UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended July 31, 2017 

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”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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, 2017, 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

Nature of Business

Heron Lake BioEnergy, LLC 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, Heron Lake BioEnergy, LLC produces and sells distillers’ grains with solubles and corn oil as co-products of ethanol production. 

Heron Lake BioEnergy, LLC’s wholly owned subsidiary, HLBE Pipeline Company, LLC (“HLBE Pipeline Company”), owns 73% of Agrinatural Gas, LLC (“Agrinatural”).  Agrinatural operates a natural gas pipeline that provides natural gas to Heron Lake BioEnergy, LLC 's ethanol production facility and other customers.

Basis of Presentation and Principles of Consolidation

The condensed consolidated unaudited financial statements as of July 31, 2017 include the accounts of Heron Lake BioEnergy, LLC and its wholly owned subsidiary, HLBE Pipeline Company (collectively the “Company”). 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% non-controlling interest identified separately in the accompanying condensed consolidated balance sheets and statements of operations.  All significant intercompany balances and transactions are eliminated in consolidation.

The condensed consolidated unaudited financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). 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, 2016, 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.

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.

Non-controlling Interest

Amounts recorded as non-controlling 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. Pursuant to the firm natural gas transportation agreement,  Agrinatural will provide natural gas to the plant with a specified price per MMBTU for a term ending on October 31, 2021, with one automatic renewal option to extend the term for an additional  five years. 

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.

Agrinatural recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee for the arrangement is fixed or determinable and collectability is reasonably assured.

Inventory

Inventory is stated at the lower of cost or net realizable value.  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.

Derivative Instruments

From time to time the Company enters into derivative transactions to hedge its exposures to commodity price fluctuations. The Company is required to record these derivatives on the balance sheets at fair value.

In order for a derivative to qualify as a hedge, specific criteria must be met and appropriate documentation maintained. Gains and losses from derivatives that do not qualify as hedges, or are undesignated, must be recognized immediately in earnings. If the derivative does qualify as a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will be either offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. Changes in the fair value of undesignated derivatives are recorded in earnings.

Additionally, the Company is required to evaluate its contracts to determine whether the contracts are derivatives. Certain contracts that literally meet the definition of a derivative may be exempted as “normal purchases or normal sales”.  Normal purchases and normal sales are contracts that 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. Contracts that meet the requirements of normal purchases or sales are documented as normal and exempted from accounting and reporting requirements, and therefore, are not marked to market in our condensed consolidated unaudited financial statements.

In order to reduce the risks caused by market fluctuations, the Company occasionally 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.

The Company has adopted authoritative guidance related to “Derivatives and Hedging,” and has included the required enhanced quantitative and qualitative disclosure about objectives and strategies for using derivatives, quantitative

disclosures about fair value amounts of gains and losses from derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. See further discussion in Note 4.

Reportable Operating Segments

Accounting Standards Codification (“ASC”) 280, “Segment Reporting,” establishes the standards for reporting information about segments in financial statements. 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 related business nature and expected financial results criteria set forth in ASC 280, the Company has two reportable operating segments for financial reporting purposes.

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 70% 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.

The supply and demand for ethanol are impacted by federal and state legislation and regulation, most significantly the Renewable Fuels Standard (“RFS”), and any changes in legislation or regulation could cause the  demand for ethanol to decline or its supply to increase, which could have a material adverse effect on our business, results of operations and financial condition, and the ability to operate at a profit.

On November 23, 2016, the U.S. Environmental Protection Agency (the “EPA”) announced the final rule for 2017 Renewable Volume Obligation (“RVO”) requirements, which is set at 15.0 billion gallons for corn-based ethanol, which equates to the original requirements set by the RFS.  On March 20, 2017, the previously announced 2017 RVOs went into effect.  

On July 5, 2017, the EPA announced the proposed rule for 2018 RVOs, which maintains the number of gallons that may be met by corn-based ethanol at 15.0 billion gallons. However, the total 2018 annual volume requirement for renewable fuel in the proposed 2018 rule is set at 19.24 billion gallons of renewable fuels, significantly below the 26 billion gallons statutorily mandated for 2018. According to the RFS, if mandatory renewable fuel volumes are reduced by at least 20% for two consecutive years, the EPA is required to modify, or reset, statutory volumes through 2022. With the 2018 being the first year the total proposed RVOs are more than 20% below statutory levels, the EPA administrator has directed  EPA staff to initiate the required technical analysis to inform a reset rule. If 2019 RVOs are also more than 20% below statutory levels, an RVO reset will be triggered under the RFS. This will require the EPA to modify statutory volumes through 2022 within one year of the trigger event, with the standard for review based on the same factors to be utilized when the EPA sets RVOs post-2022.

Beginning in January 2016, various ethanol and agricultural industry groups petitioned a federal appeals court to hear a legal challenge to of the EPA’s decision to reduce the total renewable fuel volume requirements for 2016 through use of its “inadequate domestic supply” waiver authority. On July 28, 2017, the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the petitioners, concluding the EPA erred in its exercise of  “inadequate domestic supply” waiver authority by considering demand-side constraints. As a result, the Court vacated the EPA’s decision to reduce the total renewable fuel volume requirements for 2016, and remanded to the EPA to address the 2016 total renewable fuels volume requirements. While management believes the decision should benefit the ethanol industry overall by clarifying the EPA's waiver analysis is limited to consideration of  supply-side factors only, no direct impact on the Company is expected from the decision.

Ethanol has historically traded at a discount to gasoline. However, any declines in crude oil and unleaded gasoline prices could have a negative impact on the market price of ethanol which could cause ethanol to trade at a premium to gasoline.  When ethanol trades at a premium to gasoline,  a disincentive for discretionary blending of ethanol beyond the required RFS blend rate results. 

Management anticipates that ethanol prices will continue to change in relation to changes in corn and energy prices. If corn, crude oil and gasoline prices decrease, that could have a negative impact on ethanol pricing and demand, which could result in a material adverse effect on our business, results of operations and financial condition. Further, the ethanol industry is currently experiencing growth in production capacity, largely through plant optimization and expansions versus new construction. If ethanol supply increases at a greater pace compared to ethanol demand, it could result in oversupply and negatively affecting prices unless additional demand can be created.

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 $65,000 and $108,000 for the nine months ended July 31, 2017 and 2016, respectively.

4.DERIVATIVE INSTRUMENTS

As of July 31, 2017, the total notional amount of the Company’s outstanding corn derivative instruments was approximately 4,800,000 bushels, comprised of long corn positions on 2,000,000 bushels that were entered into to hedge forecasted ethanol sales through September 2017, and short corn positions on 2,800,000 bushels that were entered into to hedge forecasted corn purchases through December 2018. 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, 2017,  the total notional amount of the Company’s outstanding ethanol derivative instruments was approximately 1,260,000 gallons that were entered into to hedge forecasted ethanol sales through September 2017.

As of July 31, 2017, the Company had approximately $144,000 of cash collateral (restricted cash) and approximately $95,000 due to broker related to corn derivatives held by a broker. 

The following tables provide details regarding the Company’s derivative instruments at July 31, 2017,  none of which are designated as hedging instruments:

As of October 31, 2016, the total notional amount of the Company's outstanding corn derivative instruments was approximately 4,285,000 bushels, comprised of long corn positions on 3,100,000 bushels that were entered into to hedge forecasted ethanol sales through March 2017, and short corn positions on 1,185,000 bushels that were entered into to hedge forecasted corn purchases through August 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 October 31, 2016, the Company had no cash collateral (restricted cash) related to corn derivatives held by a broker.

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

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

5.FAIR VALUE

The following table provides information on those derivative assets and liabilities measured at fair value on a recurring basis at July 31, 2017:

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

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. We determine the fair value of ethanol Level 2 instruments by model-based techniques in which all significant inputs are observable in the markets noted above.

6.DEBT FINANCING

Long-term debt consists of the following:

Revolving Term Note

The Company has a revolving term note payable with a lender, under which the Company could initially borrow, repay, and re-borrow in an amount up to $28,000,000 at any time prior to the March 1, 2022 maturity date.  However, the amount available for borrowing under the revolving term note reduces by $3,500,000 annually, starting March 1, 2015 and continuing each anniversary thereafter until maturity. Therefore, the aggregate principal amount available to the Company for borrowing at July 31, 2017, and October 31, 2016 was $17,500,000 and $21,000,000, respectively.  There was no outstanding balance on this facility at July 31, 2017 and October 31, 2016.

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, which was 4.48% and 3.45% at July 31, 2017 and October 31, 2016, respectively. 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 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 loan is secured by substantially all of the Company assets including a subsidiary guarantee. 

The 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.

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 revolving term loan and was appointed the administrative agent for the purpose of servicing the loan.  As a result, CoBank will act as the agent for the lender with respect to the credit facility. The Company agreed to pay CoBank an annual fee of $2,500 for its services as administrative agent.

Estimated annual maturities of long-term debt at July 31, 2017 are as follows based on the most recent debt agreements:

7.COMMITMENTS AND CONTINGENCIES

Corn Forward Contracts

At July 31, 2017, the Company had cash and basis contracts for forward corn purchase commitments totaling approximately 3,607,000 bushels for various delivery periods through July 2018.

Ethanol Forward Contracts

At July 31, 2017,  the Company had fixed and basis contracts to sell approximately $12,528,000 of ethanol for various delivery periods through September 2017.   

Distillers’ Grains Forward Contracts

At July 31, 2017, the Company had forward contracts to sell approximately $394,000 of distillers’ grains for delivery through August 2017.

Corn Oil Forward Contracts

At July 31, 2017, the Company had forward contracts to sell approximately $770,000 of corn oil for delivery through September 2017.

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 July 31, 2017 and October 31, 2016. 

In December 2015, the Board of Governors of HLBE declared a cash distribution of $0.05 per unit, or approximately $3,897,000, for unit holders of record as of December 17, 2015. The distribution was paid in January 2016.

9.LEASES

The Company leases equipment, primarily rail cars, under operating leases through 2027.  Rent expense for these leases was approximately $619,000 and $686,000 for the three months ended July 31, 2017 and 2016, respectively. Rent expense for these leases was approximately $1,597,000 and $1,931,000 for the nine months ended July 31, 2017 and 2016, respectively.  

10.RELATED PARTY TRANSACTIONS

Granite Falls Energy, LLC

The Company has a management services agreement with GFE. Under the terms of the management services agreement, GFE supplies its own personnel to act as part-time officers and managers of the Company for the positions of Chief Executive Officer, Chief Financial Officer, and Commodity Risk Manager and the Company pays GFE 50% of the total salary, bonuses, and other expenses and costs incurred by GFE for the three management positions.  The management services agreement automatically renews for successive one-year terms unless and until the Company or GFE gives the other party 90-days written notice of termination prior to expiration of then current term. The management services agreement may also be terminated by either party for cause under certain circumstances. Total expenses under this agreement were approximately $121,000 and $94,000 for the three months ended July 31, 2017 and 2016, respectively, and approximately $320,000 and $287,000 for the nine months ended July 31, 2017 and 2016, respectively.

Corn Purchases - Members

The Company purchased corn from board members of approximately $143,000 and $4,119,000 for the three months ended July 31, 2017 and 2016, respectively, and approximately $5,737,000 and $12,755,000 for the nine months ended July 31, 2017 and 2016, respectively.

Agrinatural

During 2013, the Company borrowed $300,000 from the non-controlling interest member of Agrinatural.  Total interest paid in relation to this note payable amounted to approximately $1,000 and $2,000 for the three months ended July 31, 2017 and 2016, respectively.  Interest paid in relation to this note payable amounted to approximately $5,000 and $7,000 for the nine months ended July 31, 2017 and 2016, respectively.

Swan Engineering

Agrinatural has a 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 management and operating agreement, SEI provides Agrinatural with day-to-day management and operation of Agrinatural's pipeline distribution business. In exchange for these services, Agrinatural pays 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 fee and variable customer management fee of approximately $48,000 and $44,000 for the three months ended July 31, 2017 and 2016, respectively, and approximately $145,000 and $132,000 for the nine months ended July 31, 2017 and 2016, respectively. The management and operating agreement with SEI expires July 1, 2019, unless earlier terminated for cause as defined in the agreement.

Agrinatural also has a project management agreement with SEI. Pursuant to the project management agreement, SEI supervises all of Agrinatural's pipeline construction projects. These projects are constructed by unrelated third-party pipeline construction companies. Under the project management agreement, Agrinatural pays SEI a total of 10% of the actual capital expenditures for construction projects approved by Agrinatural's board of managers, excluding capitalized marketing costs. The Company recorded project management fees of approximately $15,000 and $7,000 for the three months ended July 31, 2017 and 2016, respectively, and approximately $27,000 and $46,000 for the nine months ended July 31, 2017 and 2016, respectively. The project management with SEI expires June 30, 2019, unless earlier terminated for cause as defined in the agreement.

11.BUSINESS 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, 2017 and 2016. 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, 2016.

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, 2016  as supplemented by the risk factors disclosed in Item 1A of our Form 10-Q for the three months ended January 31, 2017, and Item 1A of our Form 10-Q for the three months ended April 30, 2017, and 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 (“Heron Lake BioEnergy” or  “HLBE”) is a Minnesota limited liability company that owns and operates a dry mill corn-based, natural gas fired ethanol plant near Heron Lake, Minnesota. 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, through a wholly owned subsidiary, HLBE Pipeline Company, LLC (“HLBE Pipeline Company”), we own a controlling interest of Agrinatural Gas, LLC (“Agrinatural”).  Agrinatural operates a natural gas pipeline that provides natural gas to Heron Lake BioEnergy, LLC 's ethanol production facility and other customers. 

When we use the terms “we”, “us”, “our”, the “Company” or similar words in this report on Form 10‑Q, unless the context otherwise requires, we are referring to Heron Lake BioEnergy and its wholly owned and majority owned subsidiaries. 

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.  We have received EPA pathway approval and have obtained permits from the Minnesota Pollution Control Authority to increase our production capacity to 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, dependent on industry conditions and plant profitability.

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 50.7% 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 management services automatically renews 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. 

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 16 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, 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, as amended (the “Orginal Credit Facility”) and the March 2015 credit facility, as amended (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. Details of these credit facilities to Agrinatural 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 HLBE’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 debottlenecking and exploring methods to improve ethanol yield per bushel and increasing production output at our plant over time dependent on industry conditions 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.

Additionally, 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,  “PART I - Item 1A. Risk Factors” of our annual report on Form 10-K for the fiscal year ended October 31, 2016, and “PART II - Item 1A. Risk Factors” of our quarterly reports on Form 10-Q for the three months ended January 31, 2017 and April 30, 2017.

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. 

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 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.

Given the relatively flat nature of ethanol prices during the three months ended July 31, 2017 as compared to historical average prices, management currently believes that the ethanol outlook for the remainder of our fiscal year will remain at the current levels and that our margins will remain tight despite certain favorable market conditions.    Continued low prices for crude oil and unleaded gasoline or further decreases in the price of such commodities could have a significant negative impact on the market price of ethanol, which could adversely impact our profitability. This negative impact could worsen in the event that domestic ethanol inventories remain high, or if U.S. exports of ethanol decline.

Domestic ethanol inventories continued to increase during the three and nine months ended July 31, 2017. According to the U.S. Energy Information Administration (“EIA”),  through the first half of calendar 2017, increasing ethanol production rates have outpaced domestic E10 gasoline demand and export growth, leading to elevated ethanol inventory levels at a time when they are typically falling to meet peak summer driving demand. The average daily domestic ethanol production reported by the EIA slowed to 1.01 million barrels per day during the three months ended July 31, 2017,  down slightly from 1.02 million barrels per day during the three months ended April 30, 2017, due in part to plant shutdowns for routine maintenance. Average daily production, however, increased 2.6% during the three months ended July 31, 2017 compared with the same period last year and increased by 4.3% for the nine months ended July 31, 2017 compared with the same period of 2016 due to increased domestic production capacity.

Gasoline domestic demand remains flat as compared to 2016 levels. The EIA released in its Short Term Energy Outlook report of April 5, 2017, that U.S. gasoline demand is expected to maintain 2016 levels of approximately 9.3 million barrels per day in 2017. During the three months ended July 31, 2017, ethanol continued trading at a discount to gasoline,  improving the economics of ethanol blending and encouraging discretionary blending as an oxygenate and octane enhancer for gasoline.  

Exports of ethanol have also been increasing,  however export demand for ethanol is less consistent compared to domestic demand which can lead to ethanol price volatility. The EIA reports that year-to-date domestic ethanol exports through June 30, 2017, were 601.1 million gallons, up 12.0%, from 537.0 million gallons for the comparable period in 2016. Brazil accounted for 36% of the domestic ethanol export volumes through June 30, 2017, while Canada, India, the Philippines and United Arab Emirates accounted for 20.4%, 12.3%, 5.5% and 2.2%, respectively. China, the second largest importer of U.S. ethanol in 2016, increased its ethanol import tariff from 5% to 30% as of January 1, 2017. As a result of the increased tariff, China has imported negligible volumes year-to-date. Recently, on  August 23, 2017, Brazil’s Chamber of Foreign Trade announced it would recommend imposing a 20% tariff on U.S. ethanol imports after a 600 million liter tariff rate quota. According EIA data, through the June 30, 2017, approximately 1,045 million liters of ethanol have been exported to Brazil from the U.S., already exceeding the Brazilian tariff free quota.  However, on June 27, 2017, the Energy Regulatory Commission of Mexico approved the use of 10% ethanol blends, effective immediately, up from 5.8%, in all but three of its largest cities: Mexico City, Guadalajara and Monterrey, which could lead to increased exports to Mexico.  Any decrease in U.S. ethanol exports could adversely impact the market price of ethanol unless domestic demand increases or foreign markets are developed. If ethanol exports decrease, this could lead to increased domestic ethanol stocks and reduce the market price of ethanol. Unless additional demand can be found in new foreign or domestic markets, a continued level of current ethanol stocks or any increase in domestic ethanol supply could further adversely impact the price of ethanol.

Our margins have also been, and could continue to be, negatively impacted due to the lower prices received for our distillers’ grains due to lower export demand and oversupply in the domestic market,  along with increased corn and soybean availability.  Export demand from China and Vietnam, historically two of the largest importers of U.S. produced distillers grains, has significantly declined. Last year, China began an anti-dumping and countervailing duty investigation related to distillers grains imported from the U.S. which contributed to a decline in distillers grains shipped to China. In January 2017, the Chinese issued final tariffs on U.S. distillers grains. The Chinese distillers grains anti-dumping tariffs range from 42.2% to 53.7% and the anti-subsidy tariffs range from 11.2% to 12%. As a result of the imposition of these duties, exports of U.S. distillers’ grains to China have signicantly declined.  

Additionally, exports of U.S. distillers’ grains to Vietnam had halted completely due to Vietnam’s imposition of stricter regulations on fumigation in December 2016. However, in a statement issued September 1, 2017, the U.S. Grains Council announced that Vietnam is lifting its suspension of U.S. distillers’ grains imports and easing fumigation requirements, potentially reopening a major market for U.S. distillers’ grains. Management anticipates distillers’ grains prices will remain lower during the remainder of our 2017 fiscal year, unless additional domestic demand or other foreign markets develop.

Corn oil prices have also been adversely impacted by oversupply of corn oil due to the substantial increase in corn oil production during the last few years. 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. Management also attributes lower corn oil prices, in part, to continued demand for corn oil from the biodiesel industry. Management anticipates lower demand for corn oil from the biodiesel industry may result if the proposed 2018 renewable volume obligations (“RVOs”) are finalized as the proposed rule reduces the renewable volume requirements for biodiesel from the statutory mandate.  If the demand for corn oil from the biodiesel industry declines due these lower mandates, corn oil prices could be adversely impacted.

Management anticipates continued lower corn prices due to the balance between corn supply and demand. Lower corn prices are primarily the result of the strong corn harvest in the fall of 2016, which increased the supply of corn available to the market.  According to the August 10, 2017 estimate of supply and demand provided by the U.S. Department of Agriculture (the “USDA”), the USDA estimates the 2017 corn supply to be 14.2 billion bushels, suggesting slightly lower corn prices for the remainder of our 2017 fiscal year and into the 2018 fiscal year.

Although natural gas prices remained steady during the three months ended July 31, 2017, management anticipates short-term increases and volatility in natural gas prices for the remainder of fiscal year 2017 due to disruptions to natural gas production and damage to natural gas infrastructure resulting from Hurricane Harvey’s late August landfall. The storm has resulted in extensive damage and flooding in Texas and Louisiana, especially in the coastal areas of these states. A full assessment of the extent of the damage is expected to be completed in the weeks ahead. There is still considerable uncertainty as to the extent of infrastructure damage and the ultimate amount of lost production from Hurricane Harvey. Therefore, we are uncertain as to how Hurricane Harvey will impact long term natural gas prices. However, management anticipates that the long-term impact of Hurricane Harvey natural gas prices will be less than the impact felt from Hurricane Katrina in 2005 due to shifts in where production takes place.  Since 2005, greater levels of production take place at inland basins, which are generally less affected by storms.We expect natural gas prices to be volatile or increase in the short to mid term given the unpredictable market situation.  Increases in the price of natural gas increases our cost of production and negatively impacts our profit margins. 

Government Supports and Regulation

The ethanol industry is dependent on several economic incentives to produce ethanol, the most significant of which is the federal Renewable Fuels Standard (the “RFS”). The RFS has been, and we expect will continue to be, a significant factor impacting ethanol usage. Under the provisions of the RFS, the Environmental Protection Agency (“EPA”) must publish an annual rule that establishes the number of gallons of different types of renewable fuels, including corn-based ethanol, that must be blended with gasoline in the U.S. by refineries, blenders, distributors and importers, which affects the domestic market for ethanol. The EPA assigns individual refiners, blenders and importers the renewable volume obligations (“RVOs”) they are obligated to use based on their percentage of total fuel sales. The EPA has the authority to waive the RVO requirements, in whole or in part, if there is inadequate domestic renewable fuel supply or the requirement severely harms the economy or the environment.

On November 23, 2016, the EPA announced the final rule for 2017 RVOs, which was set at 15.0 billion gallons for corn-based ethanol, 100% of the original statutory requirement for conventional ethanol. On March 20, 2017, the previously announced 2017 RVOs went into effect.

On July 5, 2017, the EPA announced the proposed rule for 2018 RVOs, which would set the 2018 annual volume requirement for renewable fuel at 19.24 billion gallons of renewable fuels, slightly less than the 19.28 billion gallons required under the final 2017 rule and significantly below the 26 billion gallons statutorily mandated for 2018. However, the proposed 2018 rule does maintain the number of gallons which may be met by corn-based ethanol at 15.0 billion gallons. The comment period for the proposed 2018 rule closed on August 31, 2017. By statute, the EPA is required to issue a final rule setting 2018 RVOs by November 30, 2017.

According to the RFS, if mandatory renewable fuel volumes are reduced by at least 20% for two consecutive years, the EPA is required to modify, or reset, statutory volumes through 2022. With the 2018 being the first year the total proposed RVOs are more than 20% below statutory levels, the EPA administrator has directed  EPA staff to initiate the required technical analysis to inform a reset rule. If 2019 RVOs are also more than 20% below statutory levels, an RVO reset will be triggered under the RFS. This will require the EPA to modify statutory volumes through 2022 within one year of the trigger event, with the standard for review based on the same factors to be utilized when the EPA sets RVOs post-2022.

Beginning in January 2016, various ethanol and agricultural industry groups petitioned a federal appeals court to hear a legal challenge to of the EPA’s decision to reduce the total renewable fuel volume requirements for 2016 through use of its “inadequate domestic supply” waiver authority.  The “inadequate domestic supply” waiver provision of RFS authorizes the EPA to consider supply-side factors affecting the volume of renewable fuel that is available to refiners, blenders, and importers to meet the statutory volume requirements. EPA argued that the waiver provision also permitted it to consider demand-side factors, such as the availability of renewable fuel to the ultimate consumer.    On July 28, 2017, the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the petitioners,  concluding the EPA erred in its exercise of  “inadequate domestic supply” waiver authority by considering demand-side constraints. As a result, the Court vacated the EPA’s decision to reduce the total renewable fuel volume requirements for 2016, and remanded to the EPA to address the 2016 total renewable fuels volume requirements. While management believes the decision should benefit the ethanol industry overall by clarifying the EPA's waiver analysis is limited to consideration of  supply-side factors only, no direct impact on the Company is expected from the decision.

Current conventional ethanol production capacity exceeds both the final 2017 and proposed 2018 RVO mandates that can be satisfied by corn-based ethanol.  Future demand will be influenced by economic incentives to blend based on the relative value of gasoline versus ethanol, taking into consideration the octane value of ethanol, environmental requirements and the RFS RVO requirements. Moreover, beyond the federal mandates, there are limited markets for ethanol. Although the proposed 2018 rule’s maintenance of the 15 billion gallon RVO for corn-based ethanol signals support from the EPA and the Trump administration for domestic ethanol production, the Trump administration could still elect to materially modify, repeal or otherwise invalidate the RFS. It is unclear what regulatory framework and renewable volume requirements, if any, will emerge as a result of such reforms; however, any such reform could adversely affect the demand and price for ethanol and our profitability.

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.

Our air permit requires certain on-going performance testing to be completed periodically to ensure compliance with minor source emission limits. On May 12, 2017, we submitted a letter to the Minnesota Pollution Control Agengy (“MPCA”) regarding the results of certain non-compliant tests and proposed certain amendments permit conditions and adjustments to other components of plant operations and production to ensure compliance with minor source emission limits. Since that time we have had continuing discussions with MPCA to resolve these non-compliant tests by agreement with MPCA. Such resolution may result in the payment of a civil penalty, which could be substantial, or other sanctions and remedies available to MPCA. Accordingly, we anticipate additional future expense associated with these issues, including our ongoing discussions with the MPCA. There can be no assurance that we will succeed in our discussions with the MPCA or enter into an agreement relating to our non-compliant emissions tests. Pending the resolution of this air permit issue, we continue to operate subject to the compliance agreement.

Results of Operations for the Three Months Ended July 31, 2017 and 2016

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, 2017 and 2016 (amounts in thousands).