HERON LAKE BIOENERGY, LLC General
We prepared the following discussion and analysis to help readers better
understand our financial condition, changes in our financial condition, and
results of operations for the fiscal year ended
OverviewHeron Lake BioEnergy, LLC is aMinnesota limited liability company that owns and operates a dry mill corn-based, natural gas fired ethanol plant near Heron
Lake, Minnesota .
Our revenues are derived from the sale and distribution of our ethanol
throughout the continental
Based on the criteria set forth in ASC 280, the Company has two reportable operating segments for financial reporting purposes: (1) production of ethanol and related distillers' grains, corn oil and syrup collectively referred to as ethanol production; and (2) natural gas pipeline distribution and services from the Company's majority owned subsidiary, Agrinatural. Before intercompany eliminations, revenues from our natural gas pipeline segment represented 3.0%, 3.2%, and 2.7% of our total consolidated revenues in the years endedOctober 31, 2019 , 2018, and 2017, respectively. After accounting for intercompany eliminations for fees paid by the Company for natural gas transportation services pursuant to our natural gas transportation agreement with Agrinatural, Agrinatural's revenues represented 1.3%, 1.5%, and 1.1% of our consolidated revenues for the fiscal years endedOctober 31, 2019 , 2018, and 2017 respectively, and have little to no impact on the overall performance
of the Company.
Plan of Operations For the Next Twelve Months
Over the next twelve months we will continue our focus on operational improvements at our plant. These operational improvements include exploring methods to improve ethanol yield per bushel and increasing production output at our plant, continued emphasis on safety and environmental regulation, reducing our operating costs, and optimizing our margin opportunities through prudent risk-management policies. The Company, and the ethanol industry as a whole, experienced significant adverse conditions throughout most of 2018 and into 2019 as a result of industry-wide record low ethanol prices due to reduced demand and high industry inventory levels. These factors resulted in prolonged negative operating margins, significantly lower cash flow from operations and substantial net losses. We expect to have sufficient cash generated by continuing operations and availability on our credit facility to fund our operations. However, should we experience unfavorable operating conditions in the ethanol industry that prevent us from profitably operating our plant, we may need to seek additional funding. In addition, we expect to continue to conduct routine maintenance and repair activities at the ethanol plant to maintain current plant infrastructure, as well as small capital projects to improve operating efficiency. We anticipate using cash we generate from our operations and our revolving term loan to finance these plant upgrade projects.
Trends and Uncertainties Impacting Our Operations
The principal factors affecting our results of operations and financial
conditions are the market prices for corn, ethanol, distillers' grains and
natural gas, as well as governmental programs designed to create incentives for
the use of corn-based ethanol. Other factors that may affect our future results
of operation include those risks and factors discussed in this report at "PART I
- ITEM 1. BUSINESS" and "PART I - ITEM 1A. RISK FACTORS".
39
Our operations are highly dependent on commodity prices, especially prices for corn, ethanol, distillers' grains and natural gas. As a result, our operating results can fluctuate substantially due to volatility in these commodity markets. The price and availability of corn is subject to significant fluctuations depending upon a number of factors that affect commodity prices in general, including crop conditions, yields, domestic and global stocks, weather, federal policy and foreign trade. Natural gas prices are influenced by severe weather in the summer and winter and hurricanes in the spring, summer and fall. Other factors include North American exploration and production, and the amount of natural gas in underground storage during injection and withdrawal seasons. Ethanol prices are sensitive to world crude oil supply and demand, domestic gasoline supply and demand, the price of crude oil, gasoline and corn, the price of substitute fuels and octane enhancers, refining capacity and utilization, government regulation and incentives and consumer demand for alternative fuels. Distillers' grains prices are impacted by livestock numbers on feed, prices for feed alternatives and supply, which is associated with ethanol plant production. We expect our ethanol plant to produce approximately 2.8 gallons of denatured ethanol for each bushel of grain processed in the production cycle. Because the market price of ethanol is not always directly related to corn, at times ethanol prices may lag price movements in corn prices and corn-ethanol price spread (the difference between the price per gallon of ethanol and the price per bushel of grain divided by 2.8) may be tightly compressed or negative. If the corn-ethanol spread is compressed or negative for sustained period, it is possible that our operating margins will decline or become negative and our ethanol plant may not generate adequate cash flow for operations. In such cases, we may reduce or cease production at our ethanol plant in order to minimize our variable costs and optimize cash flow. For the fiscal year endedOctober 31, 2019 compared to fiscal year endedOctober 31, 2018 , our average price per gallon of ethanol sold increased approximately 2.4%. However, the average price per gallon of ethanol sold for the fiscal year endedOctober 31, 2019 was approximately 8.7% lower than the average price per gallon of ethanol sold for the fiscal year endedOctober 31, 2017 . There has been decreased production of ethanol and gasoline demand has been flat. Additionally, the increase in approved economic hardship exemptions from the RVOs has recently effectively lowered the RVOs by a significant number of gallons of domestic demand. If this trend continues, it may continue to negatively impact theU.S. ethanol market. Management believes that the ethanol outlook moving into fiscal year 2020 will remain relatively flat and our margins will remain tight due to higher corn prices and relatively flat gasoline demand.
In recent years, exports of ethanol have been increasing; however, exports fell slightly during the 2019 fiscal year compared to the 2018 fiscal year. Export demand for ethanol is less consistent compared to domestic demand which can lead to ethanol price volatility. During 2017,Brazil andChina adopted import quotas and/or tariffs on the importation of ethanol, which are expected to continue to negatively impactU.S. exports.China , the number three importer ofU.S. ethanol in 2016, has imported negligible volumes since imposing a 70% tariff in 2018. OnSeptember 1, 2017 ,Brazil's Chamber of Foreign Trade imposed a 20% tariff onU.S. ethanol imports in excess of 150 million liters, or 39.6 million gallons, per quarter. The tariff was renewed inSeptember 2019 , but the import quota was raised to 187.5 million liters, or 49.5 million gallons, per quarter.U.S. exports toBrazil have decreased from our 2018 fiscal year to our 2019 fiscal year. This tariff may continue to have a negative impact on the export market demand and prices for ethanol produced inthe United States . Any decrease inU.S. ethanol exports could adversely impact the market price of ethanol unless domestic demand increases or foreign markets are developed. Corn prices trended upward during fiscal year 2019, but began trending slightly downward during the fourth quarter of fiscal year 2019. The latest estimates of supply and demand provided by theU.S. Department of Agriculture ("USDA") estimate the 2018-19 ending corn stocks at approximately 2.1 billion bushels, and project the 2019-2020 corn supply at approximately 15.8 billion bushels, which is less than the 2018-2019 supply, with corn consumption for ethanol and co-products steady at approximately 5.3 billion bushels, suggesting higher corn prices into the first half of fiscal 2020. Weather, world supply and demand, current and anticipated stocks, agricultural policy and other factors can contribute to volatility in corn prices. If corn prices rise, it will have a negative effect on our operating margins unless the price of ethanol and distillers' grains outpaces rising corn prices. Distillers' grains prices increased in 2019 over 2018 due to decreased supply as a result of decreased production. Top export markets includeMexico ,Japan ,Canada ,Colombia ,China , andSouth Korea . Of note, however, is that export demand fromChina , historically one of the largest importers ofU.S. produced distillers grains, has significantly declined. In 2017,China imposed significant anti-dumping and anti-subsidy tariffs on distillers' grains imported from theU.S. , which resulted in significant declines in exports ofU.S. distillers' grains toChina . The anti-dumping tariffs range from 42.2% to 53.7% and the anti-subsidy tariffs range from 11.2% to 12%. The imposition of 40 these duties has resulted in a significant decline in demand from this top importer requiringU.S. producers to seek out alternative markets. Exports toChina are substantially below the pre-tariff export levels. There is no guarantee that distillers' grains exports toChina will return to pre-tariff levels.
Management anticipates distillers' grains prices will remain steady during our 2020 fiscal year, unless additional domestic demand or other foreign markets develop. Domestic demand for distillers' grains could be negatively affected if corn prices decline and end-users switch to lower priced alternatives. Although our corn oil prices improved slightly year over year, corn oil prices as a whole have been adversely impacted during the last few years by oversupply of corn oil due to the substantial increase in corn oil production. Additionally, corn oil prices have been impacted by the oversupply of soybeans and the resulting lower price of soybean oil which competes with corn oil for biodiesel production. InDecember 2019 , legislation was signed extending the$1.00 per-gallon biodiesel blender tax credit retroactively toJanuary 1, 2018 , and throughDecember 31, 2022 . Given the inherent volatility in ethanol, distillers' grains, non-food grade corn oil, grain and natural gas prices, we cannot predict the likelihood that the spread between ethanol, distillers' grains, non-food grade corn oil and grain prices in future periods will be consistent compared to historical periods. Results of Operations for the Fiscal Years EndedOctober 31, 2019 and 2018 The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our audited consolidated statements of operations for the fiscal years endedOctober 31, 2019 and 2018 (amounts in thousands): 2019 2018 Statement of Operations Data % % Revenues$ 106,827 100.0 %$ 108,472 100.0 % Cost of Goods Sold 108,812 101.9 % 104,380 96.2 % Gross Profit (Loss) (1,985) (1.9) % 4,092 3.8 % Operating Expenses (3,398) (3.2) % (3,198) (2.9) % Operating Income (Loss) (5,383) (5.1) % 894 0.9 % Other Income, net 205 0.2 % 273 0.3 % Net Income (Loss) (5,178) (4.9) % 1,167 1.2 %
Less: Net Income Attributable to
Non-controlling Interest (278) (0.3) %
(312) (0.3) %
Net Income (Loss) Attributable to
Heron Lake BioEnergy, LLC$ (5,456) (5.2) %$ 855 0.9 % Revenues Our consolidated revenue is derived principally from revenues from our ethanol production segment, which consists of sales of our three primary products: ethanol, distillers' grains and corn oil. Our remaining consolidated revenues are attributable to incidental sales of corn syrup and Agrinatural revenues, net of eliminations for distribution fees paid by the Company to Agrinatural for natural gas transportation services. 41 The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our audited consolidated statements of operations for the fiscal year endedOctober 31, 2019 : Year Ended October 31, 2019 Sales Revenue % of Total Revenues (in thousands) Ethanol sales$ 82,544 77.3 % Distillers' grains sales 18,214 17.1 % Corn oil sales 3,514 3.3 % Corn syrup sales 1,123 1.0 % Agrinatural revenues (net of intercompany eliminations) 1,432 1.3 % Total Revenues$ 106,827 100.0 % The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our consolidated statements of operations for the fiscal year endedOctober 31, 2018 : Year Ended October 31, 2018 Sales Revenue % of Total Revenues (in thousands) Ethanol sales$ 82,136 75.7 % Distillers' grains sales 20,041 18.5 % Corn oil sales 4,028 3.7 % Corn syrup sales 607 0.6 % Agrinatural revenues (net of intercompany eliminations) 1,660 1.5 % Total Revenues$ 108,472 100.0 % Our total consolidated revenues decreased by approximately 1.5% for the fiscal year endedOctober 31, 2019 , as compared to the fiscal year 2018 primarily due to decreases in production of ethanol, distillers' grains, and corn oil, which were partially mitigated by increases in average prices realized for our ethanol, distillers' grains, and corn oil. The following table reflects quantities of our three primary products sold and the average net prices received for the fiscal years endedOctober 31, 2019 and 2018: Year Ended October 31, 2019 Year Ended October 31, 2018 Quantity Avg. Selling Quantity Sold Price Sold Avg. Selling Price (in (in Product thousands) thousands) Ethanol (gallons) 65,512 $ 1.26 66,889 $ 1.23 Distillers' grains (tons) 143$ 127.32 160 $ 125.34 Corn oil (pounds) 14,251 $ 0.25 16,657 $ 0.24 Ethanol Total revenues from sales of ethanol increased by approximately 0.5% for fiscal year 2019 compared to the fiscal year 2018 due primarily to an approximately 2.4% increase in the average price per gallon we received for our ethanol, offset by an approximate 2.1% decrease in the volumes sold from period to period. We sold fewer ethanol gallons during fiscal year 2019 as compared to fiscal year 2018 primarily due to a decrease in ethanol production. Ethanol production was lower at our plant compared to the prior year as a result of slight production slowdowns due to lower corn supply availability. We are currently operating above our nameplate capacity. Management anticipates relatively stable ethanol production and sales during our 2020 fiscal year.
The increase in the price of ethanol was due to decreased ethanol stocks
compared to the fiscal year ended
We occasionally engage in hedging activities with respect to our ethanol sales. We recognize the gains or losses that result from the changes in the value of these derivative instruments in revenues as the changes occur. AtOctober 31, 2019 , we had fixed and basis contracts for forward ethanol sales for various delivery periods throughDecember 2019 42
valued at approximately
Distillers' Grains Total revenues from sales of distillers' grains for our 2019 fiscal year decreased approximately 9.1% compared to fiscal year 2018. The decrease in distillers' grains revenues is primarily attributable to an approximately 10.6% decrease in the tons of distillers' grains sold from period to period, which was partially offset by an approximately 1.6% increase in the average price per ton we received for our distillers' grains sold during fiscal year 2019 compared to fiscal year 2018.
The increase in the market price of distillers' grains is primarily due to decreased supply as a result of decreased production. Management anticipates that distillers' grains prices will remain steady during our 2020 fiscal year unless export markets continue to shrink or production increases. We sold fewer tons of distillers' grains during fiscal year 2019 as compared to 2018 due primarily to decreased production at the plant. Management anticipates relatively stable distillers' grains production going forward.
At
Corn Oil Separating the corn oil from our distillers' grains decreases the total tons of distillers' grains that we sell; however, our corn oil has a higher per ton value than our distillers' grains. Total revenues from sales of corn oil decreased by approximately 12.8% for fiscal year 2019 compared to the fiscal year 2018. This decrease is attributable to an approximately 14.4% decrease in the number of pounds of corn oil sold from period to period, which was slightly offset by an approximately 4.2% increase in the average price we received per pound of corn oil sold during fiscal year 2019 compared to fiscal year 2018.
Management attributes the decrease in corn oil sales during fiscal year 2019 as compared to 2018 primarily to decreased production at the plant. Management expects our corn oil production will be relatively stable going forward.
Although management believes that corn oil prices will remain relatively steady, prices may decrease if there is an oversupply of corn oil production resulting from increased production rates at ethanol plants or if biodiesel producers begin to utilize lower-priced alternatives such as soybean oil or if the biodiesel blenders' tax credit is not renewed and biodiesel production declines.
At
Cost of Goods Sold
Our cost of goods sold increased by approximately 4.2% for the fiscal year endedOctober 31, 2019 , as compared to the fiscal year endedOctober 31, 2018 . Cost of goods sold, as a percentage of revenues, also increased to approximately 101.9% for the fiscal year endedOctober 31, 2019 , as compared to approximately 96.2% for the 2018 fiscal year due to a narrower margin between the price of ethanol and the price of corn. Approximately 90% of our total costs of goods sold is attributable to ethanol production. As a result, the cost of goods sold per gallon of ethanol produced for the fiscal year endedOctober 31, 2019 was approximately$1.49 per gallon of ethanol sold compared to approximately$1.40 per gallon of ethanol produced for the fiscal year endedOctober 31, 2018 . 43 The following table shows the costs of corn and natural gas (our two largest single components of costs of goods sold), as well as all other components of cost of goods sold, which includes processing ingredients, electricity, and wages, salaries and benefits of production personnel, and the approximate percentage of costs of those components to total costs of goods sold in our audited consolidated statements of operations for the fiscal year endedOctober 31, 2019 : Year Ended October 31, 2019 Amount % of Cost of Goods (in thousands) Sold Corn costs$ 80,504 74.0 % Natural gas costs 6,818 6.3 %
All other components of costs of goods sold 21,490
19.7 %
Total Cost of Goods Sold $ 108,812 100.0 %
The following table shows the costs of corn, natural gas and all other
components of cost of goods sold and the approximate percentage of costs of
those components to total costs of goods sold in our audited consolidated
statements of operations for the fiscal year ended
Year Ended October 31, 2018
Amount % of
Cost of Goods
(in thousands) Sold
Corn costs $ 74,887 71.7 %
Natural gas costs 6,660 6.4 %All other components of costs of goods sold 22,833
21.9 %
Total Cost of Goods Sold $ 104,380 100.0 %
Corn Costs
Our cost of goods sold related to corn increased approximately 7.5% for our 2019 fiscal year compared to our 2018 fiscal year, due to an approximately 12.5% increase in the average price per bushel paid for corn from period to period, which was partially offset by an approximately 4.9% decrease in the number of bushels of corn processed from period to period. The corn-ethanol price spread (the difference between the price per gallon of ethanol and the price per bushel of grain divided by 2.8) for our 2019 fiscal year was approximately$0.10 less than the corn-ethanol price spread we experienced for fiscal year 2018. The increase in our cost per bushel of corn was primarily related to higher market corn prices due to adverse weather conditions and strong demand. Due to projected decreased corn stocks and strong demand, management anticipates that corn prices will remain steady during our first half of 2020 fiscal year. For our fiscal years endedOctober 31, 2019 and 2018, we processed approximately 21.9 million and 23.0 million bushels of corn, respectively. Our corn conversion efficiency decreased slightly during our 2019 fiscal year compared to 2018. Management anticipates consistent corn consumption during our 2020 fiscal year provided that we can achieve positive operating margins that allow us to continue to operate the ethanol plant at capacity. From time to time we enter into forward purchase contracts for our corn purchases. AtOctober 31, 2019 , we had forward corn purchase contracts for approximately 740,000 bushels for deliveries throughDecember 2021 . Comparatively, atOctober 31, 2018 , we had forward corn purchase contracts for approximately 2.3 million bushels for various delivery periods throughOctober 2019 . Our corn derivative positions resulted in gains of approximately$351,000 and$1.2 million for the fiscal years endedOctober 31, 2019 and 2018, respectively, which decreased cost of goods sold. We recognize the gains or losses that result from the changes in the value of our derivative instruments from corn in cost of goods sold as the changes occur. As corn prices fluctuate, the value of our derivative instruments are impacted, which affects our financial performance. We anticipate continued volatility in our cost of goods sold due to the timing of the changes in value of the derivative instruments relative to the cost and use of the commodity being hedged. 44 Natural Gas Costs
For our 2019 fiscal year, we experienced an increase of approximately 2.4% in our overall natural gas costs compared to our 2018 fiscal year. During the past two fiscal years, there has been an increase in cost of natural gas, primarily as a result of an increase in the average price per MMBTU of natural gas due to increased domestic and export demand. Management also anticipates higher natural gas prices as we move through the winter months due to the typical seasonal natural gas cost increases experienced during the winter months. From time to time we enter into forward purchase contracts for our natural gas purchases. Our natural gas derivative positions resulted in no gain or loss for the fiscal year endedOctober 31, 2019 , which had no effect on cost of goods sold, and a loss of approximately$1,600 for the fiscal year endedOctober 31, 2018 , which increased cost of goods sold. We recognize the gains or losses that result from the changes in the value of our derivative instruments from natural gas in cost of goods sold as the changes occur. Operating Expense Operating expenses include wages, salaries and benefits of administrative employees at the plant, insurance, professional fees, property taxes and similar costs. Operating expenses as a percentage of revenues rose slightly to 3.2% of revenues for our fiscal year endedOctober 31, 2019 , compared to 2.9% of revenues for our fiscal year endedOctober 31, 2018 . This increase is due primarily to lower revenues and increased industry association costs. Our efforts to optimize efficiencies and maximize production may result in a decrease in our operating expenses on a per gallon basis. However, because these expenses generally do not vary with the level of production at the plant, we expect our operating expenses to remain steady into and throughout our 2020
fiscal year. Operating Income (Loss)
For our fiscal year ended
Other Income, Net
We had net other income of approximately
Results of Operations for the Fiscal Years EndedOctober 31, 2018 and 2017 The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our audited consolidated statements of operations for the fiscal years endedOctober 31, 2018 and 2017 (amounts in thousands): 2018 2017 Statement of Operations Data % % Revenues$ 108,472 100.0 %$ 109,918 100.0 % Cost of Goods Sold 104,380 96.2 % 99,488 90.5 % Gross Profit 4,092 3.8 % 10,430 9.5 % Operating Expenses (3,198) (2.9) % (3,125) (2.8) % Operating Income 894 0.9 % 7,305 6.7 % Other Income, net 273 0.3 % 211 0.2 % Net Income 1,167 1.2 % 7,516 6.9 %
Less: Net Income Attributable to
Non-controlling Interest (312) (0.3) %
(248) (0.2) %
Net Income Attributable to Heron Lake
BioEnergy, LLC$ 855 0.9 %$ 7,268 6.7 % 45 Revenues Our consolidated revenue is derived principally from revenues from our ethanol production segment, which consists of sales of our three primary products: ethanol, distillers' grains and corn oil. Our remaining consolidated revenues are attributable to incidental sales of corn syrup and Agrinatural revenues, net of eliminations for distribution fees paid by the Company to Agrinatural for natural gas transportation services. The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our audited consolidated statements of operations for the fiscal year endedOctober 31, 2018 : Year Ended October 31, 2018 Sales Revenue % of Total Revenues (in thousands) Ethanol sales$ 82,136 75.7 % Distillers' grains sales 20,041 18.5 % Corn oil sales 4,028 3.7 % Corn syrup sales 607 0.6 % Agrinatural revenues (net of intercompany eliminations) 1,660 1.5 % Total Revenues$ 108,472 100.0 % The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our consolidated statements of operations for the fiscal year endedOctober 31, 2017 : Year Ended October 31, 2017 Sales Revenue % of Total Revenues (in thousands) Ethanol sales$ 88,231 80.3 % Distillers' grains sales 15,002 13.6 % Corn oil sales 4,915 4.5 % Corn syrup sales 562 0.5 % Agrinatural revenues (net of intercompany eliminations) 1,208 1.1 % Total Revenues$ 109,918 100.0 % Our total consolidated revenues decreased by approximately 1.3% for the fiscal year endedOctober 31, 2018 , as compared to the fiscal year 2017 primarily due to decreases in the average price realized for our ethanol and corn oil which were partially mitigated by an increase in average price realized for our distillers' grains. The following table reflects quantities of our three primary products sold and the average net prices received for the fiscal years endedOctober 31, 2018 and 2017: Year Ended October 31, 2018 Year Ended October 31, 2017 Quantity Quantity Sold Avg. Net Price Sold Avg. Net Price (in (in Product thousands) thousands) Ethanol (gallons) 66,889 $ 1.23 64,030 $ 1.38 Distillers' grains 156 96.44 (tons) 160$ 125.34 $ Corn oil (pounds) 16,657 $ 0.24 17,755 $ 0.28 Ethanol Total revenues from sales of ethanol decreased by approximately 6.9% for fiscal year 2018 compared to the fiscal year 2017 due primarily to an approximately 10.9% decrease in the average price per gallon we received for our ethanol, offset by an approximate 4.5% increase in the volumes sold from period to period. We sold more ethanol gallons during fiscal year 2018 as compared to fiscal year 2017 primarily due to the timing of ethanol shipments and an increase in ethanol production. Ethanol production was higher at our plant in fiscal year 2018 compared to the prior year due to capital improvements we made at our plant designed to increase ethanol production and improve efficiency. The decrease in the price of ethanol was due to excess supply of ethanol, in addition to lessened demand due to the increase 46 in the approval of small refinery hardship waivers. In addition, because ethanol prices are typically directionally consistent with changes in corn prices, lower corn prices kept the price of ethanol lower.
Ethanol derivative instruments resulted in a gain of approximately
Distillers' Grains Total revenues from sales of distillers' grains for our 2018 fiscal year increased approximately 33.6% less compared to fiscal year 2017. The increase in distillers' grains revenues is primarily attributable to an approximately 30.0% increase in the average price per ton we received for our distillers' grains from period to period, coupled with an approximately 2.8% increase in the tons of distillers' grains sold during fiscal year 2018 compared to fiscal year 2017. The increase in the market price of distillers' grains is due to higher demand, particularly fromVietnam , theEuropean Union ,Thailand , andSouth Korea . We sold more total tons of distillers' grains during our 2018 fiscal year compared to the same period of 2017 due to an increase in distillers'
grains yield at the plant. Corn Oil
Total revenues from sales of corn oil decreased by approximately 18.0% for fiscal year 2018 compared to the fiscal year 2017. This decrease was attributable to an approximately 12.7% decrease in the average price we received per pound of corn oil sold, coupled with an approximately 6.2% decrease in the number of pounds sold during fiscal year 2018 compared to fiscal year 2017.
Cost of Goods Sold
Our cost of goods sold increased by approximately 4.9% for the fiscal year endedOctober 31, 2018 , as compared to the fiscal year endedOctober 31, 2017 . Cost of goods sold, as a percentage of revenues, also increased to approximately 96.2% for the fiscal year endedOctober 31, 2018 , as compared to approximately 90.5% for the 2017 fiscal year due to a narrower margin between the price of ethanol and the price of corn. Approximately 90% of our total costs of goods sold is attributable to ethanol production. As a result, the cost of goods sold per gallon of ethanol produced for the fiscal year endedOctober 31, 2018 was approximately$1.40 per gallon of ethanol sold compared to approximately$1.38 per gallon of ethanol produced for the fiscal year endedOctober 31, 2017 . The following table shows the costs of corn and natural gas (our two largest single components of costs of goods sold), as well as all other components of cost of goods sold, which includes processing ingredients, electricity, and wages, salaries and benefits of production personnel, and the approximate percentage of costs of those components to total costs of goods sold in our audited consolidated statements of operations for the fiscal year endedOctober 31, 2018 : Year Ended October 31, 2018 Amount % of Cost of Goods (in thousands) Sold Corn costs$ 74,887 71.7 % Natural gas costs 6,660 6.4 %
All other components of costs of goods sold 22,833
21.9 %
Total Cost of Goods Sold $ 104,380 100.0 %
The following table shows the costs of corn, natural gas and all other
components of cost of goods sold and the approximate percentage of costs of
those components to total costs of goods sold in our audited consolidated
statements of operations for the fiscal year ended
Year Ended October 31, 2017
Amount % of
Cost of Goods
(in thousands) Sold
Corn costs $ 72,523 72.9 %
Natural gas costs 6,645 6.7 %All other components of costs of goods sold 20,320
20.4 %
Total Cost of Goods Sold $ 99,488 100.0 %
47
Corn Costs
Our cost of goods sold related to corn increased approximately 3.3% for our 2018 fiscal year compared to our 2017 fiscal year. This increase was due primarily to an approximately 2.3% increase in the number of bushels of corn processed and an approximately 0.9% increase in the average price per bushel paid for corn from period to period. The corn-ethanol price spread (the difference between the price per gallon of ethanol and the price per bushel of grain divided by 2.8) for our 2018 fiscal year was approximately$0.16 less than the corn-ethanol price spread we experienced for our 2017 fiscal year. The increase in our cost per bushel of corn was primarily related to higher market corn prices due to strong demand and weather threats. For our fiscal years endedOctober 31, 2018 and 2017, we processed approximately 23.0 million and 22.5 million bushels of corn, respectively. We improved our corn conversion efficiency slightly during our 2018 fiscal year compared to 2017 .
At
Our corn derivative positions resulted in gains of approximately$1.2 million and$962,000 for the fiscal years endedOctober 31, 2018 and 2017, respectively, which decreased cost of goods sold. Natural Gas Costs
For our 2018 fiscal year, we experienced an increase of approximately 0.2% in our overall natural gas costs compared to our 2017 fiscal year. The increase in cost of natural gas from period to period was primarily the result of an increase in the average price per MMBTU of natural gas due to increased domestic and export demand and lower production. Our natural gas derivative positions resulted in a loss of approximately$1,600 for the fiscal year endedOctober 31, 2018 , which increased cost of goods sold. Comparatively, our natural gas derivate positions resulted in a loss of approximately$15,000 for the fiscal year endedOctober 31, 2017 , which increased cost of goods sold. Operating Expense Operating expenses as a percentage of revenues rose slightly to 2.9% of revenues for our fiscal year endedOctober 31, 2018 compared to 2.8% of revenues for our fiscal year endedOctober 31, 2017 . This increase is due primarily to fixed production expenses that were higher compared to fiscal year 2017. Operating Income
For our fiscal year endedOctober 31, 2018 , we reported operating income of approximately$894,000 and for our fiscal year endedOctober 31, 2017 , we had operating income of approximately$7.3 million . This decrease resulted largely from decreased prices for our ethanol, relative to the price of corn, and the narrowing of margins of our ethanol production segment. Other Income, Net We had net other income for our fiscal year endedOctober 31, 2018 of approximately$273,000 compared to net other income of approximately$211,000 for our fiscal year endedOctober 31, 2017 . This increase in other income is due to patronage income and decreased interest expense during our fiscal year endedOctober 31, 2018 compared to the same period of 2017 as a result of fewer borrowings under our credit facilities during the 2018 fiscal year. 48
Changes in Financial Condition at
The following table highlights the changes in our financial condition from our
audited consolidated balance sheet for the periods presented (amounts in
thousands):
October 31, 2019 October 31, 2018
Current Assets $ 16,626 $ 17,166
Total Assets $ 56,596 $ 62,021
Current Liabilities $ 6,144 $ 6,675Long-Term Debt, less current portion $ 300 $ 567 Other Long-Term Liabilities $ 551 $ - Members' Equity attributable to Heron Lake BioEnergy, LLC $ 47,599 $ 53,055 Non-Controlling Interest $ 2,002 $ 1,724 The$5.4 million decrease in total assets was primarily driven by the decrease of current assets of approximately$900,000 and our property and equipment of approximately$4.7 million . The decrease in current assets was primarily driven by a decrease in our cash and commodity derivative instruments of approximately$1.8 million , partially offset by an increase in accounts receivable of approximately$939,000 due to timing of rail shipments of ethanol. Current liabilities atOctober 31, 2019 decreased by approximately$531,000 compared toOctober 31, 2018 . This decrease was primarily due to decreases of accrued expenses by approximately$421,000 , current maturities of long-term debt by approximately$58,000 , accounts payable of approximately$27,000 atOctober 31, 2019 compared toOctober 31, 2018 .
Our long-term debt decreased by approximately
Our other long-term liabilities increased by approximately
Members' equity attributable toHeron Lake BioEnergy, LLC decreased approximately$5.5 million atOctober 31, 2019 compared toOctober 31, 2018 . This decrease was due to approximately$5.5 million in net loss attributable to HLBE. Non-controlling interest totaled approximately$2.0 million atOctober 31, 2019 compared to approximately$1.7 million atOctober 31, 2018 . This is directly related to recognition of the 27.0% non-controlling interest inAgrinatural, LLC .
Liquidity and Capital Resources
Our principal sources of liquidity consist of cash provided by operations, cash on hand, and available borrowings under our credit facility with Compeer. Our principal uses of cash are to pay operating expenses of the plant, to make debt service payments on our long-term debt, and to make distribution payments to our members. We expect to have sufficient cash generated by continuing operations and current lines of credit to fund our operations for the next twelve months. We do not currently anticipate any significant purchases of property and equipment that would require us to secure additional capital in the next twelve months. For our 2020 fiscal year, we anticipate completion of several small capital projects and to maintain current plant infrastructure and improve operating efficiency. We expect to have sufficient cash generated by continuing operations and current lines of credit to fund our operations and complete our capital expenditures during our 2020 fiscal year and beyond.
Management continues to evaluate conditions in the ethanol industry and explore opportunities to improve the efficiency and profitability of our operations which may require additional capital to supplement cash generated from operations and available for borrowing under our revolving term loan.
49
Year Ended
The following table summarizes our sources and uses of cash from our audited consolidated statements of cash flows for the periods presented (amounts in thousands):
2019 2018
Net cash provided by (used in) operating activities
Net cash used in investing activities $ (657) $ (2,509)
Net cash used in financing activities $ (325) $ (9,088)
Net decrease in cash and restricted cash $ (1,402) $ (4,070)
Operating Cash Flows
During the fiscal year ended October 31, 2019 , net cash provided by (used in)
operating activities decreased by approximately $7.9 million compared to the
fiscal year ended October 31, 2018 . The decrease resulted largely from an
approximately $6.3 million decrease in our net income in the current year,
coupled with decreases of approximately $1.6 million from period to period in
various working capital items. Net income decreased for fiscal year 2019 due
to decreased revenues and higher costs of goods sold.
Investing Cash Flows
During the fiscal year ended
Financing Cash Flows We used approximately$8.8 million less for financing activities for the fiscal year endedOctober 31, 2019 compared to the fiscal year endedOctober 31, 2018 . During the fiscal year endedOctober 31, 2019 , we used cash to make payments of approximately$325,000 on our long-term debt. For the same period of 2018, we used cash to make payments of approximately$438,000 on our long-term debt and made distributions toHeron Lake BioEnergy members of approximately$8.6 million and to non-controlling interests of approximately$81,000 .
Year Ended
The following table summarizes our sources and uses of cash from our audited
consolidated statements of cash flows for the periods presented (amounts in
thousands):
Fiscal Year Ended October 31,
2018 2017Net cash provided by operating activities $ 7,527$ 12,250 Net cash used in investing activities$ (2,509) $ (1,129) Net cash used in financing activities$ (9,088)
Operating Cash Flows During the fiscal year endedOctober 31, 2018 , net cash provided by operating activities decreased by approximately$4.7 million compared to the fiscal year endedOctober 31, 2017 . The decrease resulted largely from an approximately$6.3 million decrease in our net income in fiscal year 2018, offset by increases of approximately$1.6 million from period to period in various working capital items. Net income decreased for fiscal year 2018 due to decreased revenues
and higher costs of goods sold. Investing Cash Flows
During the fiscal year ended
50
Financing Cash Flows
We used approximately $6.7 million more for financing activities for the fiscal
year ended October 31, 2018 compared to the fiscal year ended October 31,
2017 . During fiscal year 2018, we used cash to make payments of approximately
$438,000 on our long-term debt and made distributions to Heron Lake BioEnergy
members of approximately $8.6 million and to non-controlling interests of
approximately $81,000 .
For the same period of 2017, we used cash to make payments of approximately
Contractual Obligations
The following table provides information regarding the consolidated contractual
obligations of the Company as of
Less than One to Four to Greater Than
Total One Year Three Years
Five Years Five Years
Long-term debt obligations(1)
-
Operating lease obligations(2) 12,550 1,767 3,534 3,437 3,812
Purchase obligations(3) 3,018 2,628 390 - -
Total contractual obligations
(1) Long-term debt obligations include principal and estimated interest under our
credit facilities based on the interest rates in effect as of
2019, assuming contractual maturities.
(2) The operating lease obligations in the table above include our rail car
leases.
(3) Purchase obligations consist of forward contracted corn deliveries. The
amounts were determined assuming prices, including freight costs, at current
market prices as of October 31, 2019 for basis contracts that had not yet
been fixed.
Credit Arrangements
Revolving Term Note
We had a revolving term note payable to Compeer Financial, formerly known as
AgStar Financial Services , FCLA ("Compeer") under which we could borrow, repay,
and re-borrow in an amount up to the original aggregate principal commitment at
any time prior to maturity at March 1, 2022 . The original aggregate principal
commitment was $28,000,000 , which reduced by $3,500,000 annually, starting March
1, 2015 and continuing each anniversary thereafter until maturity. In December
2017 , the Company and its lender orally agreed to reduce the aggregate principal
commitment of the revolving term loan to $8,000,000 . On April 6, 2018 , the
Company finalized loan agreements with an effective date of March 29, 2018 for
an amended credit facility with Compeer (the "2018 Credit Facility"). On January
7, 2020 , the Company finalized loan agreements for an amended credit facility
with its lender (the "2020 Credit Facility").
2018 Credit Facility with Compeer
We had a comprehensive credit facility with Compeer for which CoBank, ACP
("CoBank") served as the administrative agent. This credit facility originally
consisted of a revolving term loan with a maturity date of March 1,
2022 . However, on April 6, 2018 , we entered into an amended credit facility
with Compeer (the "2018 Credit Facility"). The 2018 Credit Facility includes an
amended and restated revolving term loan with a $4.0 million principal
commitment and a revolving seasonal line of credit with a $4.0 million principal
commitment. CoBank will continue to act as Compeer's administrative agent with
respect to our 2018 Credit Facility and has a participation interest in the
loans. The Company agreed to pay CoBank an annual fee of $2,500 for its services
as administrative agent.
Under the terms of the amended revolving term loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of$4.0 million . Final payment of amounts borrowed under amended revolving term loan is dueDecember 1, 2021 . Interest on the amended revolving term loan accrues at a variable weekly rate equal 51
to 3.10% above the One-Month London Interbank Offered Rate ("LIBOR") Index rate,
which was 4.87% at
We agreed to pay an unused commitment fee on the unused available portion of the amended revolving term loan commitment at the rate of 0.500% per annum, payable monthly in arrears.
The aggregate principal amount available to the Company for borrowing under the
revolving term loan at
Under the terms of the seasonal revolving loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of$4.0 million until its maturing onMay 1, 2020 . Amounts borrowed under the seasonal revolving loan bear interest at a variable weekly rate equal to 2.85% above the LIBOR Index rate, which was 4.62% atOctober 31, 2019 .
The Company also agreed to pay an unused commitment fee on the unused portion of the seasonal revolving loan commitment at the rate of 0.250% per annum.
The aggregate principal amount available to the Company for borrowing under the
seasonal revolving loan at
The 2018 Credit Facility is secured by substantially all of our assets, including a subsidiary guarantee.
Under the 2018 Credit Facility, the Company is subject to certain financial and non-financial covenants that limit the Company's distributions and debt and require minimum working capital, minimum local net worth, and debt service coverage ratio. We agreed to a debt service coverage ratio of 1.15 to 1.0, to maintain minimum working capital$8.0 million throughSeptember 30, 2018 and$10.0 million thereafter, and to maintain net worth of$32.0 million . We are permitted to pay distributions to our members up to 75% of our net income for the year in which the distributions are paid provided that immediately prior to the distribution and after giving effect to the distribution, no default exists and we are in compliance with all of our loan covenants. Further, we agreed not to make loans or advances to Agrinatural that exceed an aggregate principal amount of approximately$6.6 million without the consent of Compeer. InOctober 2018 , the Company had an event of non-compliance related to the debt service coverage ratio as defined in the 2018 Credit Facility. InDecember 2018 , the Company received a waiver from its lender waiving this event of noncompliance. InOctober 2019 , the Company had an event of non-compliance related to the debt service coverage ratio as defined in the 2018 Credit Facility. InDecember 2019 , the Company received a waiver from its lender waiving this event of noncompliance. If market conditions deteriorate in the future, circumstances may develop which could result in the Company violating the financial covenants or other terms of its 2018 Credit Facility. Should unfavorable market conditions result in our violation of the terms or covenants of the 2018 Credit Facility and we fail to obtain a waiver of any such term or covenant, Compeer could deem the Company in default, impose fees, charges and penalties, terminate any commitment to loan funds and require the Company to immediately repay a significant portion or possibly the entire outstanding balance of the revolving term loan. In the event of a default, Compeer could also elect to proceed with a foreclosure action on our plant.
2020 Credit Facility with Compeer
The 2020 Credit Facility includes an amended and restated revolving term loan with an$8,000,000 principal commitment. The loans are secured by substantially all of the Company's assets, including a subsidiary guarantee. The 2020 Credit Facility contains customary covenants, including restrictions on the payment of dividends and loans and advances to Agrinatural, and maintenance of certain financial ratios including minimum working capital, minimum net worth and a debt service coverage ratio as defined by the credit facility. Failure to comply with the protective loan covenants or maintain the required financial ratios may cause acceleration of the outstanding principal balances on the revolving term loan and/or the imposition of fees, charges, or penalties. Under the terms of the amended and restated revolving term loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of$8.0 million . Final payment of amounts borrowed under amended revolving term loan is dueDecember 1, 2022 . Interest on the amended and restated revolving term loan accrues at a variable weekly rate equal to 3.10% above the One-Month London Interbank Offered Rate ("LIBOR") Index rate, 52 which was 4.87% atOctober 31, 2019 . We agreed to pay an unused commitment fee on the unused available portion of the amended revolving term loan commitment at the rate of 0.500% per annum, payable monthly in arrears. As part of the 2020 Credit Facility closing, the Company entered into an amended administrative agency agreement with CoBank. As a result, CoBank will continue act as the agent for the lender with respect to the 2020 Credit Facility. The Company agreed to pay CoBank an annual fee of$2,500 for its services as administrative agent. Other Credit Arrangements
In addition to our primary credit arrangement with Compeer, we have other material credit arrangements and debt obligations.
InOctober 2003 , we entered into an industrial water supply development and distribution agreement with theCity of Heron Lake ,Jackson County , andMinnesota Soybean Processors , an unrelated company. In consideration of this agreement, we andMinnesota Soybean Processors were allocated equally the debt service on$735,000 in water revenue bonds that were issued by the City to support this project that mature inFebruary 2019 . OnSeptember 30, 2019 , we finalized a new industrial water supply development and distribution agreement with theCity of Heron Lake , effective as ofFebruary 1, 2019 . Under this agreement, we pay flow charges and fixed monthly charges to theCity of Heron Lake , in addition to certain excess maintenance costs. The term of this agreement expiresFebruary 1, 2029 . InMay 2006 , we entered into an industrial water supply treatment agreement with theCity of Heron Lake andJackson County . Under this agreement, we pay monthly installments over 24 months startingJanuary 1, 2007 equal to one years' debt service on approximately$3.6 million in water revenue bonds, which will be returned to us if any funds remain after final payment in full on the bonds and assuming we comply with all payment obligations under the agreement. As ofOctober 31, 2019 and 2018, there was a total of approximately$634,000 and$947,000 in outstanding water revenue bonds, respectively. We classify our obligations under these bonds as assessments payable. The interest rates on the bonds range from 0.50% to 8.73%. To fund the purchase of the distribution system and substation for the plant, we entered into a loan agreement withFederated Rural Electric Association pursuant to which we borrowed$600,000 under a secured promissory note secured by the distribution system and substation for the plant. Under the note we were required to make monthly payments toFederated Rural Electric Association of$6,250 consisting of principal and an annual maintenance fee of 1% beginning onOctober 10, 2009 . We paid the balance of this loan in full inSeptember 2017 . We also had a note payable to the minority owner ofAgrinatural Gas, LLC in the amount of$100,000 atOctober 31, 2017 . We paid the balance of this loan in
full inJanuary 2018 . Loans to Agrinatural
Original Agrinatural Credit Facility
OnJuly 29, 2014 , HLBE entered into an intercompany loan agreement and related loan documents with Agrinatural (the "Original Agrinatural Credit Facility"). Under the Original Agrinatural Credit Facility, HLBE agreed to make a five-year term loan in the principal amount of$3.05 million to Agrinatural for use by Agrinatural to repay approximately$1.4 million of its outstanding debt and provide approximately$1.6 million of working capital to Agrinatural. The Original Agrinatural Credit Facility contains customary financial and non-financial affirmative covenants and negative covenants for loans of this type and size.
OnMarch 30, 2015 , HLBE entered into an allonge (the "Allonge") to theJuly 29, 2014 note with Agrinatural. Under the terms of the Allonge, HLBE and Agrinatural agreed to increase the principal amount of the Original Agrinatural Credit Facility to approximately$3.06 million , defer commencement of repayment of principal untilMay 1, 2015 , decrease the monthly principal payment to$36,000 per month and shorten maturity of the Original Agrinatural Credit Facility
toMay 1, 2019 . 53 Interest on the Original Agrinatural Credit Facility was not amended and accrues at a variable rate equal to the One-Month LIBOR rate plus 4.0%, with the interest rate capped and not to exceed 6.0% per annum. Accrued interest is due and payable on a monthly basis. Except as otherwise provided in the Allonge, all of the terms and conditions contained in the Original Agrinatural Credit Facility remain in full force and effect. In exchange for the Loan Agreement, the Agrinatural executed a security agreement granting HLBE a first lien security interest in all of Agrinatural's equipment and assets and a collateral assignment assigning HLBE all of Agrinatural's interests in its contracts, leases, easements and other agreements. In addition, RES, the former minority owner of Agrinatural, executed a guarantee under which RES guaranteed full payment and performance of 27% of Agrinatural's obligations to HLBE. Upon the passage of theMay 1, 2019 maturity date, Agrinatural went into default on the Original Agrinatural Credit Facility. As noted, we have a security interest in all of Agrinatural's assets. No interruption in the service of natural gas to our ethanol production facility occurred as a result of the default. The balance of this loan was approximately$1.1 million and$1.5 million atOctober 31, 2019 andOctober 31, 2018 , respectively. Subsequent to the closing of HLBE's indirect acquisition of Agrinatural's non-controlling interest inDecember 2019 , the parties agreed to forgive the debt related to the Original Agrinatural Credit Facility.
Additional Agrinatural Credit Facility
OnMarch 30, 2015 , HLBE entered into a second intercompany loan agreement and related loan documents (the "Additional Agrinatural Credit Facility") with Agrinatural. Under the Additional Agrinatural Credit Facility, HLBE agreed to make a four-year term loan in the principal amount of$3.5 million to Agrinatural for use by Agrinatural to repay its outstanding trade debt and provide working capital. The Additional Agrinatural Credit Facility contains customary financial and non-financial affirmative covenants and negative covenants for loans of this type and size. Interest on the additional term loan accrues at a variable rate equal to the One-Month LIBOR rate plus 4.0%, with the interest rate capped and not to exceed 6.0% per annum. Prior toMay 1, 2015 , Agrinatural is required to pay only monthly interest on the term loan. CommencingMay 1, 2015 , Agrinatural is required to make monthly installments of principal plus accrued interest. The entire principal balance and accrued and unpaid interest on the term loan was due and payable in full onMay 1, 2019 . OnMay 19, 2016 , HLBE and Agrinatural amended the Additional Agrinatural Credit Facility, entering into amendment to the loan agreement datedMarch 30, 2015 (the "Amendment"). Additionally, HLBE and Agrinatural entered into an allonge to the negotiable promissory note datedMarch 30, 2015 issued by Agrinatural to HLBE (the "Additional Allonge") to increase the amount of the capital expenditures allowed by Agrinatural during the term of the facility and deferred a portion of the principal payments required for 2016. The Amendment provides that the portion of principal payments deferred in calendar year 2016 to continue to accrue interest at the rate set forth in the Note and become a part of the balloon payment due at maturity. Additionally, for calendar years, 2017, 2018 and 2019, the Amendment provides that Agrinatural may, without consent of HLBE, proceed with and pay for capital expenditures in an amount up to$100,000 plus the amount of contributions in aid of construction received by Agrinatural from customers for capital improvements ("CIAC"), less a reserve for distribution to the Agrinatural members to cover the income or other taxes imposed as a result of receipt of CIAC in an amount equal to 40% of CIAC. Prior to the Amendment, Agrinatural's capital expenditures were restricted
to$100,000 per year. In exchange for the Additional Agrinatural Credit Facility, Agrinatural executed a security agreement granting HLBE a first lien security interest in all of Agrinatural's equipment and assets and a collateral assignment assigning HLBE all of Agrinatural's interests in its contracts, leases, easements and other agreements. In addition, RES executed a guarantee under which RES guaranteed full payment and performance of 27% of Agrinatural's obligations to HLBE under the Additional Agrinatural Credit Facility. Upon the passage of theMay 1, 2019 maturity date, Agrinatural went into default on the Additional Agrinatural Credit Facility. As noted, we have a security interest in all of Agrinatural's assets. No interruption in the service of natural gas to our ethanol production facility occurred as a result of the default. The balance of this loan was approximately$1.5 million atOctober 31, 2019 and$2.0 million atOctober 31, 2018 . Subsequent to the closing of 54
HLBE's indirect acquisition of Agrinatural's non-controlling interest in
Off Balance-Sheet Arrangements
We have no off balance-sheet arrangements.
Critical Accounting Estimates Note 1 to our consolidated financial statements contains a summary of our significant accounting policies, many of which require management to use estimates and assumptions. Accounting estimates are an integral part of the preparation of financial statements and are based upon management's current judgment. We use our knowledge and experience about past events and certain future assumptions to make estimates and judgments involving matters that are inherently uncertain and that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. We believe that of our significant accounting policies, the following are most noteworthy because changes in these estimates or assumptions could materially affect our financial position and results of operations: Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. Our contracts primarily consist of agreements with marketing companies and other customers as described below. Our performance obligations consist of the delivery of ethanol, distillers' grains, and corn oil to our customers. Our customers primarily consist of three distinct marketing companies as discussed below. The consideration we receive for these products is fixed or determinable based on current observable market prices at theChicago Mercantile Exchange , generally, and adjusted for local market differentials. Our contracts have specific delivery modes, rail or truck, and dates. Revenue is recognized when the Company delivers the products to the mode of transportation specified in the contract, at the transaction price established in the contract, net of commissions, fees, and freight. Agrinatural recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration Agrinatural expects to receive in exchange for those products or services. Derivative Instruments From time to time, we enter into forward sales contracts for ethanol, distillers and corn oil, and purchase contracts for corn and natural gas to hedge our exposure to commodity price fluctuations. These contracts provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold over a reasonable period in the normal course of business. Accordingly, we classify these sales and purchase contracts as normal sales and purchase contracts and as a result, these contracts are not marked to market in our consolidated financial statements. On occasion, in order to reduce the risks caused by market fluctuations, the Company hedges its anticipated corn, natural gas, and denaturant purchases and ethanol sales by entering into options and futures contracts. These contracts are used with the intention to fix the purchase price of anticipated requirements for corn in the Company's ethanol production activities and the related sales price of ethanol. The fair value of these contracts is based on quoted prices in active exchange-traded or over-the-counter market conditions. Although the Company believes its commodity derivative positions are economic hedges, none have been formally designated as a hedge for accounting purposes and derivative positions are recorded on the balance sheet at their fair market value, with changes in fair value recognized in current period earnings or losses. The Company does not enter into financial instruments for trading or speculative purposes. 55 Inventory We value our inventory at the lower of cost or net realizable value using the first in first out method or net realized value. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management's assumptions which do not reflect unanticipated events and circumstances that may occur. In our analysis, we consider future corn costs and ethanol prices, break-even points for our plant and our risk management strategies in place through our use of derivative instruments. Given the significant assumptions required and the possibility that actual conditions will differ, we consider the valuation of the lower of cost or net realized value on inventory to be a critical accounting estimate. Property and Equipment
Management's estimate of the depreciable lives of property and equipment is based on the estimated useful lives. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Impairment testing for assets requires various estimates and assumptions, including an allocation of cash flows to those assets and, if required, an estimate of the fair value of those assets. The Company tests for impairment at the asset group level, which is the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management's assumptions, which do not reflect unanticipated events and circumstances that may occur. In our analysis, we consider future corn costs and ethanol prices, break-even points for our plant and our risk management strategies in place through our derivative instruments and forward contracts. Given the significant assumptions required and the possibility that actual conditions will differ, we consider the assessment of impairment of our long-lived assets to be a critical accounting estimate. Rail Car Rehabilitation Costs The Company leases 50 hopper rail cars under a multi-year agreement which ends inMay 2027 . Under the agreement, the Company is required to pay to rehabilitate each car for "damage" that is considered to be other than normal wear and tear upon turn in of the car(s) at the termination of the lease. Prior to the year endingOctober 31, 2019 , the Company believed ongoing repairs resulted in an insignificant future rehabilitation expense. During the year endingOctober 31, 2019 , based on new information, we re-evaluated our assumptions and believe that it is probable that we may be assessed for damages incurred. Company management has estimated total costs to rehabilitate the cars atOctober 31, 2019 to be approximately$551,000 . During the year endedOctober 31, 2019 , the Company has recorded an expense in cost of goods and a corresponding estimated long-term liability totaling$551,000 . The Company accrues the estimated cost of railcar damages over the term of the lease as the damages are incurred. It is reasonably possible that there will be a change in estimate in the future.
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