The increase in ethanol production and use has changed the agricultural economy more than anything since the “Great Russian Grain Robbery” of the early 1970s.

I think it's been good in total, and I have always felt that investing in an ethanol plant for a farmer is an excellent hedge strategy. Theoretically, if the price of corn is low at the farm gate, ethanol should be profitable. And if the price of corn is high at the farm gate, ethanol would be less profitable, thereby hedging net revenue. That all works great if farmers make up the majority of investors.

Plus, it diversifies the farm operation, which in the long run really adds to returns (see sidebar).

As I indicated in last month's column, I think biofuels are here to stay, and it looks like there may be an increase in the mandated use goals with the new farm bill.

As with any new economic change, there are periods of adjustment that the industry will have to go through in order to continue to be viable, productive and growing.

My concern is that we'll overproduce ethanol in the near term and cause significant stress to the industry before we can reap the benefits of a long-term viable industry.

AT THIS TIME, WE have replaced all of the MTBE with ethanol and are currently in an ethanol glut.

There are approximately 135 plants up and running, 60 under construction and an additional seven in expansions. There are an additional 25 plants that have broken ground but not yet started construction. One has already declared bankruptcy. We are currently producing about 7.5 billion gallons of ethanol a year. When all of the plants in expansion, under construction and breaking ground are operational, they will add approximately another 7.1 billion gallons.

New ethanol plants are coming online at the rate of about one a week. Additionally, the infrastructure to transport the ethanol and byproducts is at capacity.

Normally, it's difficult to grow an industry such as this and have supply and demand all coordinated so there are no shortages or surpluses, so some of these challenges were anticipated. However, my sense is these growing pains could be substantial and cause damage to the equity in the industry.

I HAVE REVIEWED balance sheets of clients who have made huge amounts of money in ethanol investments in the past four years. However, in many of those cases, they have reinvested those profits in additional plants. The most recent investments may not be as profitable as the initial ones.

In fact, the newest plants are marginally profitable and could likely be operating in the red.

My concern is that when there is another capital call to prop up losses, many farmers will have the attitude, “this dog won't hunt.” Then, those plants may be subject to buyout by companies with deeper pockets at a large discounted value. As a result, farmers lose the hedge concept I referred to above.

There could be a lot of equity lost in a real short period of time, damaging not only those balance sheet investments, but having other income statement and balance sheet ramifications as many of the stock investments in plants have debt payments on them.

Making payments on something that is not profitable causes significant drag on overall operations.

I hope none of this happens, but good risk management indicates one should do some what if planning to see where and how the whole operation can continue to be sustainable is there is significant stress on the bio fuels industry.

Moe Russell is president of Russell Consulting Group, Panora, IA. Russell provides risk management advice to clients in 28 states. For more risk management tips, check his Web site (www.russellconsultinggroup.net) or call toll-free 877-333-6135.

DIVERSIFICATION PAYS

NONDIVERSIFIED
$100,000 @ 7% for 10 years = $196,968
TOTAL = $196,968
DIVERSIFIED
$20,000 @ 20% for 10 years = $123,834
$20,000 @ 15% for 10 years = $80,914
$20,000 @ 7% for 10 years = $39,343
$20,000 @ 0% for 10 years = $20,000
$20,000 lose it all = $0
TOTAL = $264,715, 34% more.

Diversification can significantly enhance wealth creation as the chart illustrates.

In the first case, you invest $100,000 in a venture that generates a 7% return for 10 years. That will essentially double your money. (The rule of 72 where one divides 72 by the rate of return which results in the years it takes to double your money.)

In the second case, you diversify and invest 20% of the $100,000 in five different investments with the indicated returns over a 10-year period. Note that with one investment returning nothing over 10 years, and one not only returning nothing, but losing the original investment, you still have a third more money over the 10-year period.

The risk management lesson: diversification pays.