March 9, 2010 / 9:31 PM / 8 years ago

DDGs contract good hedge, spec interest a question

CHICAGO (Reuters) - The CME Group’s (CME.O) distillers’ grain futures contract that debuts in April can be a tool for corn-based ethanol makers to hedge their risk, but the true measure of its success would be its ability to attract deep-pocketed traders looking for investment opportunities.

“It has potential and could be utilized by ethanol makers. The trick will be to get spec (speculative) interest in it to add liquidity and do that without getting so erratic that you drive away commercial trade,” said Jerry Gidel, analyst for North America Risk Management Inc.

The industry could use the distillers’ grain contract as part of a “corn crush” in combination with corn, ethanol and natural gas futures. Natural gas, the second largest input behind corn in ethanol production, is used to fire boilers at most ethanol plants.

”Any tool that a plant is able to use to hedge forward is a good one, said Sean Broderick, distillers’ grain at CHS Inc, which markets DDGs for 29 ethanol plants.

Chicago Board of Trade launched the ethanol futures contract in 2005 but speculators avoided it. Volume last month was less than 10,000, compared with more than 950,000 corn contracts.

However, ethanol volume is growing -- up more 367 percent compared with February of last year -- as the ethanol industry matures.

“We’re finding that these ethanol plants are becoming hedgers more and more,” said Roy Huckabay, analyst at Chicago brokerage the Linn Group. “In the early days, all they did was buy corn. They didn’t worry about selling ethanol; they didn’t worry about booking their natgas and all that.”

Ethanol producers can hedge risk by buying futures for input costs of corn and natural gas, and then selling futures for outputs of ethanol and distillers’ grain.

A third of corn used in ethanol production comes out as distillers’ grain, as the fuel distillation process strips the starch out of the corn, leaving a protein-rich animal feed.

DISTILLERS’ GRAIN ON RISE AMID RECORD CORN CROP

Ethanol production increased 20 percent in 2009, according to the Renewable Fuels Association, as a record U.S. corn crop pressured grain values while energy prices remained firm.

The byproduct distillers’ grain has become competitive in the United States and elsewhere with corn and soybean meal as feed for cows, pigs and chickens.

Some hog producers started out using 10 percent distillers’ grain in the feed mix and then went to 15 and 20 percent and some all the way up to 40 percent.

    “DDGs has actually become a larger component than soybean meal and so if you had the ability to hedge soybean meal you should also have the ability to hedge DDGs,” said Randy Spronk with Spronk Brothers in Edgerton, Minnesota, which markets 120,000 head of hogs per year.

    WILL OTC STILL BE KING?

    Most ethanol transactions are conducted off the exchange in the over-the-counter market. The CME Group clears some of those deals in the form of ethanol forward month swaps, with volume in that contract more than five times than ethanol futures.

    Some ethanol producers eschew futures because the lack of speculators makes it difficult to enter or exit a trade.

    But the launch of the distillers’ grain could boost volume in ethanol and DDGs because it provides a “real crush,” said Don Roose, analyst with U.S. Commodities in Des Moines, Iowa.

    “Invariably it will be traded because there is a commercial use for it but I don’t see it being a monster contract because we saw what happened with the ethanol contract,” said a veteran CBOT floor trader.

    When the CBOT launched the ethanol contract, it put up a banner and set aside an area of the corn pit for trading but there was little activity and within weeks it was gone. Distillers’ grain futures, like ethanol, will be traded electronic-only.

    “DDGs is a byproduct of a byproduct and the further you go the smaller the funnel gets,” the trader added.

    Additional reporting by Sam Nelson, Julie Ingwersen and Jerry Bieszk; Editing by Lisa Shumaker

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