Managing risk in commodity processing using formula pricing contracts: An application to ethanol

Abstract

As is the case with many commodity processors, manufacturers of ethanol face considerable margin risk from a wide range of input and output prices and the interrelation of these risks with the technical operational efficiency of the plant. Buyers of ethanol desire greater budget certainty for future ethanol purchases. An approach to pricing that has found considerable use in the livestock, dairy, and milling industries is the use of component‐based formula pricing. This study constructs a Monte Carlo simulation model of a typical South Dakota ethanol plant that uses a formula contract to fix components of the ethanol price. The simulation results indicate that the contract has considerable margin risk management benefits for the ethanol producer. The buyer also achieves marginal risk management benefits but with greater budget certainty as the components are fixed. Additional observations of interest to the industry are drawn from the sensitivity results of the simulations. [EconLit Citations: Q13, G17].