Too conservative to hedge: How much does a corn ethanol facility lose?

While the process of producing ethanol from corn has been well established for over a decade, the process profitability still eludes the industry investors. In particular, uncertainties exist in both the feedstock and the product spot prices. To manage the sophisticated price uncertainty, current practice in industry is to negotiate long-term fixed rate prices with both the suppliers of the feedstock and the purchasers of the product. Although this practice completely eliminates the price uncertainty and simplifies production decisions, it entails the potential loss of profit. Stochastic programming methods provide a framework which takes into account the uncertainties and determines the decisions that are optimal under this uncertain future. Therefore, in this study, a stochastic optimization model is presented to determine the weekly production level and swap hedging portfolios over a year's planning horizon with the objective of maximizing the process profit. The approach is also used in a back-testing perspective to compare the profit obtained from applying the optimal decisions with the negotiated profit derived from using the current practice. This comparison in turn validates the effectiveness of the proposed model framework, in particular during times of high price uncertainty.