Posted by: usset001 | September 19, 2008

Verasun and Selective Hedging

Verasun is a large ethanol producer based in South Dakota. On Tuesday the company released some bad news to the market. It appears to me that the company was engaged in some “selective” hedging.

According to the company’s Tuesday filing with the U.S. Securities and Exchange Commission, VeraSun said it typically uses short financial positions to hedge its corn purchases. After corn rose to nearly $8 a bushel in July from around $6 a bushel in May, the company exited its short financial positions on the commodity and priced its physical corn purchases at then-market prices, which were significantly higher than corn’s current price, roughly $5.70 a bushel. VeraSun entered contracts requiring it to buy the corn at those prices that proved to be higher than the current price. (Market Scan, Corn Costs Stalk VeraSun, Melinda Peer, 09.17.08, 8:50 PM ET)

It can be difficult to translate the information offered in a press release, but let me give it a shot. Verasun is a very large purchaser of corn in the spot and forward markets, securing stocks for processing into ethanol. At some point in the past half year, they were hedging the value of these corn purchases by selling futures contracts against their cash long positions (It is also possible they were using options instead of futures). Hedging the value of their inventory indicates they had concerns about falling corn prices but (and I’m trying to read between the lines here) sometime near the top of the market they lifted their short hedges (bought back their futures or options position). Bad timing.

This looks like a textbook example of something called “selective hedging.” Selective hedging is to decide to hedge or not hedge stocks based on your price expectations. What is the difference between selective hedging and speculation? Corn stocks ownership for one, but not much else. We like to think of the trading world as a black and white divide between hedging and speculation. But reality will point to a large gray area between these two activities. “Selective hedging” is just one of many hedging activities that falls smack dab in the middle of the gray area.

In terms of corn procurement activities, the ethanol industry has been on the right side of a rising corn market for nearly two years. Early July marked the end of a one-way market – a more difficult corn market lies ahead. Price risk management is no longer a simple matter of buying ahead and waiting for the market to rise even further. Verasun’s recent announcement simply confirms the more difficult environment ahead.


Responses

  1. Ed, Looks like Verasun needs a lesson or two from you. They commited a rookie mistake. Except rookies usually aren’t in charge of millions of bushels to hedge.

    Better luck next year Verasun.

  2. Hey Ed: I’ve been joking with farmers for a few years that I missed the ethanol ship, and I’m not chasing it in a dinghy. I don’t feel quite so bad now. I will also take future margin calls in stride with thoughts such as “Well at least I didn’t lose as much as Verasun.” The Wall Street Journal said “hedging bets gone wrong.” Is “hedging bet” an oxymoron?

  3. What option move do you feel Verasun should have used if they where going to lift hedges? Assume if they thought corn was going to continue to rise they should have lifted hedges only if they where going to purchase puts to cover the market from falling apart?

    On the opposite side of things for an end user such as verasun for corn; if they where bearish prices assume the move would be to sell a call? So they recieve some money to offset a possible rise yet leave it open for the market to go down?

    I guess my point is should we be teaching as many end user such as birdseed buyers, feed buyers, etc that are maybe not used to hedging to use some of the same tools we are promoting to producers because without this education they can be left out to dry which in the end harms everyone from a butterfly effect?

  4. What you think caused Verasun’s stock to jump back up today?


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