Ethanol Futures: Thin But Effective

By IAN BERRY

CHICAGO -- More than four years in, the Chicago Board of Trade's ethanol contract is still thinly traded, but an economics professor says in recent research that it is nonetheless an effective hedge tool.
The key to the market's relative success, said Roger Dahlgran, professor of Agribusiness Economics and Management at the University of Arizona, is the robust over-the-counter market for ethanol. In a paper published in the Journal of Agricultural and Resource, Prof. Dahlgran found ethanol futures are "significantly superior to gasoline futures for hedging ethanol price risk for two-week and longer hedges."
An exchange-for-risk provision -- which allows OTC products to be traded for futures -- creates a doorway between the two markets, "and they are essentially a single market," Prof. Dahlgran said. "What it does is it gives me some confidence that the futures price reflects the value of the over-the-counter contracts, even though they're not directly traded in the futures market."
The futures market is trading about 200 contracts a day, said Dave Lehman, director of commodity research and product development for CME Group. He says volume this year through May was up by about 130% from the same time a year ago, he acknowledging it is "starting from a small base." Open interest as of the end of May was 4,381, more than double what it was a year ago.
CME is pleased with the growth of the contract, traded exclusively electronically, he said. "It's successful and works not necessarily from a liquidity perspective, but from a risk-management perspective," Mr. Lehman said. "It is doing a good job of providing a risk-management tool for the marketplace."
Jason Ward, an ethanol analyst with Northstar Commodity, said the nascent contract doesn't yet have the volume to become a viable hedge tool. Unlike trades in futures for crude oil, gasoline, corn and soybeans, Mr. Ward said, with ethanol futures he has to "work to get the hedge."
"I can call up an MF Global or an RJO and say, 'I need to do some ethanol swaps' and they can go find me the volume on the other side," he said, referring to futures brokerages. "Where I can't call up the futures exchange and say, I want to sell 'X' amount of ethanol futures. They can't find me the volume on the other side."
Open interest in CME's forward-month calendar swap is about four times that of the futures contract, Mr. Lehman said.
Write to Ian Berry at ian.berry@dowjones.com