transformation Hedging Effectiveness in Corn Crushing

In response to the development of the U.S. ethanol industry, the Chicago Board of Trade (CBOT)launched the ethanol futures contract in March 2005. This contract is promoted by the CBOT asallowing ethanol producers to hedge corn crushing using strategies similar to those used insoybean crushing. The similarities end, however, when the lack of short-term correlationbetween corn and ethanol prices is compared to the strong correlation between soybean and soyproduct prices. This contrast motivates the examination of the price risk managementcapabilities of the CBOT’s ethanol futures contract.Standard hedging methodology is applied to weekly cash and futures price data from March 23,2005 through March 7, 2007. Findings include (1) for two- to eight-week hedging horizons, theethanol futures contract effectively hedges ethanol inventory price risk. The effectiveness of thehedge increases with the hedging horizon. Thus, ethanol producers and brokers can use theethanol futures market to reduce the price risk of holding ethanol inventories. (2) Contrary toanecdotal evidence, ethanol futures are not significantly inferior to gasoline futures for hedgingethanol price risk and for a four-week hedge they are significantly superior to gasoline futures.Thus, ethanol producers and brokers get greater price risk protection from hedging with ethanolfutures than with gasoline futures. (3) The corn crushing hedge, utilizing corn and ethanolfutures contracts, is an effective means to “lock in” a processing margin. The effectiveness ofthis hedge increases as the hedging horizon increases. Finally, to understand the processinghedge, the corn crush hedge and the soybean crush hedge were compared. I found that (4) theprice risk of corn crushing is greater than that of soybean crushing and the effectiveness of corncrush hedging exceeds that of soybean crush hedging. This difference is explained by the highcorrelations in the soybean complex.