Strategies for hedging and trading in the emerging ethanol commodities market

The increasing cost of motor fuel and the need to meet environmental standards has significantly raised worldwide interest in ethanol as a fuel commodity. This paper describes basic concepts and methods developed for a market risk management strategy intended to successfully hedge ethanol market risk through the application of stochastic modeling and mitigate the negative impact of potential market events and changes in market drivers. This strategy is the core for a tool that can help serve the needs of ethanol producers and consumers by decreasing the probability of margin losses affecting the viability of their project investments, as well as a means for identification of promising arbitrage opportunities for commodity traders. The strategy is based on an adjustable model that relates ethanol prices to a basket of related commodities. The model is designed to update itself by adjusting to events impacting the market arising from changes in market fundamentals. These include changes in duties and subsidy policies, production capacity, value of by-products, production technology, transport/distribution infrastructure constraints, environmental and social attitudes, and the flexibility of small consumers to use higher percentage ethanol fuels.