Ethanol Futures: Thin but Effective? —Why?

This study examines the paradox where the ethanol futures market provides effective hypothetical hedges yet the use of this market is shunned by those with ethanol cash market positions because of its limited volume and open interest. Examining this issue requires describing ethanol cash, futures, and swaps markets, and ethanol contracting practices. We observe that ethanol futures open interest is about two percent of annual U.S. usage compared to nine percent in gasoline markets. We also observe that an attempt by a single refiner to fully hedge its production would significantly alter the volume/open interest profile of the ethanol futures market. In this respect, the ethanol futures market is thin. The ethanol futures market is nonetheless efficient except in the final month of a contract’s life. We examine causality relationships between the ethanol futures and swaps markets and find that the futures market adjusts to swaps market disequilibrium but the converse does not hold. The implications of these findings are (1) because futures equilibrium open interest adjusts to changes in swaps equilibrium open interest, the futures price reflects conditions in the deeper swaps market as well as in the futures market, (2) because of (1) using the futures settlement price for marking swaps to market provides secure bonding in the over-the-counter ethanol derivatives (swaps) market, and (3) inefficiencies in the futures market during the last month of a contract’s life are likely due to the swaps market’s use of the cumulative average of the futures prices during the last month of the swap contract’s life.