UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended July 31, 2016

OR

For the transition period from                    to                  .

COMMISSION FILE NUMBER 000-51825

HERON LAKE BIOENERGY, LLC

(Exact name of Registrant as specified in its charter)

91246 390th Avenue, Heron Lake, MN 56137-1375

(Address of principal executive offices)

(507) 793-0077

(Issuer’s telephone number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  ☒  Yes  ☐  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  ☒  Yes  ☐  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ☐  Yes  ☒  No

As of September 14, 2016, there were 62,932,107 Class A units and 15,000,000 Class B units issued and outstanding.

INDEX

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

Notes to Condensed Consolidated Unaudited Financial Statements are an integral part of this Statement.

HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

Notes to Condensed Consolidated Unaudited Financial Statements are an integral part of this Statement.

HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

Notes to Condensed Consolidated Unaudited Financial Statements are an integral part of this Statement.

1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Principles of Consolidation

The accompanying condensed consolidated unaudited financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted as permitted by such rules and regulations. These condensed consolidated unaudited financial statements and related notes should be read in conjunction with the financial statements and notes thereto included in the Company’s audited consolidated financial statements for the year ended October 31, 2015, contained in the Company’s annual report on Form 10-K.

In the opinion of management, the condensed consolidated unaudited financial statements reflect all adjustments consisting of normal recurring accruals that we consider necessary to present fairly the Company’s results of operations, financial position and cash flows. The results reported in these condensed consolidated unaudited financial statements should not be regarded as necessarily indicative of results that may be expected for any other fiscal period or for the fiscal year.

Nature of Business

The Company owns and operates an ethanol plant near Heron Lake, Minnesota with a permitted capacity of approximately 72.3 million gallons per year of undenatured ethanol on a twelve-month rolling sum basis.  In addition, the Company produces and sells distillers’ grains with solubles and corn oil as co-products of ethanol production.  Additionally, the Company, through a majority owned subsidiary, operates a natural gas pipeline that provides natural gas to the Company's ethanol production facility and other customers.

Principles of Consolidation

The condensed consolidated unaudited financial statements as of July 31, 2016 include the accounts of Heron Lake BioEnergy, LLC and its wholly owned subsidiary, HLBE Pipeline Company, LLC, collectively the “Company”. HLBE Pipeline Company, LLC owns 73% of Agrinatural Gas, LLC (“Agrinatural”). Given the Company’s control over the operations of Agrinatural and its majority voting interest, the Company consolidates the unaudited financial statements of Agrinatural with its consolidated unaudited financial statements, with the equity and earnings (loss) attributed to the remaining 27% noncontrolling interest identified separately in the accompanying condensed consolidated balance sheets and statements of operations.  All significant intercompany balances and transactions are eliminated in consolidation.

Accounting Estimates

Management uses estimates and assumptions in preparing these condensed consolidated unaudited financial statements in accordance with generally accepted accounting principles. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses.  The Company uses estimates and assumptions in accounting for significant matters including, among others, the economic lives of property and equipment, the analysis of impairment of long-lived assets and valuation of commodity derivative instruments, inventory, and inventory purchase and sales commitments.  The Company periodically reviews estimates and assumptions, and the effects of revisions are reflected in the period in which the revision is made. Actual results could differ from those estimates.

Noncontrolling Interest

Amounts recorded as noncontrolling interest on the balance sheets relate to the net investment by an unrelated party in Agrinatural. Income and losses are allocated to the members of Agrinatural based on their respective percentage of membership units held. Agrinatural will provide natural gas to the plant with a specified price per MMBTU for an initial term of 5 years expiring October 31, 2016, with two automatic renewal options for five year periods.  On July 1, 2015, the Company entered into an amendment of its natural gas transportation agreement dated May 13, 2011 with Agrinatural, in which the Company agreed on an early exercise of one of the two automatic five-year term renewals thereby extending the term of the transportation agreement to October 31, 2021.

Revenue Recognition

The Company generally sells ethanol and related products pursuant to marketing agreements. Revenues from the production of ethanol and the related products are recorded when the customer has taken title and assumed the risks and rewards of ownership, prices are fixed or determinable and collectability is reasonably assured. Title is generally assumed by the buyer at the Company’s shipping point.

In accordance with the Company's agreements for the marketing and sale of ethanol and related products, marketing fees and commissions due to the marketers are deducted from the gross sales price as earned. These fees and commissions are recorded net of revenues as they do not provide an identifiable benefit that is sufficiently separable from the sale of ethanol and related products. Shipping costs incurred by the Company in the sale of ethanol are not specifically identifiable and as a result, are recorded based on the net selling price reported to the Company from the marketer. Shipping costs incurred by the Company in the sale of ethanol related products are included in cost of goods sold.

Inventory

Inventory is stated at the lower of cost or net realizable value in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) No. 2015-11 issued in July 2015.  Cost for all inventories is determined using the first in first out method (FIFO). Net realizable value is the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation.  Inventory consists of raw materials, work in process, finished goods, and spare parts. Corn is the primary raw material along with other raw materials.  Finished goods consist of ethanol, distillers’ grains, and corn oil.

Correction Of An Immaterial Error

The Company revised the condensed consolidated unaudited statement of cash flows for the nine months ended July 31, 2015, to correct for a non-cash acquisition of property and equipment resulting in an increase in cash provided by operating activities of approximately $3,359,225 and a corresponding decrease in net cash provided by investing activities.

2.RISKS AND UNCERTAINTIES

The Company has certain risks and uncertainties that it experiences during volatile market conditions. These volatilities can have a severe impact on operations. The Company’s revenues are derived from the sale and distribution of ethanol and distillers’ grains to customers primarily located in the U.S. Corn for the production process is supplied to the plant primarily from local agricultural producers.  Ethanol sales average 75% to 85% of total revenues and corn costs average 75% to 90% of cost of goods sold.

The Company’s operating and financial performance is largely driven by the prices at which it sells ethanol and the net expense of corn. The price of ethanol is influenced by factors such as supply and demand, the weather, government policies and programs, unleaded gasoline prices and the petroleum markets as a whole. Excess ethanol supply in the market, in particular, puts downward pressure on the price of ethanol. The largest cost of production is corn. The cost of corn is generally impacted by factors such as supply and demand, the weather, government policies and programs, and a risk management program used to protect against the price volatility of these commodities. Market fluctuations in the price of and demand for these products may have a significant adverse effect on the Company’s operations, profitability and the availability and adequacy of cash flow to meet the Company’s working capital requirements.

3.INVENTORY

Inventory consisted of the following:

The Company performs a lower of cost or net realizable value analysis on inventory to determine if the market values of certain inventories are less than their carrying value, which is attributable primarily to decreases in market prices of corn and ethanol. Based on the lower of cost or net realizable value analysis, the Company recorded a loss on ethanol inventories, as a component of cost of goods sold, of approximately $108,000 and $0 for nine month periods ended July 31, 2016 and 2015, respectively.

4.DERIVATIVE INSTRUMENTS

As of July 31, 2016, the total notional amount of the Company’s outstanding corn derivative instruments was approximately 3,875,000 bushels that were entered into to hedge forecasted corn purchases through July 2017. There may be offsetting positions that are not shown on a net basis that could lower the notional amount of positions outstanding.

As of July 31, 2016, the total notional amount of the Company’s outstanding ethanol derivative instruments was approximately 420,000 gallons that were entered into to hedge forecasted ethanol sales through September 2016.

The following tables provide details regarding the Company’s derivative instruments at July 31, 2016, none of which are designated as hedging instruments:

As of October 31, 2015, the total notional amount of the Company's outstanding corn derivative instruments was approximately 1,875,000 bushels, comprised of long corn positions on 360,000 bushels, and short corn positions on 1,515,000 bushels, that were hedge forecasted corn purchases through July 2016.

The following tables provide details regarding the Company’s derivative instruments at October 31, 2015, none of which are designated as hedging instruments:

The following tables provide details regarding the gains and (losses) from Company’s derivative instruments in its consolidated statements of operations, none of which are designated as hedging instruments:

As of July 31, 2016, the Company had approximately $63,000 of cash collateral (restricted cash) related to corn derivatives held by a broker.  At October 31, 2015, the Company had no cash collateral (restricted cash) related to derivatives held by a broker.

5.FAIR VALUE

The following table provides information on those derivative instruments measured at fair value on a recurring basis at July 31, 2016:

The following table provides information on those derivative instruments measured at fair value on a recurring basis at October 31, 2015:

The Company determines the fair value of commodity derivative instruments by obtaining fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes and live trading levels from the Chicago Board of Trade market and New York Mercantile Exchange.

6.DEBT FINANCING

Debt financing consists of the following:

Revolving Term Loan

The Company has a revolving term loan with a lender that initially had an aggregate principal commitment of $28,000,000.  Amounts borrowed by the Company under the revolving term loan and repaid or prepaid may be re-borrowed at any time prior to the March 1, 2022 maturity date. Under the terms of the credit facility, the revolving term loan principal commitment declines by $3,500,000 annually, starting March 1, 2015 and continues each anniversary thereafter until maturity. Therefore, the aggregate principal commitment under this facility at July 31, 2016 was $21,000,000.  After accounting for amounts outstanding under this facility at July 31, 2016, the aggregate principal amount available to the Company for borrowing was approximately $15,877,000.  The outstanding balance on the revolving term loan totaled approximately $5,123,000 and $4,823,000 at July 31, 2016, and October 31, 2015, respectively. 

Interest on the revolving term loan accrues at a variable rate equal to 3.25% above the One-Month London Interbank Offered Rate (“LIBOR”) Index rate. The Company may elect to enter into a fixed interest rate on this loan at various times throughout the term of the loan as provided in the loan agreements. The interest rate on the revolving term loan was 3.75% and 3.45% at July 31, 2016, and October 31, 2015, respectively.

The Company also agreed to pay an unused commitment fee on the unused portion of the revolving term loan commitment at the rate of 0.50% per annum. The credit facility contains customary covenants.  The loan is secured by substantially all of the Company assets including a subsidiary guarantee. 

During the term of the revolving term loan, HLBE is subject to certain financial covenants at various times calculated monthly, quarterly or annually, including restriction of 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. As of July 31, 2016 and October 31, 2015, the Company was in compliance with these financial covenants and expects to be in compliance throughout fiscal 2016.

As part of the credit facility closing, the Company entered into an administrative agency agreement with CoBank, ACP (“CoBank”).  CoBank purchased a participation interest in the AgStar loans and was appointed the administrative agent for the purpose of servicing the loans.  As a result, CoBank will act as the agent for AgStar with respect to the credit facility.

In October 2003, the Company entered into an industrial water supply development and distribution agreement with the City of Heron Lake, Jackson County, and Minnesota Soybean Processors. In consideration of this agreement, the Company and Minnesota Soybean Processors are allocated equally the debt service on $735,000 in water revenue bonds that were issued by the City to support this project that mature in February 2019. The parties have agreed that prior to the scheduled expiration of the agreement, they will negotiate in good faith to replace the agreement with a further agreement regarding the wells and related facilities. In May 2006, the Company entered into an industrial water supply treatment agreement with the City of Heron Lake and Jackson County. Under this agreement, the Company pays monthly installments over 24 months starting January 1, 2007 equal to one years' debt service on approximately $3.6 million in water revenue bonds, which will be returned to the Company if any funds remain after final payment in full on the bonds and assuming we comply with all payment obligations under the agreement. As of July 31, 2016 and October 31, 2015, there was a total of approximately $1,780,000 and $1,963,000, respectively, in outstanding water revenue bonds. The Company classifies its obligations under these bonds as assessments payable. The interest rates on the bonds range from 0.50% to 8.73%.

Estimated annual maturities of debt at July 31, 2016 are as follows based on the most recent debt agreements:

7.COMMITMENTS AND CONTINGENCIES

Corn Contracts

At July 31, 2016, the Company had cash and basis contracts for forward corn purchase commitments for approximately 3,826,000 bushels for deliveries through July 2017, which approximates 18% of its anticipated corn needs during this period.

Ethanol Contracts

At July 31, 2016, the Company had forward contracts (both fixed and basis) to sell approximately $17,100,000 of ethanol for various delivery periods through December 2016, which approximates 44% of its anticipated ethanol sales during this period.

During the third fiscal quarter,  the Company amended its ethanol marketing agreement with Eco-Energy, LLC. As amended, the term of the marketing agreement shall continue through December 31, 2019.  Additionally, the amended agreement also provides for certain negotiated changes to the marketing fees payable to Eco-Energy and payment terms based on prevailing market-rate conditions for comparable ethanol marketed services.

Distillers’ Grains Contracts

At July 31, 2016, the Company had forward contracts to sell approximately $1,393,000 of distillers’ grains for delivery through December 2016, which approximates 16% of its anticipated distillers’ grains sales during this period.

Corn Oil Contracts

At July 31, 2016, the Company had forward contracts to sell approximately $621,000 of corn oil for delivery through December 2016, which approximates 30% of its anticipated corn oil sales during this period.

8.MEMBERS’ EQUITY

The Company is authorized to issue 80,000,000 capital units, of which 65,000,000 have been designated Class A units and 15,000,000 have been designated as Class B units. Members of the Company are holders of units who have been admitted as members and who hold at least 2,500 units. Any holder of units who is not a member will not have voting rights. Transferees of units must be approved by our Board of Governors to become members. Members are entitled to one vote for each unit held. Subject to the Member Control Agreement, all units share equally in the profits and losses and distributions of assets on a per unit basis.

The Company has a total of 62,932,107 Class A units and 15,000,000 Class B units issued and outstanding, for an aggregate total of 77,932,107 units issued and outstanding at both July 31, 2016 and October 31, 2015.

In December 2015, the Board of Governors declared a cash distribution of $0.05 per unit, or approximately $3,897,000. The distribution was paid in January 2016.

In December 2014, the Board of Governors declared a cash distribution of $0.12 per unit, or approximately $9,352,000. The distribution was paid in January 2015. 

9.LEASES

The Company leases equipment, primarily rail cars, under operating leases through 2017.  Rent expense for these leases was approximately $686,000 and $525,000 for the three months ended July 31, 2016 and 2015, respectively, and approximately $1,931,000 and $1,572,000 for the nine months ended July 31, 2016 and 2015, respectively.

10.RELATED PARTY TRANSACTIONS

On March 27, 2015, Agrinatural executed a new management and operating agreement with Swan Engineering, Inc. (“SEI”). SEI, together with an unrelated third party owns Rural Energy Solutions, LLC ("RES"), the 27% minority owner of Agrinatural. Under the new management and operating agreement, SEI will continue to provide Agrinatural with day-to-day management and operation of Agrinatural's pipeline distribution business. In exchange for these services, Agrinatural will pay SEI an aggregate management fee equal to the fixed monthly base fee plus the variable customer management fee based on the number of customers served on the pipeline less the agreed monthly fee reduction of $4,500. The Company paid monthly base fees and variable customer management fees of approximately $44,000 and $43,000 for the three months ended July 31, 2016 and 2015, respectively, and approximately $132,000 and $151,000 for the nine month periods ended July 31, 2016 and 2015, respectively. The new management and operating agreement with SEI expires July 1, 2019, unless earlier terminated for cause as defined in the agreement.

On March 27, 2015, Agrinatural also executed a new project management agreement with SEI. Pursuant to the new project management agreement, SEI will continue to supervise all of Agrinatural's pipeline construction projects. These projects are constructed by unrelated third-party pipeline construction companies. Under the new project management agreement, Agrinatural will pay SEI a total of 10% of the actual capital expenditures for construction projects approved by Agrinatural's Board of Directors, excluding capitalized marketing costs. The Company recorded project management fees of approximately $7,000 and $18,000 for the three months ended July 31, 2016 and 2015, respectively, and approximately $46,000 and $55,000 for the nine month periods ended July 31, 2016 and 2015, respectively. The new project management with SEI expires June 30, 2019, unless earlier terminated for cause as defined in the agreement.

11.BUSINESS SEGMENTS

Based on the growth of the Company’s natural gas pipeline subsidiary during the fourth quarter of fiscal 2014, the Company has determined they have two operating segments. The Company groups its operations into the following two business segments:

Segment reporting is intended to give financial statement users a better view of how the Company manages and evaluates its businesses. The accounting policies for each segment are the same as those described in the summary of significant accounting policies. Segment income or loss does not include any allocation of shared-service costs.  Segment assets are those that are directly used in or identified with segment operations. Inter-segment balances and transactions have been eliminated.

The following tables summarize financial information by segment and provide a reconciliation of segment revenue, contribution to operating income, and total assets:

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 three and nine months ended July 31, 2016, compared to the same periods of prior fiscal year 2015. This section should be read in conjunction with the condensed consolidated unaudited financial statements and related notes in PART I - Item 1 of this report and the information contained in the Company’s annual report on Form 10-K for the fiscal year ended October 31, 2015.

Disclosure Regarding Forward-Looking Statements

The SEC encourages companies to disclose forward-looking information so investors can better understand future prospects and make informed investment decisions. As such, we have historical information, as well as forward-looking statements regarding our business, financial condition, results of operations, performance and prospects in this report.  All statements that are not historical or current facts are forward-looking statements. In some cases,  you can identify forward-looking statements by terms such as “anticipates”, “believes”, “could”, “estimates”, “expects”, “intends”, “may”, “plans”, “potential”, “predicts”, “projects”, “should”, “will”, “would”, and similar expressions. 

Forward-looking statements are subject to a number of known and unknown risks, uncertainties and other factors, many of which may be beyond our control, and may cause actual results, performance or achievements to differ materially from those projected in, expressed or implied by forward-looking statements. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us are described more particularly in the “Risk Factors” section of our annual report on Form 10-K for the year ended October 31, 2015 and of this report on Form 10-Q. These risks and uncertainties include, but are not limited to, the following:

We believe our expectations regarding future events are based on reasonable assumptions; however, these assumptions may not be accurate or account for all risks and uncertainties. Consequently, forward-looking statements are not guaranteed. Actual results may vary materially from those expressed or implied in our forward-looking statements. In addition, we are not obligated and do not intend to update our forward-looking statements as a result of new information unless it is required by applicable securities laws. We caution investors not to place undue reliance on forward-looking statements, which represent management’s views as of the date of this report. We qualify all of our forward-looking statements by these cautionary statements.

Industry and Market Data

Much of the information in this report regarding the ethanol industry, including government regulation relevant to the industry is from information published by the Renewable Fuels Association (“RFA”), a national trade association for the United States (“U.S.”) ethanol industry, and information about the market for our products and competition is derived from publicly available information from governmental agencies or publications and other published independent sources.  Although we believe our third-party sources are reliable, we have not independently verified the information.

Available Information

Our website address is www.heronlakebioenergy.com. Our annual report on Form 10-K, periodic reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available, free of charge, on our website under the link “SEC Filings”, as soon as reasonably practicable after we electronically file such materials with, or furnish such materials to, the Securities and Exchange Commission. The contents of our website are not incorporated by reference in this report on Form 10-Q.

Overview

Heron Lake BioEnergy, LLC is a Minnesota limited liability company that owns and operates a dry mill corn-based, natural gas fired ethanol plant near Heron Lake, Minnesota. References to “we”, “us”, “our”, “Heron Lake BioEnergy”, “HLBE”, and the “Company” refer to Heron Lake BioEnergy, LLC. Our business consists of the production and sale of our ethanol throughout the continental U.S. and sale of its co-products (wet, modified wet and dried distillers’ grains, corn oil and corn syrup) locally, and throughout the continental U.S. Additionally, our business includes natural gas pipeline operations, natural gas pipeline distribution and services through the Company's majority owned subsidiary, Agrinatural Gas, LLC (“Agrinatural”).

Reportable Operating Segments

Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Based on the nature of the products, services and operations and the expected financial results, we review our operations within the following two separate operating segments: (1) ethanol production; and (2) natural gas pipeline operations. We currently do not have or anticipate we will have any other lines of business or other significant sources of revenue other than the sale of ethanol, distillers’ grains, corn oil and natural gas transportation.  Refer to Note 11, “Business Segments”, of the notes to the condensed consolidated unaudited financial statements for financial information about our financial reporting segments.

Ethanol Production

Our primary line of business is the Company’s operation of its ethanol plant, including the production and sale of ethanol and its co-products (distillers’ grains, non-edible corn oil and corn syrup). These operations are aggregated into one financial reporting segment. 

Our ethanol plant has a nameplate capacity of 50 million gallons per year and our permitted production capacity is approximately 72.3 million gallons of undenatured fuel-grade ethanol on a twelve-month rolling sum basis. We are currently operating above our stated nameplate capacity and intend to continue to do into the near future, taking advantage of the additional production allowed pursuant to our permit, as long as we believe it is profitable to do so.

We have entered into a management services agreement with Granite Falls Energy, LLC, a Minnesota limited liability company that operates an ethanol plant located in Granite Falls, Minnesota (“GFE”). GFE owns approximately 50.6% of our outstanding membership units. Pursuant to the management services agreement, GFE provides its chief executive officer, chief financial officer, and commodity risk manager to act in those positions as our part-time officers. The initial term of the management services agreement expired in July 2016. However, the management services agreement automatically renewed for an additional one-year term and will continue to automatically renew for successive one-year terms until either party gives the other party written notice of termination prior to expiration of the then current term. The management services agreement may also be terminated by either party for cause under certain circumstances.

We market and sell our products primarily using third party marketers. The markets in which our products are sold may be local, regional, national, and international and depend primarily upon the efforts of third party marketers. We have contracted with Eco-Energy, LLC to market all of our ethanol, Gavilon Ingredients, LLC to market our distillers’ grains, and Renewable Products Marketing Group, LLC to market our corn oil. We also occasionally independently market and sell excess corn syrup from the distillation process to local livestock feeders. 

On July 22, 2016, we executed Amendment No. 1 (the “Amendment”) to our ethanol marketing agreement dated September 17, 2013 (the “Marketing Agreement”) with Eco-Energy, LLC (“Eco-Energy”). Under the terms of the Marketing Agreement, Eco-Energy purchases our entire ethanol output and we pay a marketing fee in consideration of Eco-Energy's services. The Marketing Agreement was set to expire on December 31, 2016. However, the Amendment provides for an extension of the term of the Marketing Agreement through December 31, 2019, with automatic renewals for additional consecutive terms of three years unless either party provides written notice to the other at least 90 days prior to the end of the term or the renewal term. Additionally, the Amendment also provides for certain negotiated changes to the marketing fees payable to Eco-Energy and payment terms based on prevailing market-rate conditions for comparable ethanol marketed services. The Amendment is effective as of January 1, 2017.

Our cost of our goods sold consists primarily of costs relating to the corn and natural gas supplies necessary to produce ethanol and distillers’ grains for sale at our ethanol plant. We generally do not have long-term, fixed price contracts for the purchase of corn. Typically, we purchase our corn directly from grain elevators, farmers, and local dealers within approximately 80 miles of Heron Lake, Minnesota.

We have a facilities agreement with Northern Border Pipeline Company, which allows us access to an existing interstate natural gas pipeline located approximately 17 miles north from our plant. We have entered into a firm natural gas transportation agreement with Agrinatural, our majority owned subsidiary. We also have an agreement with Constellation NewEnergy—Gas Division, LLC to supply the natural gas necessary to operate our plant.

Natural Gas Pipeline

We own a controlling 73% interest in Agrinatural, which is a natural gas distribution and sales company located in Heron Lake, Minnesota.  Agrinatural owns approximately 187 miles of natural gas pipeline and provides natural gas to the Company's ethanol plant and other commercial, agricultural and residential customers through a connection with the natural gas pipeline facilities of Northern Border Pipeline Company.  Agrinatural's revenues are generated through natural gas distribution fees and sales.  The operations of Agrinatural's natural gas pipeline are aggregated into a separate financial reporting segment.

The Company has entered into two intercompany credit facilities with Agrinatural, the July 2014 credit facility (the “Orginal Credit Facility”) and the March 2015 credit facility (the “Additional Credit Facility”). Under the Orignal Credit Facility, the Company made a five-year term loan in the principal amount of $3.05 million and pursuant to the Additional Credit Facility, made a four-year term loan in the principal amount of $3.5 million to Agrinatural.

On May 19, 2016, the Company amended the Additional Credit Facility, entering into amendment to the loan agreement dated March 30, 2015 and an allonge to the negotiable promissory note dated March 30, 2015 issued by Agrinatural to the Company.

Under the terms of the amendment and allonge, the Company agreed to increase the amount of the capital expenditures allowed by Agrinatural during the term of the facilty and defer a portion of the principal payments required for 2016 and capitalize the deferred principal to the balloon payment due at maturity.  Details of the credit facilities and the amendment and allonge to the Additional Credit Facility are provided below in the section below entitled “PART I - Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources; Indebtedness”.

During the normal course of business, the Company enters into transactions between its two operating segments as a result of the Company's firm natural gas transportation agreement with Agrinatural. These intersegment activities are recorded by each segment at prices approximating market and treated as if they are third-party transactions. Consequently, these transactions impact segment performance. However, the revenues and corresponding costs are eliminated in consolidation and do not impact the Company’s unaudited condensed consolidated results.

Plan of Operations for the Next Twelve Months

Over the next twelve months, we will continue our focus on operational improvements at our ethanol plant. These operational improvements include exploring methods to improve ethanol yield per bushel and increasing production output at our plant to take full advantage of our permitted production capacity, reducing our operating costs, and optimizing our margin opportunities through prudent risk-management policies.

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.

Several upscaling projects will be required to increase the plant's current production capacity and take full advantage of the additional production allowed under our air permit. One such project included replacing our existing regenerative thermal oxidizer (“RTO”).    During the three months ended July 31, 2016, we completed installation of the RTO and completed emissions testing. The RTO replacement project was funded from current earnings from operations. With installation complete, management expects the new RTO will improve emissions control and allow us to continue to maintain regulatory compliance under our amended air permit. 

In addition, we expect to continue to conduct routine maintenance and repair activities at the ethanol plant. 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 discussed below and in “PART II - Item 1A. Risk Factors” of this report and “PART I - Item 1. Business” and “PART I - Item 1A. Risk Factors” of our annual report on Form 10-K for the fiscal year ended October 31, 2015.

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.

Our operating margin for the three months ended July 31, 2016, was impacted by volatility in the commodity markets.  As a result of the lower gasoline prices and the traditional summer driving season, gasoline demand increased for the three months ended July 31, 2016, which in turn increased demand for ethanol. However, the increased ethanol demand was countered by increased domestic ethanol production,  which resulted in slight increases in ethanol prices through June 2016.  However, in July 2016,  favorable weather conditions during the growing season led to higher than expected production projections for the current year corn crop, which resulted in declining corn prices.  Following corn prices, ethanol prices also decreased. Despite the commodity market volatility, ethanol traded at a premium to wholesale gasoline for much of the three months ended July 31, 2016. 

Management believes distillers’ grains has also been negatively impacted by the Chinese government initiating an anti-dumping and countervailing duty investigation in January 2016. On July 8, 2016, China’s Ministry of Commerce issued an official notice concerning the hearing in the anti-dumping and countervailing investigations against distillers’ grains originating in the U.S. The hearing was held August 2, 2016, in Beijing.    China is not expected to make a decision on whether to impose antidumping duties on U.S. dried distillers’ grain imports until after the scheduled visit of President Barack Obama to China in early September.  If China were to impose a high tariff on distillers’ grains exports from the U.S., it could negatively impact the market price of distillers’ grains in the U.S. which could negatively impact our financial performance.

The Renewable Fuels Standard

The RFS has been, and we expect will continue to be, a significant factor impacting ethanol usage. In the Environmental Protection Agency’s (“EPA”) November 2015 final rule, the RFS required blending volume obligations (“RVOs”) for corn-based ethanol for 2014, 2015 and 2016 were reduced from the statutorily mandated levels.  As set in the November 2015 rule, the required blending volume for corn-based ethanol blending for 2016 is 14.5 billion gallons, compared to 15 billion gallons as originally set by statute. Additionally, on May 18, 2016, the EPA released its preliminary rulemaking for 2017, setting the RVO for corn-based ethanol at 14.8 billion gallons, an increase over the 2016 requirement but still below the statutory mandate of 15 billion gallons. The proposal modestly increases the minimum volume requirements of ethanol to 14.8 billion gallons for the coming year. This proposal is expected to be finalized by November of 2016.

The EPA’s departure from the RFS statutory requirements in both the final rule and proposed 2017 volumes are expected to limit demand for ethanol and may have a negative impact on ethanol prices and demand unless additional demand is created by discretionary blending.  Beyond the federal mandates, there are limited markets for ethanol. Further, due to the lower price of gasoline, management does not anticipate that renewable fuels blenders will use more ethanol than is required by the RFS which may result in a significant decrease in ethanol demand. A reduction in ethanol demand could have a material adverse effect on our results of operations, cash flows and financial condition, unless additional demand from exports or discretionary or E85 blending develops.

Environmental and Other Regulations

Our business subjects us to various federal, state, and local environmental laws and regulations.  These laws and regulations require us to obtain and comply with numerous permits to construct and operate our ethanol plant, including water, air and other environmental permits. Although we have been successful in obtaining all of the permits currently required, any retroactive change in environmental regulations, either at the federal or state level, could require us to obtain additional or new permits or spend considerable resources in complying with such regulations. Additionally, any changes that are made to the ethanol plant or its operations must be reviewed to determine if amended permits need to be obtained in order to implement these changes.

In connection with the RTO replacement project, we have filed an application for a major amendment of our air emissions permit with the Minnesota Pollution Control Agency (“MPCA”) to allow for the replacement under our current permit. However, due to backlog in the permit approval process, on April 27, 2016, we entered into a compliance agreement with the MPCA. Under the compliance agreement, the MPCA allowed us to proceed with replacement of our RTO prior to receiving approval of our major amendment application provided we operate the new RTO in compliance with our existing air emissions permit and complete certain green initiatives at the facility, including constructing a butterfly and bee garden at the plant site, installing LED lighting throughout the facility, and installing variable frequency drives on our evaporator pumps. As of July 31, 2016, we had completed construction of the butterfly and bee garden and installation of LED lighting throughout the facility. Installation of the variable frequency drives is expected to be completed this fall during our regular semi-annual maintenance shutdown.  

Results of Operations for the Three Months Ended July 31, 2016 and 2015

The following table shows summary information from the results of our operations and the approximate percentage of revenues, costs of goods sold, operating expenses and other items to total revenues in our unaudited condensed consolidated statements of operations for the three months ended July 31, 2016 and 2015 (amounts in thousands).

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. Revenues from our three primary products represented approximately 99.7%  and 99.8% of our total revenues for the three months ended July 31, 2016 and 2015, respectively. 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. These miscellaneous other revenues represented approximately 0.3% and 0.2% of our consolidated revenues for the three months ended July 31, 2016 and 2015, respectively.

The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our unaudited condensed consolidated statements of operations for the three months ended July 31, 2016: