UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

☒     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended October 31, 2017.

Or

☐     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

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)

Registrant’s telephone number, including area code: (507) 793-0077

Name of Exchange on which registered: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act: Yes ☐    No ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act: Yes ☐    No ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ☒

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth 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 126-2 of the Act) Yes ☐    No ☒

As of April 30, 2017, the aggregate market value of the 32,199,012 Class A units held by non-affiliates (computed by reference to the most recent offering price of Class A membership units) was approximately $9,659,704.  The units are not listed on an exchange or otherwise publicly traded. Additionally, the membership units are subject to significant restrictions on transfer under the registrant’s operating and member control agreement. In determining this value, the registrant has assumed that all of its governors, chief executive officer, chief financial officer, Granite Falls Energy, LLC and beneficial owners of 5% or more of its outstanding membership units are affiliates, but this assumption shall not apply to or be conclusive for any other purpose.

As of April 30, 2017, all of the 15,000,000 Class B units were held by an affiliate of the Company.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of January 29, 2018, there were 62,932,107 Class A units and 15,000,000 Class B units outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the registrant’s definitive Proxy Statement for the registrant’s 2018 Annual Meeting of Members are incorporated by reference into Part III.

INDEX

CAUTION REGARDING FORWARD-LOOKING STATEMENTS

This annual report contains historical information, as well as forward-looking statements regarding our business, financial condition, results of operations, performance and prospects. All statements that are not historical or current facts are forward-looking statements and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve known and unknown risks and relate to future events, our future financial performance, or our expected future operations and actions. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “future,” “intend,” “could,” “hope,” “predict,” “target,” “potential,” or “continue” or the negative of these terms or other similar expressions. These forward-looking statements are only our predictions based on current information and involve numerous assumptions, risks and uncertainties, including, but not limited to the following:

Our actual results or actions may differ materially from these forward-looking statements for many reasons, including the reasons described in Part I, Item 1A. “Risk Factors” of this Form 10-K.  We undertake no duty to update these forward-looking statements, even though our situation may change in the future.  We cannot guarantee future results, levels of activity, performance or achievements.  We caution you not to put undue reliance on any forward-looking statements, which speak only as of the date of this report.  You should read this report and the documents that we reference in this report and have filed as exhibits, completely and with the understanding that our actual future results may be materially different from what we currently expect.  We qualify all of our forward-looking statements with these cautionary statements. Unless otherwise stated, references in this report to particular years or quarters refer to our fiscal years ended October 31 and the associated quarters of those fiscal years.

INDUSTRY AND MARKET DATA

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

AVAILABLE INFORMATION

Our principal executive offices are located at 91246 390th Avenue, Heron Lake, Minnesota 56137, and our telephone number is 507-793-0077.  We make available free of charge on or through our Internet website, www.heronlakebioenergy.com, all of our reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”).  The SEC also maintains an internet site (http://www.sec.gov) through which the public can access our reports.  We will provide electronic or paper copies of these documents free of charge upon request.

PART I

When we use the terms “Heron Lake BioEnergy”, “Heron Lake”, or “HLBE” or similar words, unless the context otherwise requires, we are referring to Heron Lake BioEnergy, LLC and our operations at our ethanol production facility located near Heron Lake, Minnesota. When we use the terms the “Company”, “we”, “us”, “our” or similar words in this Annual Report on Form 10-K, unless the context otherwise requires, we are referring to Heron Lake BioEnergy and its wholly owned subsidiary, HLBE Pipeline Company, LLC, through which HLBE holds a 73.0% controlling interest in Agrinatural Gas, LLC (“Agrinatural”).

Additionally, when we refer to “units” in this Annual Report on Form 10-K, unless the context otherwise requires, we are referring to the Class A units of Heron Lake BioEnergy.

ITEM 1.    BUSINESS

Overview

Heron Lake BioEnergy, LLC was organized as a Minnesota limited liability company on April 12, 2001 under the name “Generation II, LLC”.  In June 2004, we changed our name to Heron Lake BioEnergy, LLC.    

In July 2013, Granite Falls Energy, LLC (“Granite Falls” or “GFE”) acquired a controlling interest in the Company from Project Viking, L.L.C. GFE, now a related party, owns an ethanol plant located in Granite Falls, Minnesota. As of January 29, 2018, GFE owns approximately 31.4% of our outstanding Class A membership units and 100.0% of our outstanding Class B Units, for total ownership of approximately 50.7%, an decrease from its prior ownership percentage of approximately 50.6% due to its April 1, 2017 purchase of approximately 55,000 Class A Units in a private transaction with a HLBE unitholder at a price of $0.85 per unit.  As a result of its majority ownership, GFE has the right to appoint five (5) of the nine (9) governors to our board of governors under our member control agreement.

We operate a dry mill fuel-grade ethanol plant in Heron Lake, Minnesota.  Since beginning operation of our ethanol plant on September 21, 2007, our primary business has been the production and sale of ethanol and co-products, including dried distillers’ grains and since February 2012, non-edible corn oil. Our plant was originally constructed as a coal fired plant but was converted to natural gas in November 2011. 

Our ethanol plant has a nameplate capacity of 50 million gallons per year.  On July 10, 2015, the Minnesota Pollution Control Agency approved a major amendment to our air emission permit which increased our permitted production capacity from 59.9 million gallons 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 at an annual rate of approximately 65 million gallons and intend to continue to take advantage of the additional production allowed pursuant to our permit as long as we believe it is profitable to do so.

In fiscal years 2017, 2016, and 2015, we sold approximately 64.0 million gallons, 61.4 million gallons,  and 59.3 million gallons of ethanol, respectively.

Our wholly owned subsidiary, HLBE Pipeline Company, LLC, owns 73% of Agrinatural Gas, LLC (“Agrinatural”).  Agrinatural is a natural gas pipeline company that was formed to construct, own, and operate the natural gas pipeline that provides natural gas to the Company’s ethanol production facility and other customers through a connection with the natural gas pipeline facilities of Northern Border Pipeline Company in Cottonwood County, Minnesota.  Rural Energy Solutions, LLC (“RES”) owns the remaining 27%  non-controlling interest in Agrinatural.

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.

Before intercompany eliminations, revenues from our natural gas pipeline segment represented 2.7%, 2.5%, and 2.4% of our total consolidated revenues in the years ended October 31, 2017, 2016, and 2015, respectively.  After accounting for intercompany eliminations for fees paid by the Company to Agrinatural for natural gas transportation services pursuant to our natural gas transportation agreement, Agrinatural’s revenues represented 1.1%, 0.9%, and 0.9%, of our consolidated revenues for the fiscal years ended October 31, 2017, 2016, and 2015, respectively, and have little to no impact on the overall performance of the Company.

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 15,  “Business Segments”, of the notes to audited consolidated financial statements for financial information about our financial reporting segments.

Financial Information

Please refer to “ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” for information about our revenue, profit and loss measurements and total assets and liabilities and “ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for our consolidated financial statements and supplementary data.

Ethanol Production Segment

Revenues from our ethanol production segment have represented 98.9%, 99.1%, and 99.1%  of our revenues in the years ended October 31, 2017, 2016, and 2015 respectively.    

Principal Products

The principal products from our ethanol production are fuel-grade ethanol, distillers’ grains, non-edible corn oil and miscellaneous sales of distillers’ syrup, a by-product of the ethanol production process.  We did not introduce any new products or services as part of our ethanol production segment during our fiscal year ended October 31, 2017. 

The table below shows the approximate percentage of our total revenue which is attributable to each of our principal products for each of the last three fiscal years.

Ethanol

Ethanol is a type of alcohol produced in the U.S. principally from corn.  Ethanol is ethyl alcohol, a fuel component made primarily from corn in the U.S. but can also be produced from various other grains. Ethanol is primarily used as:

Ethanol produced in the U.S. is primarily used for blending with unleaded gasoline and other fuel products as an octane enhancer or fuel additive.  Ethanol is most commonly sold as E10 (10% ethanol and 90% gasoline), which is the blend of ethanol approved by the U.S. Environmental Protection Agency (“EPA”) for use in all American automobiles. Increasingly, ethanol is also available as E85, a higher percentage ethanol blend (85% ethanol and 15% gasoline) approved by the EPA for use in flexible fuel vehicles.

Distillers’ Grains

The principal co-product of the ethanol production process is distillers’ grains, a high protein and high-energy animal feed ingredient primarily marketed to the dairy and beef industries.  Dry mill ethanol processing creates three primary forms of distillers’ grains: wet distillers’ grains, modified wet distillers’ grains, and dried distillers’ grains with solubles.  Most of the distillers’ grains that we sell are in the form of dried distillers’ grains and modified/wet distillers’ grains.  Modified/wet distillers’ grains are processed corn mash that has been dried to approximately 50% moisture and has a shelf life of approximately 7 days.  Modified/wet distillers’ grains are often sold to nearby markets.  Dried distillers’ grains with solubles are corn mash that has been dried to approximately 10% to 12% moisture.  It has an almost indefinite shelf life and may be sold and shipped to any market and fed to almost all types of livestock.

Corn Oil

We  also extract a portion of the crude corn oil contained in our distillers’ grains which we market separately from our distillers’ grains.  The corn oil that we produce is not food grade corn oil and therefore cannot be used for human consumption. Corn oil is used primarily as a biodiesel feedstock and as a supplement for animal feed.

Corn Syrup

We also occasionally sell excess corn syrup in liquid syrup form to livestock feeders.  The excess syrup results from a plant upset, or when the amount of syrup produced during the drying process exceeds our distillers’ grains’ dryer capacity. Corn syrup is used primarily as a feed additive to moisten dry feed stuffs such as hay.

Principal Product Markets

As described below in “Distribution of Principal Products”, we market and distribute all of our ethanol, distillers’ grains and corn oil through professional third party marketers. Our marketers make all decisions with regard to where our products are marketed and we have little control over the marketing decisions they make.  

Our ethanol, distillers’ grains and corn oil are primarily sold in the domestic market; however, as markets allow, our products can be, and have been, sold in the export markets. We expect our marketers to explore all markets for our products, including export markets. We believe that there is some potential for increased international sales of our products. Nevertheless, due to high transportation costs, and the fact that we are not located near a major international shipping port, we expect our products to continue to be marketed primarily domestically. 

Ethanol Markets

The markets in which our ethanol is sold will depend primarily upon the efforts of Eco-Energy, Inc. (“Eco-Energy”), which buys and markets our ethanol. There are local, regional, national, and international markets for ethanol.  The principal markets for our ethanol are petroleum terminals in the continental U.S.  The principal purchasers of ethanol are generally wholesale gasoline distributors or blenders.

We believe that local markets will be limited and must typically be evaluated on a case-by-case basis.  Although local markets may be the easiest to service, they may be oversold because of the number of ethanol producers near our plant, which may depress the price of ethanol in those markets.

Typically, a regional market is one that is outside of the local market, yet within the neighboring states.  Some regional markets include large cities that are subject to anti-smog measures in either carbon monoxide or ozone non-attainment areas, or that have implemented oxygenated gasoline programs, such as Chicago, St. Louis, Denver, and Minneapolis.  We consider our primary regional market to be large cities within a 450-mile radius of our ethanol plant.  In the national ethanol market, the highest demand by volume is primarily in the southern U.S. and the east and west coast regions.

We expect a majority of our ethanol to continue to be marketed and sold domestically. In addition, as domestic production of ethanol continues to expand, we anticipate increased international sales. Over our past fiscal year, exports of ethanol have increased with Brazil receiving the largest percentage of ethanol produced in the United States and Canada in second place. India, the Philippines and South Korea have also been top destinations.   However, ethanol export demand is more unpredictable than domestic demand and tends to fluctuate over time as it is subject to monetary and political forces in other nations. For example, a strong US Dollar is a force that may negatively impact ethanol exports from the United States.  Additionally, the imposition of tariffs and duties on ethanol imported from the U.S. can also negatively impact domestic export demand.

Although exports to China also substantially increased during 2016 over 2015,  China imported negligible volumes during 2017.  This reduction was due to China’s increase of the tariff on ethanol imported from the U.S. and Brazil to 30% as of January 1, 2017, compared to a 5% tariff in 2016.  However, on September 13, 2017, China’s National Development and Reform Commission, the National Energy Board and 15 other state departments issued a joint plan to expand the use and production of biofuels containing up to 10% ethanol by 2020. There is no assurance the recently issued joint plan will lead to increased imports of US ethanol. 

During 2017 Brazil also adopted import quotas on imported ethanol, which is expected to negatively impact U.S. exports. On September 1, 2017, Brazil’s Chamber of Foreign Trade, or CAMEX, issued an official written resolution, imposing a 20% tariff on U.S. ethanol imports in excess of 150 million liters, or 39.6 million gallons per quarter. The ruling is valid for two years. According to the RFA, during September 2017, Brazil fell out of the top two customers of U.S. ethanol exports which is most likely the result of the implementation of the 20% tariff on imported ethanol. Exports to Brazil in September 2017 decreased by 20% compared to August 2017 exports and by 70% compared to the peak in May 2017. These tariffs have had, and likely will continue to have, a negative impact on the export market demand and prices for ethanol produced in the United States.

On June 27, 2017, Mexico’s Energy Regulatory Commission (“CRE”) 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.  However, several lawsuits were filed in Mexico challenging the June 2017 decision by the CRE to approve the use of 10% ethanol blends.  Although four of these lawsuits were dismissed, a fifth lawsuit was allowed to proceed for judicial review, despite precedent set by the Mexico Supreme Court for dismissal. The CRE is expected to defend its position before the judge makes a final decision. Should the judge rule in favor of the plaintiff, the case will go to the Mexico Supreme Court.

We transport our ethanol primarily by rail.  In addition to rail, we service certain regional markets by truck from time to time.  We believe that regional pricing tends to follow national pricing less the freight difference.

Distillers’ Grains Markets

We sell distillers’ grains as animal feed for beef and dairy cattle, poultry, and hogs. Most of the distillers’ grains that we sell are in the form of dried distillers’ grains.  Currently, the U.S. ethanol industry exports a significant amount of dried distillers’ grains, which may increase as worldwide acceptance grows.  However, according to the U.S. Grains Council, total U.S. distiller’s grains exports through October 2017 were approximately 3% lower than distiller’s grains exports for the same period last year with Mexico, Turkey, South Korea, Canada, Thailand and Indonesia.

 Historically, the United States ethanol industry exported a significant amount of distillers’ grains to China and Vietnam. However, during 2016, 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 during 2016. 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%. The imposition of these duties has resulted in a significant decline in demand from this top importer requiring U.S. producers to seek out alternative markets.  In November 2017, the China Ministry of Commerce announced that the anti-subsidy tariffs would be repealed.  While the anti-subsidy tariffs may be removed, the substantial anti-dumping duties remain.  As a result, there is no guarantee that distillers’ grains exports to Chinese will resume.

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.  The lift of this suspension may result in increased exports to Vietnam; however, there is no guarantee that the Vietnamese export market will achieve significant growth.

We also sell modified wet distillers’ grains, which typically have a shelf life of a maximum of 7 days.  This provides for a much smaller, more local market and makes the timing of its sale critical. Further, because of its moisture content, the modified wet distillers’ grains are heavier and more difficult to handle. The customer must be close enough to justify the additional handling and shipping costs. As a result, modified wet distillers’ grains are principally sold only to local feedlots and livestock operations.

Various factors affect the price of distillers’ grains, including, among others, the price of corn, soybean meal and other alternative feed products, the performance or value of distillers’ grains in a particular feed market, and the supply and demand within the market.  Like other commodities, the price of distillers’ grains can fluctuate significantly.

Corn Oil Markets

Our corn oil is primarily sold to biodiesel manufacturers and, to a lesser extent, feed lot and poultry markets. We generally transport our corn oil by truck to users located primarily in the upper Midwest.

Distribution of Principal Products

Our ethanol plant is located in Heron Lake, Minnesota in Jackson County. We selected the plant site because of its accessibility to road and rail transportation and its proximity to grain supplies.  The ethanol plant has the facilities necessary to load ethanol and distillers’ grains onto trucks and rail cars.  It is served by the Union Pacific Railroad. Our site is in close proximity to major highways that connect to major population centers such as Minneapolis, Minnesota; Chicago, Illinois; and Detroit, Michigan.

Ethanol Distribution

Eco-Energy is our ethanol marketer.  Pursuant to our marketing agreement with Eco-Energy, it has agreed to purchase and market the entire ethanol output of our ethanol plant.  Additionally, Eco-Energy arranges for the transportation of our ethanol.  We pay Eco-Energy a marketing fee based on a percentage of the applicable sales price per gallon of ethanol sold, as well as a fixed lease fee for rail cars leased from Eco-Energy. The marketing fee was negotiated based on prevailing market-rate conditions for comparable ethanol marketing services.

The term of our agreement with Eco-Energy expires on December 31, 2019.  However, the agreement provides for 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 then-current term.    

Distillers’ Grains Distribution

Gavilon Ingredients, LLC (“Gavilon”) serves as the distillers’ grains marketer for our plant pursuant to a distillers’ grains off-take agreement.  Pursuant to our agreement with Gavilon, Gavilon purchases all of the distillers’ grains produced at our ethanol plant.  We pay Gavilon a service fee for its services under this agreement. The contract commenced on November 1, 2013 with an initial term of six months, and will continue to remain in effect until terminated by either party at its unqualified option, by providing written notice of not less than 60 days to the other party.

Corn Oil Distribution

RPMG, Inc. (“RPMG”) markets the corn oil produced at our ethanol plant pursuant to a corn oil marketing agreement.  We pay RPMG a commission based on each pound of corn oil sold by RPMG under the agreement.

We independently market and sell the excess corn syrup occasionally produced from the distillation process at our plant to local livestock feeders.

Dependence on One or a Few Major Customers

As discussed above, we have exclusive ethanol marketing agreements with Eco-Energy. Additionally, we have agreements with Gavilon and RPMG to market all of the distillers’ grains and corn oil, respectively, produced at the plant. We rely on Eco-Energy, RPMG and Gavilon for the sale and distribution of all of our products, therefore, we are highly dependent on Eco-Energy, RPMG and Gavilon for the successful marketing of our products. Any loss of these companies as our marketing agents for our ethanol, distillers’ grains, or corn oil could have a negative impact on our revenues.

Seasonality of Ethanol Sales

Since ethanol is predominantly blended with conventional gasoline for use in automobiles, ethanol demand tends to shift in relation to gasoline demand. As a result, we experience some seasonality of demand for ethanol in the summer months related to increased driving. In addition, we experience some increased ethanol demand during holiday seasons related to increased gasoline demand.

Pricing of Corn and Ethanol

We expect that ethanol sales will represent our primary revenue source and corn will represent our primary component of cost of goods sold.  Therefore, changes in the price at which we can sell the ethanol we produce and the price at which we buy corn for our ethanol plant present significant operational risks inherent in our business. Trends in ethanol prices and corn prices are subject to a number of factors and are difficult to predict.

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. With the volatility of the weather and commodity markets, we cannot predict the future price of corn. Historically, ethanol prices have tended to correlate with corn prices, wholesale gasoline prices, with demand for and the price of ethanol increasing as supplies of petroleum decreased or appeared to be threatened, crude oil prices increased and wholesale gasoline prices increased. However, the prices of both ethanol and corn do not always follow historical trends. 

Generally, higher corn prices will produce lower profit margins and, therefore, negatively affect our financial performance.  If a period of high corn prices were to be sustained for some time, such pricing may reduce our ability to operate profitably because of the higher cost of operating our plants.  Because the market price of ethanol is not directly related to corn prices, we, like most ethanol producers, are not able to compensate for increases in the cost of corn through adjustments in our prices for our ethanol although we do see increases in the prices of our distillers’ grains during times of higher corn prices. Given that ethanol sales comprise a majority of our revenues, our inability to adjust our ethanol prices can result in a negative impact on our profitability during periods of high corn prices.

Ethanol prices were higher during fiscal year 2017 compared to fiscal year 2016.  Ethanol prices were higher during the fiscal year ended October 31, 2017 due to increased export demand which offset increased industry-wide production.  Management expects additional volatility for the price of ethanol in 2018.  Ethanol supply and demand both are expected to increase in 2018, which may lead to market imbalances.  Due to low ethanol and feedstock prices, exports grew in 2017 and are projected to continue to grow in 2018.  This is positive for the ethanol industry, but does introduce additional risk as international demand is more volatile than domestic demand.  U.S. gas demand was flat year over year in 2017, while ethanol as a percentage of the fuel supply increased slightly.  A decrease in demand for either gasoline or ethanol blends would adversely impact the price of ethanol, which could result in a material adverse effect on our business, results of operations and financial condition. 

Sources and Availability of Raw Materials

The primary raw materials used in the production of ethanol at our plant are corn and natural gas.  Our ethanol plant also requires significant and uninterrupted amounts of electricity and water.  We have entered into agreements for our supply of electricity, natural gas, and water.

Corn Procurement

Ethanol production requires substantial amounts of corn. The cost of corn represented approximately 72.9%, 74.4%, and 74.1% of our cost of sales for the years ended October 31, 2017, 2016, and 2015, respectively.  At our current production rate of approximately 65 million gallons of ethanol per year, we need to procure approximately 22.5 million bushels of corn per year for our dry mill ethanol process.  We believe our facility has sufficient corn storage capacity, with the capability to store approximately 8 days of corn supply.

We generally purchase corn through spot cash, fixed-price forward, basis only, and futures only contracts. Our fixed-price forward contracts specify the amount of corn, the price and the time period over which the corn is to be delivered.  These forward contracts are at fixed prices indexed to Chicago Board of Trade (“CBOT”) prices. Our corn requirements can be contracted in advance under fixed-price forward contracts or options. The parameters of these contracts are based on the local supply and demand situation and the seasonality of the price. For delayed pricing contracts, producers will deliver corn to us, but the pricing for that corn and the related payment will occur at a later date. We may also purchase a portion of our corn on a spot basis. For our spot purchases, we post daily corn bids so that corn producers can sell to us on a spot basis.

Typically, we purchase our corn directly from grain elevators, farmers, and local dealers within approximately 80 miles of Heron Lake, Minnesota. We compete with ethanol producers in close proximity for the supplies of corn we will require to operate our plant.  There are 8 ethanol plants within an approximate 50 mile radius of our plant. The existence of other ethanol plants, particularly those in close proximity to our plant, increase the demand for corn and may result in higher costs for supplies of corn. We also compete with other users of corn, including ethanol producers regionally and nationally, producers of food and food ingredients for human consumption (such as high fructose corn syrup, starches, and sweeteners), producers of animal feed and industrial users.

Since corn is the primary raw material we use to produce our products, the availability and cost of corn can have a significant impact on the profitability of our operations. Corn prices were lower during our 2017 fiscal year as a result of several consecutive years of favorable corn crops which has increased the amount of corn available to us. As a result of these favorable corn crops, we have not had difficulty securing the corn we need to operate the ethanol plant at prices that have allowed us to operate profitably. If we experience a drought or other unfavorable weather condition during our 2018 fiscal year, the price we pay for corn and the availability of corn near our plant could be negatively impacted. If we experience a localized shortage of corn, we may be forced to purchase corn from producers who are farther away from our ethanol plant which can increase our transportation costs.

Natural Gas Procurement

The primary source of energy in our manufacturing process is natural gas.  The cost of natural gas represented approximately 6.7%, 5.6%, and 6.9% of our cost of sales for the years ended October 31, 2017, 2016, and 2015, respectively. 

We do not anticipate any problems securing the natural gas we require to continue to operate our plant at capacity during our 2018 fiscal year or beyond.  We have a facilities agreement with Northern Border Pipeline Company, which allows us to access an existing interstate natural gas pipeline located approximately 16 miles north from our plant. We also have entered into a firm natural gas transportation agreement with our majority owned subsidiary, Agrinatural.  Under the terms of 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 an additional five years. 

We also have a base agreement for the sale and purchase of natural gas with Constellation NewEnergy—Gas Division, LLC.  We buy all of our natural gas from Constellation and this agreement runs until March 31, 2019.

The prices for and availability of natural gas are subject to volatile market conditions.  These market conditions often are affected by factors beyond our control such as higher prices as a result of colder than average weather conditions or natural disasters, overall economic conditions and foreign and domestic governmental regulations and relations.  Significant disruptions in the supply of natural gas could impair our ability to manufacture ethanol and more significantly, dried distillers’ grains for our customers.  Furthermore, increases in natural gas prices or changes in our natural gas costs relative to natural gas costs paid by competitors may adversely affect our results of operations and financial condition.

Electricity

Our plant requires a continuous supply of electricity. We have an agreement in place to supply electricity to our plant. We do not anticipate any problems securing the electricity that we require to continue to operate our plant at capacity during our 2018 fiscal year or beyond.

Water

Our plant also requires a continuous supply of water, which we obtain pursuant to an industrial water supply agreement with the City of Heron Lake and Jackson County, Minnesota. We do not anticipate any problems securing the water that we require to continue to operate our plant at capacity during our 2018 fiscal year or beyond.

Risk Management and Hedging

The profitability of our operations is highly dependent on the impact of market fluctuations associated with commodity prices.  We use various derivative instruments as part of an overall strategy to manage market risk and to reduce the risk that our ethanol production will become unprofitable when market prices among our principal commodities and products do not correlate.  

In order to mitigate our commodity and product price risks, we enter into hedging transactions, including forward corn, ethanol, distillers’ grains and natural gas contracts, in an attempt to partially offset the effects of price volatility for corn and ethanol.  However, we are not always presented with an opportunity to lock in a favorable margin and our plant’s profitability may be negatively impacted during periods of high grain prices. We also enter into over-the-counter and exchange-traded futures, swaps and option contracts for corn, ethanol and distillers’ grains, designed to limit our exposure to increases in the price of corn and manage ethanol price fluctuations.  

Although we believe that our hedging strategies can reduce the risk of price fluctuations, the financial statement impact of these activities depends upon, among other things, the prices involved and our ability to physically receive or deliver the commodities involved.  Our hedging activities could cause net income to be volatile from quarter to quarter due to the timing of the change in value of the derivative instruments relative to the cost and use of the commodity being hedged.  As corn and ethanol prices move in reaction to market trends and information, our income statement will be affected depending on the impact such market movements have on the value of our derivative instruments.

Hedging arrangements expose us to the risk of financial loss in situations where the counterparty to the hedging contract defaults or, in the case of exchange-traded contracts, where there is a change in the expected differential between the price of the commodity underlying the hedging agreement and the actual prices paid or received by us for the physical commodity bought or sold.  There are also situations where the hedging transactions themselves may result in losses, as when a position is purchased in a declining market or a position is sold in a rising market. Hedging losses may be offset by a decreased cash price for corn and natural gas and an increased cash price for ethanol and distillers’ grains.

We have established a risk management committee which assists the board and our risk management manager to, among other things, establish appropriate policies and strategies for hedging and enterprise risk. We continually monitor and manage our commodity risk exposure and our hedging transactions as part of our overall risk management policy.  As a result, we may vary the amount of hedging or other risk mitigation strategies we undertake, and we may choose not to engage in hedging transactions.  Our ability to hedge is always subject to our liquidity and available capital.

Process Improvement

We are continually working to develop new methods of operating the ethanol plant more efficiently.  We continue to conduct process improvement activities in order to realize these efficiency improvements.

Patents, Trademarks, Licenses, Franchises and Concessions

We do not currently hold any patents, trademarks, franchises or concessions. We were granted a license by ICM, Inc. to use certain ethanol production technology necessary to operate our ethanol plant. The cost of the license granted by ICM was included in the amount we paid to Fagen, Inc. to design and build our ethanol plant.

Competition

Ethanol Competition

We sell our ethanol in a highly competitive market.  Ethanol is a commodity product where competition in the industry is predominantly based on price. On a national scale, we are in direct competition with numerous other ethanol producers.  According to the RFA, as of October 27, 2017, there are approximately 214 biorefineries with a total nameplate capacity of approximately 16.2 billion gallons of ethanol per year, with an additional six plants under expansion or construction with capacity to produce an additional 463 million gallons.  However, the RFA estimates that approximately 2.6% of the ethanol production capacity in the U.S. was not operating as of October 27, 2017. 

The following table identifies the top five largest ethanol producers in the U.S. along with their production capacities.

Each of the large ethanol producers above are capable of producing significantly more ethanol than we produce. These producers and other large producers are, among other things, capable of producing a significantly greater amount of ethanol or have multiple ethanol plants that may help them achieve certain benefits that we could not achieve with one ethanol plant. This could put us at a competitive disadvantage to other ethanol producers.

Larger ethanol producers may have an advantage over us from economies of scale and stronger negotiating positions with purchasers.  Large producers own multiple ethanol plants and may have flexibility to run certain facilities while shutting or slowing down production at their other facilities. This added flexibility may allow these producers to compete more effectively, especially during periods when operating margins are unfavorable in the ethanol industry.

Some large producers own ethanol plants in geographically diverse areas of the U.S. and as result, may be able to more effectively spread the risk they encounter related to feedstock prices. Some of our competitors are owned subsidiaries of larger oil companies, such as Valero Renewable Fuels and Flint Hills Resources. Because their parent oil companies are required to blend a certain amount of ethanol each year, these competitors may be able to operate their ethanol production facilities at times when it is unprofitable for us to operate our ethanol plant. Further, new products or methods of ethanol production developed by larger and better-financed competitors could provide them competitive advantages over us and harm our business.

A majority of the U.S. ethanol plants, and therefore, the greatest number of gallons of ethanol production capacity, are concentrated in the corn-producing states of Iowa, Nebraska, Illinois, Indiana, Minnesota, South Dakota, Ohio, Wisconsin, Kansas, and North Dakota.  According to the RFA, as of October 27, 2017, Minnesota  is one of the top producers of ethanol in the U.S. with 21 ethanol plants producing an aggregate of approximately 1.5 billion gallons of ethanol per year. Therefore, we face increased regional and local competition because of the location of our ethanol plant. 

Eco-Energy markets out ethanol primarily on a regional and national basis.  We compete with other ethanol producers both for markets in Minnesota and markets in other states. We believe that we are able to reach the best available markets through the use of our experienced marketer and by the rail delivery methods we use. We believe that we can compete favorably with other ethanol producers due to our proximity to ample grain, natural gas, electricity and water supplies at favorable prices.

In addition to intense competition with domestic producers of ethanol, we have faced increased competition from ethanol produced in foreign countries. Depending on feedstock prices, ethanol imported from foreign countries may be less expensive than domestically-produced ethanol.  However, foreign demand, transportation costs and infrastructure constraints may temper the market impact on the U.S. Ethanol imports have been lower in recent years and ethanol exports have been higher. However, if demand for imported ethanol were to increase again, demand for domestic ethanol may be reduced, which could lead to lower domestic prices and lower operating margins. Large international companies with much greater resources than ours have developed, or are developing, increased foreign ethanol production capacities. Many international suppliers produce ethanol primarily from inputs other than corn, such as sugar cane, and have cost structures that may be substantially lower than U.S. based ethanol producers including us. Many of these international suppliers are companies with much greater resources than us with greater production capacities.

Competition from Alternative Fuels and Other Fuel Additives

Alternative fuels and alternative ethanol production methods are continually under development. New ethanol products or methods of ethanol production developed by larger and better-financed competitors could provide them competitive advantages over us and harm our business.

We anticipate increased competition from renewable fuels that do not use corn as the feedstock. Many of the current ethanol production incentives are designed to encourage the production of renewable fuels using raw materials other than corn. One type of ethanol production feedstock that is being explored is cellulose. Cellulose is found in wood chips, corn stalks and rice straw, amongst other common plants. Several companies and researchers have commenced pilot projects to study the feasibility of commercially producing cellulosic ethanol. Additionally, a few companies have begun construction or completed commercial scale cellulosic ethanol plants. If this technology can be profitably employed on a commercial scale, it could potentially lead to ethanol that is less expensive to produce than corn based ethanol. Cellulosic ethanol may also capture more government subsidies and assistance than corn based ethanol. This could decrease demand for our product or result in competitive disadvantages for our ethanol production process.

In addition to competing with ethanol producers, we also compete with producers of other gasoline oxygenates.  Many gasoline oxygenates are produced by other companies, including oil companies.  The major oil companies have significantly greater resources than we have to develop alternative products and to influence legislation and public perception of ethanol. Historically, as a gasoline oxygenate, ethanol primarily competed with two gasoline oxygenates, both of which are ether-based: MTBE (methyl tertiary butyl ether) and ETBE (ethyl tertiary butyl ether).  While ethanol has displaced these two gasoline oxygenates, the development of ethers intended for use as oxygenates is continuing and we will compete with producers of any future ethers used as oxygenates.

A number of automotive, industrial and power generation manufacturers are developing alternative fuels and clean power systems using fuel cells, plug-in hybrids, electric cars or clean burning gaseous fuels. Electric car technology has recently grown in popularity, especially in urban areas. While there are currently a limited number of vehicle recharging stations, there has been increased focus on developing these recharging stations to make electric car technology more feasible and widely available in the future. Additional competition from these other sources of alternative energy, particularly in the automobile market, could reduce the demand for ethanol, which would negatively impact our profitability.

Distillers’ Grains Competition

The amount of distillers’ grains produced annually in North America has increased significantly as the number of ethanol plants increased.  We compete with other producers of distillers’ grains products both locally and nationally, with more intense competition for sales of distillers’ grains among ethanol producers in close proximity to our ethanol plant.  These competitors may be more likely to sell to the same markets that we target for our distillers’ grains.

Distillers’ grains are primarily used as an animal feed, competing with other feed formulations using corn and soybean meal. As a result, we believe that distillers’ grains prices are positively impacted by increases in corn and soybean prices. In recent years the U.S. ethanol industry has increased exports of distillers’ grains which management believes has positively impacted demand and prices for distillers’ grains in the U.S. However, with the recent imposition of Chinese import duties on U.S. distillers’ grains,  distillers’ grains exports have been negatively impacted, increasing the domestic supply of distillers’ grains. Increased domestic supply has had a corresponding negative impact on distillers’ grains prices and has decreased the price of distillers’ grains as compared to a comparable volume of corn. In the event these distillers’ grains exports continue to decrease, it could result in increased competition among ethanol producers for sales of distillers’ grains and could negatively impact distillers’ grains prices in the U.S.

Government Ethanol Supports

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 is a national program that does not require that any renewable fuels be used in any particular area or state, allowing refiners to use renewable fuel blends in those areas where it is most cost-effective. The RFS has been, and we expect will continue to be, a significant factor impacting ethanol usage.

Under the RFS, the EPA is supposed to pass an annual rule that establishes the number of gallons of different types of renewable fuels that must be used in the U.S. by refineries, blenders, distributors and importers which is called the renewable volume obligations (“RVOs”). The EPA has the authority to waive the mandates in whole or in part if one of two conditions is met: 1) there is inadequate domestic renewable fuel supply, or 2) implementation of the mandate requirement severely harms the economy or environment of a state, region or the U.S.

The RFS sets the statutory RVO for corn-based ethanol at 15 billion gallons beginning in 2016 and each year thereafter through 2022.  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.  This rule is set at 100% of the original conventional biofuel requirement of 15.0 billion gallons, and is considered a favorable outcome by the industry.

On July 5, 2017, the United States Environmental Protection Agency (“EPA”) released a proposed rule to set the 2018 renewable volume requirements (“RVOs”) for conventional ethanol at 15.0 billion gallons while lowering the RVO for advanced alternatives, reducing overall RVOs to 19.24 billion gallons for 2018.    

On October 19, 2017, EPA Administrator Pruitt issued a letter to several U.S. Senators representing states in the Midwest reiterating his commitment to the text and spirit of the RFS. He stated that the EPA would meet the November 30, 2017 deadline for issuing final 2018 volume requirements, that the EPA’s preliminary analysis suggests that final volume requirements should be set at amounts at or greater than those provided in the July proposed rule for 2018.  On November 30, 2017, the EPA announced the final 2018 RVOs, and consistent with EPA Administrator Pruitt’s October 2017 letter, set the RVOs for conventional ethanol at 15.0 billion gallons, advanced biofuels at 4.29 billion gallons and cellulosic ethanol at 0.29 billion gallons, for overall RVOs of 19.29 billion gallons for 2018.  Although this final rule achieves the statutory RVO for conventional corn-based ethanol originally set by Congress when the RFS was enacted, it reduces the overall RVOs below the overall statutory level of 26 billion gallons. 

The following chart illustrates the potential U.S. ethanol demand based on the schedule of minimum usage established by the RFS program through the year 2022 (in billions of gallons):

(1)Final EPA RFS RVOs for 2017 issued November 2016.

(2)Final EPA RFS RVOs for 2018 issued November 2017

Current ethanol production capacity exceeds the EPA’s 2017 and 2018 RVOs that can be satisfied by corn-based ethanol.  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. Since 2018 is the first year the total proposed RVOs were more than 20% below statutory levels, in September 2017, the EPA Administrator Pruitt directed his staff to initiate the required technical analysis to perform any future reset consistent with the reset rules. Since the final 2018 RVOs are more than 20% below statutory levels, if 2019 RVOs are also more than 20% below statutory levels, the RVO reset will be triggered under RFS.  As a result, the EPA will be required to modify statutory volumes through 2022 within one year of the trigger event, based on the same factors used to set the RVOs post-2022. If the statutory RVOs are reduced as a result of reset, it could have an adverse effect on the market price and demand for ethanol which would negatively impact our financial performance.

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 2014-2016 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 that 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.

Management anticipates that there will be further legal challenges to the EPA's reduction in the volume requirements, including the final rules for 2017 and 2018. However, if the EPA's decision to reduce the volume requirements under the RFS is allowed to stand, or if the volume requirements are further reduced, it could have an adverse effect on the market price and demand for ethanol which would negatively impact our financial performance. 

Beyond the federal mandates, there are limited domestic markets for ethanol.  Further, opponents of ethanol such as large oil companies will likely continue their efforts to repeal or reduce the RFS through lawsuits or lobbying of Congress.  If such efforts are successful in further reducing or repealing the blending requirements of the RFS, a significant decrease in ethanol demand may result and 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.

Most ethanol that is used in the U.S. is sold in a blend called E10. E10 is a blend of 10% ethanol and 90% gasoline. E10 is approved for use in all standard vehicles. Estimates indicate that gasoline demand in the U.S. is approximately 140 billion gallons per year. Assuming that all gasoline in the U.S. is blended at a rate of 10% ethanol and 90% gasoline, the maximum demand for ethanol is 14.0 billion gallons per year.  This is commonly referred to as the “blend wall,” which represents a theoretical limit where more ethanol cannot be blended into the national gasoline pool. This is a theoretical limit because it is believed that it would not be possible to blend ethanol into every gallon of gasoline that is being used in the U.S. and it discounts the possibility of additional ethanol used in higher percentage blends such as E15 and E85. These higher percentage blends may lead to additional ethanol demand if they become more widely available and accepted by the market.

There is growing availability of E85 for use in flexible fuel vehicles, however it is limited due to lacking infrastructure. In addition, the industry has been working to introduce E15 to the retail market since the EPA approved its use vehicles model year 2001 and newer. However, wide spread adoption of E15 is hampered by regulatory and infrastructure hurdles in many states, as well as consumer acceptance. Additionally, sales of E15 may be limited because: (i) it is not approved for use in all vehicles; (ii) the EPA requires a label that management believes may discourage consumers from using E15; and (iii) retailers may choose not to sell E15 due to concerns regarding liability. In addition, different gasoline blendstocks may be required at certain times of the year in order to use E15 due to federal regulations related to fuel evaporative emissions. This may prevent E15 from being used during certain times of the year in various states. As a result, management believes that E15 may not have an immediate impact on ethanol demand in the U.S. 

Many in the ethanol industry believe that it will be difficult to meet the stator RFS RVOs in future years without an increase in the percentage of ethanol that can be blended with gasoline for use in standard (non-flex fuel) vehicles. In EPA Administrator Pruitt’s October 2017 letter, he also stated that the EPA is actively exploring its authority to remove arbitrary barriers to the year-rounds use of E15 and other mid-level ethanol blends so that E15 may be sold throughout the year without disruption. However, it is unclear what regulatory framework, if any, will emerge.

Obligated parties use renewable identification numbers (“RINs”) to show compliance with RFS-mandated volumes. RINs are attached to renewable fuels by producers and detached when the renewable fuel is blended with transportation fuel or traded in the open market. The market price of detached RINs affects the price of ethanol in certain markets and influences the purchasing decisions by obligated parties. In November 2016, the EPA also proposed denying a petition to change the point of obligation under the RFS to the parties that own the gasoline before it is sold. EPA Administrator Pruitt’s October 2017 letter stated that the EPA would soon finalize a decision to deny the request to change the point of obligation for RINs from refiners and importers to blenders and that the EPA will not pursue regulations to allow ethanol exports to generate RINs.  Management believes that these statements represent actions that would likely have a positive impact on the ethanol industry either directly or indirectly.

Compliance with Environmental Laws and Other Regulatory Matters

Our business subjects us to various federal, state, and local environmental laws and regulations, including: those relating to discharges into the air, water, and ground; the generation, storage, handling, use, transportation, and disposal of hazardous materials; and the health and safety of our employees. 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.  The costs associated with obtaining these permits and meeting the conditions of these permits have increased our costs of construction and production.  Additionally, compliance with environmental laws and permit conditions in the future could require expensive pollution control equipment or operational changes to limit actual or potential impacts to the environment, as well as significant management time and expense.  A violation of these laws, regulations or permit conditions can result in substantial fines, natural resource damage, criminal sanctions, permit revocations, and/or plant shutdown, any of which could have a material adverse effect on our operations.  Although violations and environmental non-compliance still remain a possibility following our conversion from coal to natural gas combustion, the exposure to the company has been greatly reduced.

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 Agency (“MPCA”) regarding the certain non-compliant results from on-going performance testing required under our air permit. Since reporting to MPCA, The Company cooperated with MPCA’s review of the non-compliant tests and maintained open communication with MPCA staff to resolve the matter.  On October 17, 2017, we entered into a stipulation agreement with MPCA relating to the non-compliant test results.  Under the stipulation agreement, we agreed to pay a civil penalty of $63,500, which was paid in October 2017.

For the fiscal year ended October 31, 2017, we incurred costs and expenses of approximately $265,000 complying with environmental laws, including civil penalties for non-compliance.  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.

On January 13, 2015, we submitted an efficient producer petition to the EPA which was approved by the EPA on March 12, 2015.  In the approval determination, the EPA’s analysis indicated that we achieved at least a 20.1% reduction in GHG emissions for their non-grandfathered volumes compared to the baseline lifecycle GHG emissions. Pursuant to the award approval, we are only authorized to generate RINs for our plant’s non-grandfathered volumes if we can demonstrate that all ethanol produced at the plant during an averaging period (defined as the prior 365 days or the number of days since the date of the EPA efficient producer pathway approval) meets the 20% GHG reduction requirement. To make this demonstration, we must comply with the compliance plan we developed and keep certain records as specified in the EPA’s approval.  Additionally, we must register with the EPA as a renewable fuel producer for the non-grandfathered volumes.  Although we believe we will be able to maintain continuous compliance with the 20% reduction in GHG emissions requirement, there is no guarantee that we will do so.  If we do not maintain continuous compliance with the 20% reduction in GHG emissions requirement, we will not be able issue RINs for the non-grandfathered volumes of ethanol produced at our plant.  As a result, we may be forced to rely on export sales for these non-grandfathered volumes of ethanol, which could adversely affect our operating margins, which, in turn could adversely affect our results of operations, cash flows and financial condition.

The California Air Resources Board, or CARB, has adopted a Low Carbon Fuel Standard, or LCFS, requiring a 10% reduction in average carbon intensity of gasoline and diesel transportation fuels from 2010 to 2020.  After a series of rulings that temporarily prevented CARB from enforcing these regulations, the federal appellate court reversed the federal district court finding the LCFS constitutional and remanding the case back to federal district court to determine whether the LCFS imposes a burden on interstate commerce that is excessive in light of the local benefits. On June 30, 2014, the U.S. Supreme Court declined to hear the appeal of the federal appellate court ruling and CARB recently re-adopted the LCFS with some slight modifications. The LCFS could have a negative impact on demand for corn-based ethanol and result in decreased ethanol prices affecting our ability to operate profitably. 

In February 2013, an anti-dumping tariff was imposed as a regulation by the Council of the European Union ethanol produced in the U.S. and exported to Europe. The Company does not export any ethanol to Europe at this time. However, continuation of this duty or imposition of tariffs by other countries or regions could reduce U.S. exports to Europe, and possibly other export markets. A reduction of exports to Europe could have an adverse effect on domestic ethanol prices, as the available supply of ethanol for the domestic market would increase.

Employees

We compete with ethanol producers in close proximity of our facility for the personnel required to operate our plant.  The existence and development of other ethanol plants will increase competition for qualified managers, engineers, operators and other personnel.  We also compete for personnel with businesses other than ethanol producers and with businesses located outside the community of Heron Lake, Minnesota.

As of the date of this report, we have 40 full time employees, of which 7 employees are involved primarily in management and administration and the remaining employees are involved primarily in plant operations.  We do not currently anticipate any significant change in the number of employees at our plant.

We  have entered into a management services agreement with Granite Falls Energy.  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 part-time officers and managers of the Company.  Each person providing management services to the Company under the management services agreement is subject to oversight by our board of governors.  However, the chief executive officer is solely responsible for hiring and firing persons providing management services under the management services agreement.

The initial term of the management services agreement 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.

GFE is responsible for and agreed to directly pay salary, wages, and/or benefits to the persons providing management services under the management services agreement.  Under the terms of the management services agreement, the Company pays GFE 50% of the estimated total salary, bonuses and other expenses and costs (including all benefits and tax contributions) incurred by GFE for the three management positions on a monthly basis with a “true-up” following the close of GFE’s fiscal year.

Natural Gas Pipeline Segment

Through our wholly owned subsidiary, HLBE Pipeline Company, we indirectly own 73% of Agrinatural Gas, LLC, a Delaware limited liability company.  RES owns the remaining 27%  non-controlling interest in Agrinatural.  Swan Engineering, Inc. (“SEI”), an affiliate of RES, provides project management and management and operating services to Agrinatural as described below.

Agrinatural is governed by a 7 member board of managers.  Under Agrinatural’s operating agreement, we have the right to appoint 4 of the 7 managers and RES has the right to appoint 3 managers. Mychael Swan, the principal of SEI and largest owner of RES, serves as the Chairman of the Agrinatural board of managers.

Agrinatural is a natural gas distribution and sales company located in Heron Lake, Minnesota.  Agrinatural’s natural gas pipeline originates from an interconnection with the natural gas transmission pipeline of Northern Border Pipeline Company approximately seven miles southwest of Jeffers, Minnesota in Cottonwood County. Agrinatural currently owns and operates approximately 190 miles of pipeline, including 164 miles of distribution mains and 26 miles of service lines. The Agrinatural pipeline was initially installed in 2011 to serve the Company.  Since the initial installation of the pipeline, Agrinatural has added several other commercial, agricultural and residential customers in the communities and surrounding areas of Heron Lake, Jeffers, Delft, Dundee, Storden, and Okabena, Minnesota. 

Agrinatural has a management and operating agreement with SEI, whereby 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 management and operating agreement with SEI expires July 1, 2019 unless earlier terminated for cause as defined in the agreement. For the fiscal year ended October 31, 2017, the Company paid SEI approximately $36,000 of monthly base fees and approximately $157,000 of variable customer management fees.

Agrinatural also has a project management agreement with SEI, whereby 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 project management with SEI expires June 30, 2019 unless earlier terminated for cause as defined in the agreement. For the fiscal year ended October 31, 2017, the Company paid SEI approximately $44,000 for project management and capital work fees.

Agrinatural has a professional services agreement with Wildwood Technology, LLC, pursuant to which, Wildwood Technology will act as the chief financial officer of Agrinatural through the services of its principal, Ann Tessier.  Pursuant to the Wildwood Technology agreement, Agrinatural pays Wildwood Technology $6,000 per month for the services provided by Ms. Tessier.  The Wildwood Technology agreement may be terminated at any time upon 30 days prior written notice by either party.    For the fiscal year ended October 31, 2017, the Company paid Wildwood Technology $72,000 in monthly fees.

Agrinatural also has a professional services agreement with Woodbury Consulting, LLC, an affiliate of RES. Pursuant to the Woodbury Consulting agreement, Woodbury Consulting will act as the chief executive officer of Agrinatural, through the services of its principal, John Sprangers.  Pursuant to the Woodbury Consulting agreement, Agrinatural pays Woodbury Consulting $150 per hour for the services provided by Mr. Sprangers plus travel expenses.  The Woodbury Consulting agreement may be terminated at any time upon 30 days prior written notice by either party. For the fiscal year ended October 31, 2017, the Company paid Woodbury Consulting approximately $22,000 for consulting services and approximately $1,000 for travel expense reimbursement.

The Company has entered into two intercompany credit facilities with Agrinatural, the July 2014 credit facility (the “Original Credit Facility”) and the March 2015 credit facility (the “Additional Credit Facility”). Under the Original 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 facility 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 Agrinatural credit facilities are provided below in the section below entitled “PART II - ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Credit Arrangements”.

Assets from our natural gas pipeline segment have represented 18.1%, 19.9%, and 19.5% of our consolidated total assets in the years ended October 31, 2017, 2016, and 2015, respectively.  Agrinatural’s assets consist of distribution main pipelines and service pipelines, together with the associated easement and land rights, a town border station, meters and regulators, office and other equipment and construction in process.

Agrinatural’s revenues are generated through natural gas distribution fees and sales, including distribution fees paid by the Company pursuant to our firm natural gas transportation agreement with Agrinatural.  Before intercompany eliminations, revenues from our natural gas pipeline segment represented 2.7%, 2.5%, and 2.4% of our total consolidated revenues in the years ended October 31, 2017, 2016, and 2015, respectively.  After accounting for intercompany eliminations for fees from the Company for natural gas transportation services, Agrinatural’s revenues represented 1.1%, 0.9%, and 0.9% of our consolidated revenues for the fiscal years ended October 31, 2017, 2016, and 2015, respectively, and have little to no impact on the overall performance of the Company.

Financial Information about Geographic Areas

All of our operations are domiciled in the U.S., including those of Agrinatural, our majority owned subsidiary.  All of the products sold to our customers for the fiscal years ended October 31, 2017, 2016, and 2015 were produced in the U.S. and all of our long-lived assets are domiciled in the U.S.    

For the principal products of our ethanol production segment, we have engaged third-party professional marketers who decide where our products are marketed and we have no control over the marketing decisions made by our third-party professional marketers.  These third-party marketers may decide to sell our products in countries other than the U.S.  However, we anticipate that our products will primarily be sold in the U.S.

ITEM 1A.    RISK FACTORS

You should carefully read and consider the risks and uncertainties below and the other information contained in this report.  The risks and uncertainties described below are not the only ones we may face.  The following risks, together with additional risks and uncertainties not currently known to us or that we currently deem immaterial could impair our financial condition and results of operation.  If any of the following risks actually occur, our results of operations, cash flows and the value of our units could be negatively impacted.

Risks Relating to Our Ethanol Production Operations

Because we are primarily dependent upon one product of our ethanol production segment, our business is not significantly diversified, and we may not be able to adapt to changing market conditions or endure any decline in the ethanol industry.

Our success depends on our ability to efficiently produce and sell ethanol, and, to a lesser extent, distillers’ grains and corn oil.  Although we operate a natural gas pipeline through our majority owned subsidiary, it does not produce significant revenue to rely upon if we are unable to produce and sell ethanol, distillers’ grains and corn oil, or if the market for those products decline. Our lack of diversification means that we may not be able to adapt to changing market conditions, changes in regulation, increased competition or any significant decline in the ethanol industry.

Our profitability depends upon purchasing corn at lower prices and selling ethanol at higher prices and because the difference between ethanol and corn prices can vary significantly, our financial results may also fluctuate significantly.

The results of our ethanol production business are highly impacted by commodity prices.  The substantial majority of our revenues are derived from the sale of ethanol. Our gross profit relating to the sale of ethanol is principally dependent on the difference between the price we receive for the ethanol we produce and the cost of corn and natural gas that we must purchase.  Changes in the prices and supplies of corn and natural gas are subject to and determined by market forces over which we have no control, such as weather, domestic and global demand, shortages, export prices, and various governmental policies in the U.S. and around the world. As a result of price volatility for these commodities, our operating results may fluctuate substantially. Increases in corn or natural gas prices or decreases in ethanol, distillers’ grains and corn oil prices may make it unprofitable to operate our plant. No assurance can be given that we will be able to purchase corn and natural gas at, or near, current prices and that we will be able to sell ethanol, distillers’ grains and corn oil at, or near, current prices. Consequently, our results of operations and financial position may be adversely affected by increases in the price of corn or natural gas or decreases in the price of ethanol, distillers’ grains and corn oil.

We seek to minimize the risks from fluctuations in the prices of corn and natural gas through the use of hedging instruments.  However, these hedging transactions also involve risks to our business.  If we were to experience relatively higher corn and natural gas costs compared to the selling prices of our products for an extended period of time, the value of our units may be reduced.

Sustained negative operating margins may require some ethanol producers to temporarily limit or cease production.

Our ability and the ability of other ethanol producers to operate profitably is largely determined by the spread between the price paid for corn and the price received for ethanol.  If this spread is narrow or is negative for a sustained period, some ethanol producers may elect to temporarily limit or cease production until their possibility for profitability returns.  Although we currently have no plans to limit or cease ethanol production, we may be required to do so if we experience a period of sustained negative operating margins.  In such an event, we would still incur certain fixed costs, which would impact our financial performance.

Volatility in oil and gas prices may materially affect ethanol pricing and demand.

Ethanol has historically traded at a discount to gasoline.  When ethanol trades at a discount to gasoline it encourages discretionary blending, thereby increasing the demand for ethanol beyond required blending rates. Conversely, when ethanol trades at a premium to gasoline, there is a disincentive for discretionary blending and ethanol demand is negatively impacted.  Consequently,  ethanol pricing and demand may also be volatile, which makes it difficult to manage profit margins and which could result in a material adverse effect on our business, results of operations and financial condition.

If the supply of ethanol exceeds the demand for ethanol, the price we receive for our ethanol and distillers’ grains may decrease.

Domestic ethanol production capacity has increased substantially over the past decade.  However, demand for ethanol may not increase as quickly as expected or to a level that exceeds supply, or at all.

Excess ethanol production capacity may result from decreases in the demand for ethanol or increased domestic production or imported supply. There are many factors affecting demand for ethanol, including regulatory developments and reduced gasoline consumption as a result of increased prices for gasoline or crude oil. Higher gasoline prices could cause businesses and consumers to reduce driving or acquire vehicles with more favorable gasoline mileage, or higher prices could spur technological advances, such as the commercialization of engines utilizing hydrogen fuel-cells, which could supplant gasoline-powered engines. There are a number of governmental initiatives designed to reduce gasoline consumption, including tax credits for hybrid vehicles and consumer education programs.

Because ethanol production produces distillers’ grains as a co-product, increased ethanol production will also lead to increased production of distillers’ grains. An increase in the supply of distillers’ grains, without corresponding increases in demand, could lead to lower prices or an inability to sell our distillers’ grains production. A decline in the price of distillers’ grains or the distillers’ grains market generally could have a material adverse effect on our business, results of operations and financial condition.

Management expects additional volatility for the price of ethanol in 2018.  Ethanol supply and demand both are expected to increase in 2018, which may lead to market imbalances.  Due to low ethanol and feedstock prices, exports grew in 2017 and are projected to continue to grow in 2018.  This is positive for the ethanol industry, but does introduce additional risk as international demand is more volatile than domestic demand.  U.S. gas demand was flat year over year in 2017, while ethanol as a percentage of the fuel supply increased slightly.  A decrease in demand for either gasoline or ethanol blends would adversely impact the price of ethanol, which could result in a material adverse effect on our business, results of operations and financial condition.

The price of distillers’ grains is affected by the price of other commodity products, such as soybeans, and decreases in the price of these commodities could decrease the price of distillers’ grains.

Distillers’ grains compete with other protein-based animal feed products. The price of distillers’ grains may decrease when the price of competing feed products decrease. The prices of competing animal feed products are based in part on the prices of the commodities from which they are derived. Downward pressure on commodity prices, such as soybeans, will generally cause the price of competing animal feed products to decline, resulting in downward pressure on the price of distillers’ grains. The price of distillers’ grains is not tied to production costs. However, decreases in the price of distillers’ grains would result in less revenue from the sale of distillers’ grains and could result in lower profit margins.

Historically, sales prices for distillers’ grains have been correlated with prices of corn. However, there have been occasions when the price increase for this co-product has lagged behind increases in corn prices. In addition, our distillers’ grains co-product competes with products made from other feedstocks, the cost of which may not have risen as corn prices have risen. Consequently, the price we may receive for distillers grains may not rise as corn prices rise, thereby lowering our cost recovery percentage relative to corn.

The prices of ethanol and distillers’ grains may decline as a result of trade barriers imposed by foreign countries with respect to ethanol and distillers’ grains originating in the U.S. and negatively affect our profitability.

An increasing amount of our industry’s products are being exported.  The U.S. ethanol industry was supported during our 2016 fiscal year with exports of ethanol which increased demand for our ethanol. Management believes these additional exports of ethanol were due to lower market ethanol prices in the U.S. and increased global demand for ethanol.  However, these ethanol exports may not continue. If producers and exporters of ethanol and distillers’ grains are subjected to trade barriers when selling products to foreign customers, there may be a reduction in the price of these products in the U.S.  Declines in the price we receive for our products will lead to decreased revenues and may result in our inability to operate the ethanol plant profitably. 

If  U.S. producers can not satisfy import requirements imposed by countries importing distillers’ grains, export demand could be significantly reduced as a result. If export demand of distillers’ grains is significantly reduced as a result, the price of distillers’ grains in the U.S. would likely continue to decline which would have a negative effect on our revenue and could impact our ability to profitably operate which could in turn reduce the value of our units.

We face intense competition that may result in reductions in the price we receive for our ethanol, increases in the prices we pay for our corn, or lower gross profits.

Competition in the ethanol industry is intense. We face formidable competition in every aspect of our business from both larger and smaller producers of ethanol and distillers’ grains. Some larger producers of ethanol, such as POET Biorefining, Archer Daniels Midland Company, Cargill, Inc., Valero Energy Corporation, have substantially greater financial, operational, procurement, marketing, distribution and technical resources than we have. We may not be able to compete with these larger entities. These larger ethanol producers may be able to affect the ethanol market in ways that are not beneficial to us which could affect our financial performance. 

Additionally, smaller competitors, such as farmer-owned cooperatives and independent companies owned by farmers and investors, have business advantages, such as the ability to more favorably procure corn by operating smaller plants that may not affect the local price of corn as much as a larger-scale plant like ours or requiring their farmer-owners to sell them corn as a requirement of ownership. Because Minnesota is one of the top producers of ethanol in the U.S., we face increased competition because of the location of our ethanol plants. Competing ethanol producers may introduce competitive pricing pressures that may adversely affect our sales levels and margins or our ability to procure corn at favorable prices. As a result, we cannot assure you that we will be able to compete successfully with existing or new competitors.

Until recently, oil companies, petrochemical refiners and gasoline retailers have not been engaged in ethanol production to a large extent. These companies, however, form the primary distribution networks for marketing ethanol through blended gasoline. During the past few years, several large oil companies have begun to penetrate the ethanol production market. If these companies increase their ethanol plant ownership or other oil companies seek to engage in direct ethanol production, such as Valero Renewable Fuels and Flint Hills Resources which are subsidiaries of larger oil companies, there may be a decrease in the demand for ethanol from smaller independent ethanol producers like us which could result in an adverse effect on our operations, cash flows and financial condition.

We also face increasing competition from international ethanol suppliers. Most international ethanol producers have cost structures that can be substantially lower than ours and therefore can sell their ethanol for substantially less than we can.

Competing ethanol producers may introduce competitive pricing pressures that may adversely affect our sales levels and margins or our ability to procure corn at favorable prices. As a result, we cannot assure you that we will be able to compete successfully with existing or new competitors.

We engage in hedging transactions which involve risks that could harm our business.

We are exposed to market risk from changes in commodity prices.  Exposure to commodity price risk results from our dependence on corn and natural gas in the ethanol production process.  We seek to minimize the risks from fluctuations in the prices of corn, natural gas and ethanol through the use of hedging instruments.  The effectiveness of our hedging strategies is dependent on the price of corn, natural gas and ethanol and our ability to sell sufficient products to use all of the corn and natural gas for which we have futures contracts.  Our hedging activities may not successfully reduce the risk caused by price fluctuation which may leave us vulnerable to high corn and natural gas prices, as well as low ethanol prices.

Operational difficulties at our plant could negatively impact our sales volumes and could cause us to incur substantial losses.

We have experienced operational difficulties at our plant in the past that have resulted in scheduled and unscheduled downtime or reductions in the number of gallons of ethanol we produce. Some of the difficulties we have experienced relate to production problems, repairs required to our plant equipment and equipment maintenance, the installation of new equipment and related testing, and our efforts to improve and test our air emissions. Our revenues are driven in large part by the number of gallons of ethanol and the number of tons of distillers’ grains we produce. If our ethanol plant does not efficiently produce our products in high volumes, our business, results of operations, and financial condition may be materially adversely affected.

Our operations are also subject to operational hazards inherent in our industry and to manufacturing in general, such as equipment failures, fires, explosions, abnormal pressures, blowouts, pipeline ruptures, transportation accidents and natural disasters. Some of these operational hazards may cause personal injury or loss of life, severe damage to or destruction of property and equipment or environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. The occurrence of any of these operational hazards may materially adversely affect our business, results of operations and financial condition. Further, our insurance may not be adequate to fully cover the potential operational hazards described above or we may not be able to renew this insurance on commercially reasonable terms or at all.

Our operations and financial performance could be adversely affected by infrastructure disruptions and lack of adequate transportation and storage infrastructure in certain areas.

We ship our ethanol to our customers primarily by the railroad adjacent to our site. We also have the potential to receive inbound corn via the railroad. Our customers require appropriate transportation and storage capacity to take delivery of the products we produce. We also receive our natural gas through a pipeline that is approximately 16 miles in length. Without the appropriate flow of natural gas through the pipeline our plant may not be able to run at desired production levels or at all. Therefore, our business is dependent on the continuing availability of rail, highway and related infrastructure.

Any disruptions in our infrastructure network, whether caused by labor difficulties, earthquakes, storms, other natural disasters, human error or malfeasance or other reasons, could have a material adverse effect on our business. We rely upon third-parties to maintain the rail lines from our plant to the national rail network, and any failure on their part to maintain the lines could impede our delivery of products, impose additional costs on us and could have a material adverse effect on our business, results of operations and financial condition.

In addition, lack of this infrastructure prevents the use of ethanol in certain areas where there might otherwise be demand and results in excess ethanol supply in areas with more established ethanol infrastructure, depressing ethanol prices in those areas. In order for the ethanol industry to grow and expand into additional markets and for our ethanol to be sold in these new markets, there must be substantial development of infrastructure including:

The substantial investments that will be required for these infrastructure changes and expansions may not be made on a timely basis, if at all, and decisions regarding these infrastructure improvements are outside of our control. Significant delay or failure to improve the infrastructure that facilitates the distribution could curtail more widespread ethanol demand or reduce prices for our products in certain areas, which would have a material adverse effect on our business, results of operations or financial condition.

Rail logistical problems may result in delays in shipments of our products which could negatively impact our financial performance.

There has been an increase in rail traffic congestion throughout the U.S. primarily due to the increase in cargo trains carrying shale oil. From time to time, periodic high demand and unusually adverse weather conditions may cause rail congestion resulting in rail delays and rail logistical problems. Although we have not been materially affected by prior rail congestion period, future periods of congestion may affect our ability to operate our plant at full capacity due to ethanol storage capacity constraints, which in turn could have a negative effect on our financial performance.

We depend on our management and key employees, and the loss of these relationships could negatively impact our ability to operate profitably.

Our success depends in part on our ability to attract and retain competent personnel. For our ethanol plant, we must hire qualified managers, operations personnel, accounting staff and others, which can be challenging in a rural community.   Further, our current employees may decide to end their employment with us.  Competition for employees in the ethanol industry is intense, and we may not be able to attract and retain qualified personnel. 

Part of our management team is provided by Granite Falls Energy pursuant to the management services agreement.  The management services agreement provides that it can be terminated on thirty days notice in certain circumstances. If the management services agreement is terminated or one or more of our employees terminate their employment, either with us or Granite Falls Energy, we may not be able to replace these individuals.  Any loss of these managers or key employees may prevent us from operating the ethanol plant efficiently and comply with our other obligations.

Technology in our industry evolves rapidly, potentially causing our plant to become obsolete, and we must continue to enhance the technology of our plant or our business may suffer.

We expect that technological advances in the processes and procedures for processing ethanol will continue to occur. It is possible that those advances could make the processes and procedures that we utilize at our ethanol plant less efficient or obsolete. These advances could also allow our competitors to produce ethanol at a lower cost than we are able. If we are unable to adopt or incorporate technological advances, our ethanol production methods and processes could be less efficient than those of our competitors, which could cause our ethanol plant to become uncompetitive.

Competition from the advancement of alternative fuels may lessen the demand for ethanol.

Alternative fuels, gasoline oxygenates and ethanol production methods are continually under development. A number of automotive, industrial and power generation manufacturers are developing alternative clean power systems using fuel cells, plug-in hybrids or clean burning gaseous fuels. Like ethanol, these emerging technologies offer an option to address worldwide energy costs, the long-term availability of petroleum reserves and environmental concerns. If these alternative technologies continue to expand and gain broad acceptance and become readily available to consumers for motor vehicle use, we may not be able to compete effectively. This additional competition could reduce the demand for ethanol, resulting in lower ethanol prices that might adversely affect our results of operations and financial condition.

Our sales will decline, and our business will be materially harmed if our third party marketers do not effectively market or sell the ethanol, distillers’ grains and corn oil we produce or if there is a significant reduction or delay in orders from our marketers.

We have entered into agreements with third parties to market our supply of ethanol, distillers’ grains and corn oil. Our marketers are independent businesses that we do not control. We cannot be certain that our marketers will market or sell our ethanol, distillers’ grains and corn oil effectively. Our agreements with our marketers do not contain requirements that a certain percentage of sales are of our products, nor do the agreements restrict the marketer’s ability to choose alternative sources for ethanol, distillers’ grains or corn oil.

Our success in achieving revenue from the sale of ethanol, distillers’ grains and corn oil will depend upon the continued viability and financial stability of our marketers. Our marketers may choose to devote their efforts to other producers or reduce or fail to devote the necessary resources to provide effective sales and marketing support of our products. We believe that our financial success will continue to depend in large part upon the success of our marketers in operating their businesses.

If our marketers breach their contracts or do not have the ability, for financial or other reasons, to market all of the ethanol we produce or to market the co-products produced at our plant, we may not have any readily available alternative means to sell our products. Our lack of a sales force and reliance on these third parties to sell and market most of our products may place us at a competitive disadvantage. Our failure to sell all of our ethanol and co-products may result in lower revenues and reduced profitability.

We are exposed to credit risk resulting from non-payment by significant customers.

We have a concentration of credit risk because we sell our primary product, ethanol, and its primary co-product, distillers’ grains to two customers. Although we typically receive payments timely and within the terms of our marketing agreements with these customers, we continually monitor this credit risk exposure. These customers accounted for approximately 99.5%, 98.3%, and 98.5% of revenue for the years ended October 31, 2017, 2016, and 2015, respectively and approximately 98.1% and 93.0% of the outstanding accounts receivable balance at October 31, 2017 and 2016, respectively.  The inability of a third party to pay our accounts receivable may cause us to experience losses and may adversely affect our liquidity and our ability to make our payments when due.

Consumer resistance to the use of ethanol based on the belief that ethanol is expensive, adds to air pollution, harms engines and/or takes more energy to produce than it contributes may affect the demand for ethanol.

Certain individuals believe that the use of ethanol will have a negative impact on gasoline prices at the pump. Some also believe that ethanol adds to air pollution and harms car and truck engines. Still other consumers believe that the process of producing ethanol actually uses more fossil energy, such as oil and natural gas, than the amount of energy that is produced. These consumer beliefs could potentially be wide-spread and may be increasing as a result of recent efforts to increase the allowable percentage of ethanol that may be blended for use in conventional automobiles.  If consumers choose not to buy ethanol based on these beliefs, it would affect the demand for the ethanol we produce which could negatively affect our profitability and financial condition.

Risks Related to Regulation and Government Action

Our failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition and results of operations.

We are subject to various federal, state and local environmental laws and regulations, including those relating to the discharge of materials into the air, water and ground. Certain aspects of our operations require environmental permits and controls to prevent and reduce air and water pollution, and these permits are subject to modification, renewal and revocation by issuing authorities including the Minnesota Pollution Control Agency. We could incur substantial costs, including cleanup costs, fines and civil or criminal sanctions and third-party claims for property damage and personal injury as a result of violations of or liabilities under environmental laws or non-compliance with environmental permits. We could also incur substantial costs and experience increased operating expenses as a result of operational changes to comply with environmental laws, regulations and permits. We have previously incurred substantial costs relating to our air emissions permit and expect additional costs relating to this permit in the future.

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 MPCA regarding the results of certain non-compliant tests. On October 17, 2017, we entered into a stipulation agreement with the MPCA relating to these non-compliant tests.  Under the stipulation agreement, we agreed to pay a civil penalty of $63,500, which was paid in October 2017.  

Environmental laws and regulations are subject to substantial change. We cannot predict what material impact, if any, these changes in laws or regulations might have on our business. The MPCA’s approval of our amendment, as well as future changes in regulations or enforcement policies could impose more stringent requirements on us, compliance with which could require additional capital expenditures, increase our operating costs or otherwise adversely affect our business. These changes may also relax requirements that could prove beneficial to our competitors and thus adversely affect our business. Further, regulations of the EPA and the MPCA depend heavily on administrative interpretations. We cannot assure you that future interpretations made by regulatory authorities, with possible retroactive effect, will not adversely affect our business, financial condition and results of operations. Failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition and results of operations.

Because federal and state regulation heavily influence the supply of and demand for ethanol, changes in government regulation that adversely affect demand or supply will have a material adverse effect on our business.

Various federal and state laws, regulations and programs impact the supply of and demand for ethanol.  We believe the most important of these is the RFS, which sets minimum national volume standards for use of cellulosic, biomass-based diesel and total advanced renewable fuels.  The RFS helps support a market for ethanol that might disappear without this incentive. In the case of the RFS, while it creates a demand for ethanol, the existence of specific categories of renewable fuels also creates a demand for these types of renewable fuels and will likely provide an incentive for companies to further develop these products to capitalize on that demand. In these circumstances, the RFS may also reduce demand for ethanol in favor of the renewable fuels for which specific categories exist.

By statute, the RFS requires that 16.55 billion gallons be sold or dispensed in 2013, increasing to 36.0 billion gallons by 2022, but caps the amount of corn-based ethanol that can be used to meet the renewable fuels blending requirements at 15.0 billion gallons for 2015 and thereafter.  On November 30, 2017, the EPA announced final RVO requirements for the RFS for calendar year 2018. The corn-based biofuel requirement of 15.0 billion gallons equating to the statutory requirement level as originally set by Congress when the RFS was enacted. However, the overall RVOs were set at 19.29 billion gallons for 2018, more than 20% below the overall statutory level of 26 billion gallons, due to decreases in the RVOs for cellulosic ethanol and advanced biofuels. 

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. Since 2018 is the first year the total RVOs are more than 20% below statutory levels, the EPA Administrator directed his staff to initiate the required technical analysis to perform any future reset consistent with the reset rules. If 2019 RVOs are also more than 20% below statutory levels, the RVO reset will be triggered under RFS II and the EPA will be required to modify statutory volumes through 2022 within one year of the trigger event, based on the same factors used to set the RVOs post-2022. Current ethanol production capacity exceeds the 2018 RVO standard which can be satisfied by corn-based ethanol. Reduction of blending requirements could reduce the demand for and price of ethanol. If demand for ethanol decreases, it could materially adversely affect our business, results of operations and financial condition.

Additionally, opponents of ethanol such as large oil companies will likely continue their efforts to repeal or reduce the RFS through lawsuits or lobbying of Congress. Successful reduction or repeal of the blending requirements of the RFS could have an adverse effect on the market price and demand for ethanol which would negatively impact our financial performance.

The EPA imposed E10 “blend wall” if not overcome will have an adverse effect on demand for ethanol.

We believe that the E10 “blend wall” is one of the most critical governmental policies currently facing the ethanol industry. The “blend wall” issue arises because of several conflicting requirements. First, the renewable fuels standards dictate a continuing increase in the amount of ethanol blended into the national gasoline supply. Second, the EPA mandates a limit of 10% ethanol inclusion in non-flex fuel vehicles, and the E85 vehicle marketplace is struggling to grow due to lacking infrastructure. The EPA policy of 10% and the RFS increasing blend rate are at odds, which is sometimes referred to as the “blend wall.” 

While the issue is being considered by the EPA, there have been no regulatory changes that would reconcile the conflicting requirements. In 2011, the EPA allowed the use of E15, gasoline which is blended at a rate of 15% ethanol and 85% gasoline, in vehicles manufactured in the model year 2001 and later. Management believes that many gasoline retailers will refuse to provide E15 due to the fact that not all standard vehicles will be allowed to use E15 and due to the labeling requirements the EPA may impose. As a result, the approval of E15 may not significantly increase demand for ethanol.

The California Low Carbon Fuel Standard may decrease demand for corn based ethanol which could negatively impact our profitability.

California passed a Low Carbon Fuels Standard (“LCFS”) which requires that renewable fuels used in California must accomplish certain reductions in greenhouse gases which reductions are measured using a lifecycle analysis. Management believes that these regulations could preclude corn based ethanol produced in the Midwest from being used in California. California represents a significant ethanol demand market. If the ethanol industry is unable to supply corn based ethanol to California, it could significantly reduce demand for the ethanol we produce. This could result in a reduction of our revenues and negatively impact our ability to profitably operate the ethanol plant.

Meeting the requirements of evolving environmental, health and safety laws and regulations, and in particular those related to climate change, could adversely affect our financial performance.

When the EPA released its final regulations on RFS, these regulations grandfathered our plant at its current production capacity for the generation of RINs for compliance with RFS.  Any expansion of our plant beyond the grandfathered volumes must meet a threshold of a 20% reduction in GHG emissions from a 2005 baseline measurement for the ethanol to be eligible to generate RINS for compliance with the RFS II mandate.

In 2015, our plant was awarded “efficient producer” status under the pathway petition program for the non-grandfathered volumes of ethanol produced at our plant. Pursuant to the award approval, we are only authorized to generate RINs for our non-grandfathered volume if we can demonstrate that all ethanol produced at the plant during an averaging period (defined as the prior 365 days or the number of days since the date EPA efficient producer pathway approval) meets the 20% GHG reduction requirement.

Although we believe our plant will be able to maintain continuous compliance with the 20% reduction in GHG emissions requirement as presently operated, there is no guarantee that we will not have to install carbon dioxide mitigation equipment or take other steps unknown to us at this time in order to comply with the efficient producer requirements or other future law or regulation.  Continued compliance with the efficient producer GHG reduction requirements or compliance with future law or regulation of carbon dioxide, could be costly and may prevent us from operating our plant as profitably, which may have an adverse impact on our operations, cash flows and financial position.

If we fail to comply with the 20% reduction in GHG emissions requirement, we will not be able to generate RINs for our non-grandfathered volumes of ethanol, which could adversely affect our operating margins.

We expect that nearly all of the anticipated demand for our ethanol production will be by customers obligated to comply with the RFS. The EPA’s approval of our efficient producer petitions requires that the plant demonstrates continuous compliance with the 20% reduction in GHG emissions for all volumes of ethanol produced, not just non-grandfathered volumes of ethanol. If we cannot show continuous compliance with the requirement for all volumes of ethanol, we will not be able issue RINs for the non-grandfathered volumes of ethanol produced. If our ethanol production does not meet the requirements for RIN generation as administered by the EPA, we may be required to sell those gallons of ethanol without RINs at lower prices in the domestic market to compensate for the lack of RINs or sell these gallons of ethanol in the export market where RINs are not required, which could adversely affect our results of operations, cash flows and financial condition.

Risks Related to Agrinatural and Natural Gas Pipeline Operations

The expansion of Agrinatural’s existing assets and construction of new assets is subject to regulatory, environmental, political, legal and economic risks, which could adversely affect our results of operations and financial condition, and require additional capital contributions or loans from us.

One of the ways Agrinatural intends to grow its business is through the expansion of its existing assets and construction of new energy infrastructure assets. The construction of additions or modifications to Agrinatural’s existing pipelines, and the construction of other new energy infrastructure assets, involve numerous regulatory, environmental, political and legal uncertainties beyond Agrinatural’s control and may require the expenditure of significant capital.  Therefore, as the majority-owner of Agrinatural, we may be required to make additional capital contributions, loans and/or guaranty loans to Agrinatural in order to fund such expansion projects.  If Agrinatural undertakes these projects they may not be completed on schedule, at the budgeted cost or at all. Moreover, Agrinatural’s revenues may not increase immediately upon the expenditure of funds on a particular project. For instance, if it expands or adds a new pipeline, the construction may occur over an extended period of time, and we will not receive any material increases in revenues until the project is completed.

Agrinatural may also construct facilities to capture anticipated future growth in production or demand, which may not materialize or where contracts are later canceled. As a result, new pipelines may not be able to attract enough throughput volume to achieve our expected investment return, which could adversely affect our results of operations and financial condition. The construction of new pipelines may also require Agrinatural to obtain new rights-of-way, and it may become more expensive for Agrinatural to obtain these new rights-of-way or to renew existing rights-of-way. If the cost of renewing or obtaining new rights-of-way increases, Agrinatural’s cash flows could be adversely affected.

Transporting natural gas involves inherent risks that could cause Agrinatural, and therefore the Company as its majority owner, to incur significant financial losses.

There are inherent hazards and operation risks in gas distribution activities, such as leaks, accidental explosions and mechanical problems that could cause the loss of human life, significant damage to property, environmental pollution, impairment of operations and substantial losses to Agrinatural. The location of pipelines near populated areas, including residential areas, commercial business centers and industrial sites, could increase the level of damages resulting from these risks. These activities may subject us to litigation and administrative proceedings that could result in substantial monetary judgments, fines or penalties against us. To the extent that the occurrence of any of these events is not fully covered by insurance, they could adversely affect Agrinatural’s earnings and cash flow.

Volatility in the price of natural gas could result in customers switching to alternative energy sources which could reduce Agrinatural’s revenues, earnings and cash flow.

The market price of alternative energy sources such as coal, electricity, propane, oil and steam is a competitive factor affecting the demand for Agrinatural’s gas distribution services. Its customers may have or may acquire the capacity to use one or more of the alternative energy sources if the price of natural gas and Agrinatural’s distribution services increase significantly. Natural gas has typically been less expensive than these alternative energy sources. However, if natural gas prices increase significantly, some of these alternative energy sources may become more economical or more attractive than natural gas, which could reduce our earnings and cash flow.

Agrinatural’s natural gas pipeline operations are subject to significant governmental and private sector regulations.

Agrinatural’s natural gas pipeline operations are subject to government regulation, including the Federal Energy Regulatory Commission and Minnesota Office of Pipeline Safety, compliance with which can impose significant costs on Agrinatural’s natural gas distribution business. Failure to comply with such regulations can result in additional costs, fines or criminal action.

Risks Related to the Units

Granite Falls Energy owns a large percentage of our units, which may allow it to control or heavily influence matters requiring member approval, and has additional board rights under our member control agreement.

As of January 29, 2018, Granite Falls Energy, LLC, through its wholly owned subsidiary, Project Viking, L.L.C., owns approximately 50.7% of our outstanding units.  As a result, Granite Falls Energy can significantly influence our management and affairs and all matters requiring member approval, including the approval of significant corporate transactions.

Our member control agreement gives members who hold significant amounts of equity in us the right to designate governors to serve on our board of governors. Therefore, Granite Falls Energy has the right to appoint five persons to our nine-person board pursuant to this provision. With the right to designate a majority of our board, Granite Falls Energy can significantly influence the outcome of any actions taken by our board of governors and our business. 

In addition, given the large ownership of Granite Falls Energy, they can significantly influence other actions, such as amendments to our operating agreement, mergers, going private transactions, and other extraordinary transactions, and any decisions concerning the terms of any of these transactions. The ownership and voting positions of Granite Falls Energy may have the effect of delaying, deterring, or preventing a change in control or a change in the composition of our board of directors.

Further, the interests of Granite Falls Energy may not coincide with our interests or the interests of our other members. For example, Granite Falls Energy owns and operates an ethanol production facility that could be considered our competitor. Granite Falls Energy may also use its rights under the member control agreement and their large ownership position to address their own interests, which may be different from those of our other members.

There is no public market for our units and no public market is expected to develop.

There is no established public trading market for our units, and we do not expect one to develop in the foreseeable future.  We have established a Unit Trading Bulletin Board through FNC Ag Stock, LLC, in order to facilitate trading among our members.  The Unit Trading Bulletin Board is a private online matching service that has been designed to comply with federal tax laws and IRS regulations establishing a “qualified matching service,” as well as state and federal securities laws.  The Unit Trading Bulletin Board does not automatically affect matches between potential sellers and buyers and it is the sole responsibility of sellers and buyers to contact each other to make a determination as to whether an agreement to transfer units may be reached. 

There are detailed timelines that must be followed under the Unit Trading Bulletin Board Rules and Procedures with respect to offers and sales of membership units. All transactions must comply with the Unit Trading Bulletin Board Rules, our member control agreement, and are subject to approval by our board of governors.  As a result, units held by our members may not be easily resold and members may be required to hold their units indefinitely. Even if members are able to resell our units, the price may be less than the members’ investment in the units or may otherwise be unattractive to the member.

There are significant restrictions on the transfer of our units.

To protect our status as a partnership for tax purposes and to assure that no public trading market in our units develops, our units are subject to significant restrictions on transfer and transfers are subject to approval by our board of governors. All transfers of units must comply with the transfer provisions of our member control agreement and the unit transfer policy adopted by our board of governors. Our board of governors will not approve transfers which could cause us to lose our tax status or violate federal or state securities laws. As a result of the provisions of our member control agreement, members may not be able to transfer their units and may be required to assume the risks of the investment for an indefinite period of time.

There is no assurance that we will be able to make distributions to our unit holders, which means that holders could receive little or no return on their investment.

Distributions of our net cash flow may be made at the sole discretion of our board of governors, subject to the provisions of the Minnesota Limited Liability Company Act, our member control agreement and restrictions imposed by Compeer Financial, formerly known as AgStar Financial Services, FCLA (“Compeer”) under our credit facility. Our credit facility with Compeer currently limits our ability to make distributions to our members. If our financial performance and loan covenants permit, we expect to make cash distributions at times and in amounts that will permit our members to make income tax payments, along with distributions in excess of these amounts. However, our board may elect to retain cash for operating purposes, debt retirement, plant improvements or expansion. Although we have declared distributions that were paid to members in January 2015 and 2016, there is no guarantee that we will be in a financial position to pay distributions in the future, that the terms of our credit facility will allow us to make distributions to our members, or that distributions, if any, will be at times or in amounts to permit our members to make income tax payments. Consequently, members may receive little or no return on their investment in the units.

We may authorize and issue units of new classes which could be superior to or adversely affect holders of our outstanding units.

Our board of governors, upon the approval of a majority in interest of our members, has the power to authorize and issue units of classes which have voting powers, designations, preferences, limitations and special rights, including preferred distribution rights, conversion rights, redemption rights and liquidation rights, different from or superior to those of our present units. New units may be issued at a price and on terms determined by our board of governors. The terms of the units and the terms of issuance of the units could have an adverse impact on your voting rights and could dilute your financial interest in us.

Our use of a staggered board of governors and allocation of governor appointment rights may reduce the ability of members to affect the composition of the board.

We are managed by a board of governors, currently consisting of four (4) elected governors and five (5) appointed governors. The seats on the board that are not subject to a right of appointment will be elected by the members without appointment rights. An appointed governor serves indefinitely at the pleasure of the member appointing him or her (so long as such member and its affiliates continue to hold a sufficient number of units to maintain the applicable appointment right) until a successor is appointed, or until the earlier death, resignation or removal of the appointed governor.

Under our member control agreement, non-appointed governors are divided into three classes, with the term of one class expiring each year. As the term of each class expires, the successors to the governors in that class will be elected for a term of three years. As a result, members elect only approximately one-third of the non-appointed governors each year.

The effect of these provisions may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, control of us and may discourage attempts to change our management, even if an acquisition or these changes would be beneficial to our members.

Our units represent both financial and governance rights, and loss of status as a member would result in the loss of the holder’s voting and other rights and would allow us to redeem such holder’s units.

Holders of units are entitled to certain financial rights, such as the right to any distributions, and to governance rights, such as the right to vote as a member. If a unit holder does not continue to qualify as a member or such holder’s member status is terminated, the holder would lose certain rights, such as voting rights, and we could redeem such holder’s units. The minimum number of units presently required for membership is 2,500 units. In addition, holders of units may be terminated as a member if the holder dies or ceases to exist, violates our member control agreement or takes actions contrary to our interests, and for other reasons. Although our member control agreement does not define what actions might be contrary to our interests, and our board of governors has not adopted a policy on the subject, such actions might include providing confidential information about us to a competitor, taking a board or management position with a competitor or taking action which results in significant financial harm to us in the marketplace. If a holder of units is terminated as a member, our board of governors will have no obligation to redeem such holder’s units.

Voting rights of members are not necessarily equal and are subject to certain limitations.

Members of our company are holders of units who have been admitted as members upon their investment in our units and who are admitted as members by our board of governors. The minimum number of units required to retain membership is 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 who are holders of our present units are entitled to one vote for each unit held. The provisions of our member control agreement relating to voting rights applicable to any class of units will apply equally to all units of that class.

However, our member control agreement gives members who hold significant amounts of equity in us the right to designate governors to serve on our board of governors. For every 9% of our units held, the member has the right to appoint one person to our board. Granite Falls has the right to appoint five persons to our board pursuant to this provision and has currently appointed five persons. If units of any other class are issued in the future, holders of units of that other class will have the voting rights that are established for that class by our board of governors with the approval of our members. Consequently, the voting rights of members may not be necessarily proportional to the number of units held.

Further, cumulative voting for governors is not allowed, which makes it substantially less likely that a minority of members could elect a member to the board of governors. Members do not have dissenter’s rights. This means that they will not have the right to dissent and seek payment for their units in the event we merge, consolidate, exchange or otherwise dispose of all or substantially all of our property. Holders of units who are not members have no voting rights. These provisions may limit the ability of members to change the governance and policies of our company.

All members will be bound by actions taken by members holding a majority of our units, and because of the restrictions on transfer and lack of dissenters’ rights, members could be forced to hold a substantially changed investment.

We cannot engage in certain transactions, such as a merger, consolidation, dissolution or sale of all or substantially all of our assets, without the approval of our members. However, if holders of a majority of our units approve a transaction, then all members will also be bound to that transaction regardless of whether that member agrees with or voted in favor of the transaction. Under our member control agreement, members will not have any dissenters’ rights to seek appraisal or payment of the fair value of their units. Consequently, because there is no public market for the units, members may be forced to hold a substantially changed investment.

Risks Related to Tax Issues in a Limited Liability Company

EACH UNIT HOLDER SHOULD CONSULT THE INVESTOR’S OWN TAX ADVISOR WITH RESPECT TO THE FEDERAL AND STATE TAX CONSEQUENCES OF AN INVESTMENT IN HERON LAKE BIOENERGY, LLC AND ITS IMPACT ON THE INVESTOR’S TAX REPORTING OBLIGATIONS AND LIABILITY.

If we are not taxed as a partnership, we will pay taxes on all of our net income and you will be taxed on any earnings we distribute, and this will reduce the amount of cash available for distributions to holders of our units.

We consider Heron Lake BioEnergy, LLC to be a partnership for federal income tax purposes. This means that we will not pay any federal income tax, and our members will pay tax on their share of our net income. If we are unable to maintain our partnership tax treatment or qualify for partnership taxation for whatever reason, then we may be taxed as a corporation. We cannot assure you that we will be able to maintain our partnership tax classification. For example, there might be changes in the law or our company that would cause us to be reclassified as a corporation. As a corporation, we would be taxed on our taxable income at rates of up to 35% for federal income tax purposes (21% beginning after December 31, 2017). Further, distributions would be treated as ordinary dividend income to our unit holders to the extent of our earnings and profits. These distributions would not be deductible by us, thus resulting in double taxation of our earnings and profits. This would also reduce the amount of cash we may have available for distributions.

Your tax liability from your allocated share of our taxable income may exceed any cash distributions you receive, which means that you may have to satisfy this tax liability with your personal funds.

As a partnership for federal income tax purposes, all of our profits and losses “pass-through” to our unit holders. You must pay tax on your allocated share of our taxable income every year. You may incur tax liabilities from allocations of taxable income for a particular year or in the aggregate that exceed any cash distributions you receive in that year or in the aggregate. This may occur because of various factors, including but not limited to, accounting methodology, the specific tax rates you face, and payment obligations and other debt covenants that restrict our ability to pay cash distributions. If this occurs, you may have to pay income tax on your allocated share of our taxable income with your own personal funds.

You may not be able to fully deduct your share of our losses or your interest expense.

It is likely that your interest in us will be treated as a “passive activity” for federal income tax purposes. In the case of unit holders who are individuals or personal services corporations, this means that a unit holder’s share of any loss incurred by us will be deductible only against the holder’s income or gains from other passive activities, e.g., S corporations and partnerships that conduct a business in which the holder is not a material participant. Some closely held C corporations have more favorable passive loss limitations. Passive activity losses that are disallowed in any taxable year are suspended and may be carried forward and used as an offset against passive activity income in future years. Upon disposition of a taxpayer’s entire interest in a passive activity to an unrelated person in a taxable transaction, suspended losses with respect to that activity may then be deducted.

Interest paid on any borrowings incurred to purchase units may not be deductible in whole or in part because the interest must be aggregated with other items of income and loss that the unit holder has independently experienced from passive activities and subjected to limitations on passive activity losses.

Deductibility of capital losses that we incur and pass through to you or that you incur upon disposition of units may be limited. Capital losses are deductible only to the extent of capital gains plus, in the case of non-corporate taxpayers, the excess may be used to offset up to $3,000 of ordinary income. If a non-corporate taxpayer cannot fully utilize a capital loss because of this limitation, the unused loss may be carried forward and used in future years subject to the same limitations in the future years.

You may be subject to federal alternative minimum tax.

Individual taxpayers are subject to an “alternative minimum tax” if that tax exceeds the individual’s regular income tax. For alternative minimum tax purposes, an individual’s adjusted gross income is increased by items of tax preference. We may generate such preference items. Accordingly, preference items from our operations together with other preference items you may have may cause or increase an alternative minimum tax to a unit holder. You are encouraged and expected to consult with your individual tax advisor to analyze and determine the effect on your individual tax situation of the alternative minimum taxable income you may be allocated, particularly in the early years of our operations.

Preparation of your tax returns may be complicated and expensive.

The tax treatment of limited liability companies and the rules regarding partnership allocations are complex. We will file a partnership income tax return and will furnish each unit holder with a Schedule K-1 that sets forth our determination of that unit holder’s allocable share of income, gains, losses and deductions. In addition to U.S. federal income taxes, unit holders will likely be subject to other taxes, such as state and local taxes, that are imposed by various jurisdictions. It is the responsibility of each unit holder to file all applicable federal, state and local tax returns and pay all applicable taxes. You may wish to engage a tax professional to assist you in preparing your tax returns and this could be costly to you.

Any audit of our tax returns resulting in adjustments could result in additional tax liability to you.

The IRS may audit our tax returns and may disagree with the positions that we take on our returns or any Schedule K-1. If any of the information on our partnership tax return or a Schedule K-1 is successfully challenged by the IRS, the character and amount of items of income, gains, losses, deductions or credits in a manner allocable to some or all our unit holders may change in a manner that adversely affects those unit holders. This could result in adjustments on unit holders’ tax returns and in additional tax liabilities, penalties and interest to you. An audit of our tax returns could lead to separate audits of your personal tax returns, especially if adjustments are required.

ITEM 1B.    UNRESOLVED STAFF COMMENTS

None.

ITEM 2.    PROPERTIES

We own approximately 216 acres of land located near Heron Lake, Minnesota on which we have constructed and operate our ethanol plant, which also includes corn, ethanol, distillers’ grains and corn oil storage and handling facilities.  Located on these 216 acres is an approximately 7,320 square foot building that serves as our headquarters.  Our address is 91246 390th Avenue, Heron Lake, Minnesota 56137-3175.

All of our real property is subject to mortgages in favor of Compeer as security for loan obligations.

Our majority owned subsidiary, Agrinatural, property consists of 190 miles of distribution main pipelines and service pipelines, together with the associated easement and land rights, a town border station, meters and regulators, office and other equipment and construction in process.  Agrinatural’s  assets have represented 18.1%, 19.9%, and 19.5% of our consolidated total assets in the years ended October 31, 2017, 2016, and 2015, respectively.  All of Agrinatural’s real property and assets are subject to mortgages in favor of HLBE as security for loan obligations.

Our and Agrinatural’s credit facilities are discussed in more detail under “ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Credit Arrangements”.

ITEM 3.    LEGAL PROCEEDINGS

From time to time in the ordinary course of business, Heron Lake BioEnergy, LLC may be named as a defendant in legal proceedings related to various issues, including workers’ compensation claims, tort claims, or contractual disputes.  We are not currently involved in any material legal proceedings.

ITEM 4.    MINE SAFETY DISCLOSURES

None.

PART II

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

There is no public trading market for our Class A or Class B units.

However, we have established an online unit trading bulletin board (“QMS”) through FNC Ag Stock, LLC, in order to facilitate trading in our units. The QMS has been designed to comply with federal tax laws and IRS regulations establishing a “qualified matching service,” as well as state and federal securities laws. Our QMS consists of an electronic bulletin board that provides a list of interested buyers with a list of interested sellers, along with their non-firm price quotes. The QMS does not automatically affect matches between potential sellers and buyers and it is the sole responsibility of sellers and buyers to contact each other to make a determination as to whether an agreement to transfer units may be reached.

We do not become involved in any purchase or sale negotiations arising from our QMS and have no role in effecting the transactions beyond approval, as required under our member control agreement, and the issuance of new certificates. We do not give advice regarding the merits or shortcomings of any particular transaction. We do not receive, transfer or hold funds or securities as an incident of operating the QMS. We do not receive any compensation for creating or maintaining the QMS. In advertising our QMS, we do not characterize Heron Lake BioEnergy, LLC as being a broker or dealer or an exchange. We do not use the QMS to offer to buy or sell securities other than in compliance with securities laws, including any applicable registration requirements.

There are detailed timelines that must be followed under the QMS rules and procedures with respect to offers and sales of membership units. All transactions must comply with the QMS rules and procedures, our member control agreement, and are subject to approval by our board of governors.

So long as we remain a publicly reporting company, information about the Company will be publicly available through the SEC’s filing system. However, if at any time we cease to be a publicly reporting company, we anticipate continuing to make information about the Company publicly available on our website in order to continue operating the QMS.

The following table contains historical information by fiscal quarter for the past two fiscal years regarding the actual unit transactions that were completed by our unit-holders during the periods specified. We believe the following table most accurately represents the current trading value of the Company’s units. The information was compiled by reviewing the completed unit transfers that occurred on our qualified matching service bulletin board during the quarters indicated.

As a limited liability company, we are required to restrict the transfers of our membership units in order to preserve our partnership tax status.  Our membership units may not be traded on any established securities market or readily traded on a secondary market (or the substantial equivalent thereof).  All transfers are subject to a determination that the transfer will not cause Heron Lake BioEnergy to be deemed a publicly traded partnership.

Issuer Repurchases of Equity Securities

We did not make any repurchases of our Class A or Class B units during fiscal 2017.

Holders of Record

As of January 29, 2018, there were 62,932,107 Class A units outstanding held of record by 1,196 unit holders, and 15,000,000 Class B units outstanding held of record by one unit holder. There are no other classes of units outstanding.  The determination of the number of members is based upon the number of record holders of the units as reflected in the Company’s internal unit records.

As of January 29, 2018, Granite Falls Energy, LLC owns an approximately 50.7% controlling interest in the Company through its wholly owned subsidiary, Project Viking, L.L.C. GFE is a related party by virtue of its ownership interest in us.  As a result of its majority ownership, GFE has the right to appoint five (5) of the nine (9) governors to our board of governors under our member control agreement.

As of October 31, 2017 and January 29, 2018, there were no outstanding options or warrants to purchase, or securities convertible for or into, our units.

Distributions

Distributions by the Company to our unit holders are in proportion to the number of units held by each unit holder. A unit holder’s distribution is determined by multiplying the number of units by distribution per unit declared. Our board of governors has complete discretion over the timing and amount of distributions to our unit holders.

Distributions are restricted by certain loan covenants in our comprehensive credit facility with Compeer. We may only make distributions to our members in an amount that does not exceed 65% of our net profit (determined according to GAAP) for such fiscal year; provided that the we are and will remain in compliance with all of the covenants, terms and conditions of the comprehensive credit facility. If our financial performance and loan covenants permit, we expect to make future cash distributions at times and in amounts that will permit our members to make income tax payments, along with distributions in excess of these amounts. Cash distributions are not assured, however, and we may never be in a position to make distributions. Under Minnesota law, we cannot make a distribution to a member if, after the distribution, we would not be able to pay our debts as they become due or our liabilities, excluding liabilities to our members on account of their capital contributions, would exceed our assets.

On December 18, 2014, our board of governors declared a distribution of $0.12 per membership unit for a total of approximately $9.4 million to be paid to members of record as of December 18, 2014. The distribution was paid on or about January 19, 2015.

On December 17, 2015, our board of governors declared a distribution of $0.05 per membership unit for a total of approximately $3.9 million to be paid to members of record as of December 17, 2015. The distribution was paid on or about January 25, 2016. 

We did not make any distributions to our members during fiscal year 2017.

On December 21, 2017, our board of governors declared a distribution of $0.11 per membership unit for a total of approximately $8.6 million to be paid to members of record as of December 21, 2017. The distribution was paid on or about January 29, 2018. 

Our board of directors has complete discretion over the timing and amount of distributions to our members. Our expectations with respect to our ability to make future distributions are discussed in greater detail in “ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.”

Unregistered Sales of Equity Securities

The Company had no unregistered sales of securities in fiscal year 2017.

Securities Authorized for Issuance Under Equity Compensation Plans

As of the date of this annual report, we had no “equity compensation plans” (including individual equity compensation arrangements) under which any of our equity securities are authorized for issuance.

Performance Graph

The following graph shows a comparison of cumulative total member return since October 31, 2012, calculated on a dividend reinvested basis, for the Company, the NASDAQ Composite Index (the “NASDAQ”) and an index of other companies that have the same SIC code as the Company (the “SIC Code Index”). The graph assumes $100 was invested in each of the Company’s units, the NASDAQ, and the Industry Index on October 31, 2012. Data points on the graph are semi-annual. Note that historic stock price performance is not necessarily indicative of future unit price performance.

Pursuant to the rules and regulations of the Securities and Exchange Commission, the performance graph and the information set forth therein shall not be deemed to be filed for purposes of Section 18 of the Securities Exchange Act of 1934, and shall not be deemed to be incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such a filing.

ITEM 6.    SELECTED FINANCIAL DATA

The following table presents selected consolidated financial and operating data as of the dates and for the periods indicated. The selected financial data for the consolidated balance sheets as of October 31, 2017 and 2016 and the consolidated statements of operations data for the years ended October 31, 2017, 2016, and 2015 have been derived from the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The selected financial data for the consolidated balance sheets as of October 31, 2015, 2014 and 2013 and the consolidated statements of operations data for the years ended October 31, 2014 and 2013 were derived from audited consolidated financial statements filed previously. This selected consolidated financial data should be read in conjunction with “ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and the consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. Among other things, those financial statements include more detailed information regarding the basis of presentation for the following consolidated financial data (amounts in thousands, except per unit data and unless context otherwise requires).

ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

We prepared the following discussion and analysis to help readers better understand our financial condition, changes in our financial condition, and results of operations for the fiscal year ended October 31, 2017.  This discussion should be read in conjunction with the consolidated financial statements included herewith and notes to the consolidated financial statements thereto and the risk factors contained herein.

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.

Our revenues are derived from the sale and distribution of our ethanol throughout the continental U.S. and in the sale and distribution of our distillers’ grains (DGS) locally, and throughout the continental U.S.

Based on the criteria set forth in ASC 280, the Company has two reportable operating segments for financial reporting purposes: (1) production of ethanol and related distillers’ grains, corn oil and syrup collectively referred to as ethanol production; and (2) natural gas pipeline distribution and services from the Company’s majority owned subsidiary, Agrinatural.

Before intercompany eliminations, revenues from our natural gas pipeline segment represented 2.7%, 2.5%, and 2.4% of our total consolidated revenues in the years ended October 31, 2017, 2016, and 2015, respectively.  After accounting for intercompany eliminations for fees paid by the Company for natural gas transportation services pursuant to our natural gas transportation agreement with Agrinatural, Agrinatural’s revenues represented 1.1%, 0.9%, and 0.9% of our consolidated revenues for the fiscal years ended October 31, 2017, 2016, and 2015, respectively, and have little to no impact on the overall performance of the Company.

Plan of Operations For the Next Twelve Months

Over the next twelve months we will continue our focus on operational improvements at our plant. These operational improvements include exploring methods to improve ethanol yield per bushel and increasing production output at our plant, continued emphasis on safety and environmental regulation, reducing our operating costs, and optimizing our margin opportunities through prudent risk-management policies.

We expect to have sufficient cash generated by continuing operations and availability on our credit facility to fund our operations.  However, should we experience unfavorable operating conditions in the ethanol industry that prevent us from profitably operating our plant, we may need to seek additional funding.

In addition, we expect to continue to conduct routine maintenance and repair activities at the ethanol plant to maintain current plant infrastructure, as well as small capital projects to improve operating efficiency. We anticipate using cash we generate from our operations and our revolving term loan to finance these plant upgrade projects.

Trends and Uncertainties Impacting Our Operations

The principal factors affecting our results of operations and financial conditions are the market prices for corn, ethanol, distillers’ grains and natural gas, as well as governmental programs designed to create incentives for the use of corn-based ethanol.  Other factors that may affect our future results of operation include those risks and factors discussed in this report at “PART I - ITEM 1. BUSINESS” and “PART I - ITEM 1A. RISK FACTORS”.

Our operations are highly dependent on commodity prices, especially prices for corn, ethanol, distillers’ grains and natural gas. As a result, our operating results can fluctuate substantially due to volatility in these commodity markets. The price and availability of corn is subject to significant fluctuations depending upon a number of factors that affect commodity prices in general, including crop conditions, yields, domestic and global stocks, weather, federal policy and foreign trade. Natural gas prices are influenced by severe weather in the summer and winter and hurricanes in the spring, summer and fall. Other factors include North American exploration and production, and the amount of natural gas in underground storage during injection and withdrawal seasons. Ethanol prices are sensitive to world crude oil supply and demand, domestic gasoline supply and demand, the price of crude oil, gasoline and corn, the price of substitute fuels and octane enhancers, refining capacity and utilization, government regulation and incentives and consumer demand for alternative fuels. Distillers’ grains prices are impacted by livestock numbers on feed, prices for feed alternatives and supply, which is associated with ethanol plant production.

We expect our ethanol plant to produce approximately 2.8 gallons of denatured ethanol for each bushel of grain processed in the production cycle. Because the market price of ethanol is not always directly related to corn, at times ethanol prices may lag price movements in corn prices and corn-ethanol price spread (the difference between the price per gallon of ethanol and the price per bushel of grain divided by 2.8) may be tightly compressed or negative. If the corn-ethanol spread is compressed or negative for sustained period, it is possible that our operating margins will decline or become negative and our ethanol plant may not generate adequate cash flow for operations. In such cases, we may reduce or cease production at our ethanol plant in order to minimize our variable costs and optimize cash flow.

For the fiscal year ended October 31, 2017 compared to fiscal year ended October 31, 2016, our average price per gallon of ethanol sold increased 1.8%. Although there has been an increased domestic supply of ethanol, the price of ethanol increased in part due to domestic demand as relatively low fuel prices resulted in increased consumers driving and increased export demand. The price of ethanol has also seen positive impact from the rising ethanol blend rates at the pump. In addition, because ethanol prices are typically directionally consistent with changes in corn and energy prices, lower corn prices were offset by rising crude oil and gasoline prices throughout the fiscal year which had a favorable effect on ethanol price. Management believes that, despite the uptick in ethanol price, the ethanol outlook moving into fiscal year 2018 will remain relatively flat and our margins will remain tight due to abundant corn supplies and relatively flat gasoline demand.  

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. During 2017 Brazil and China adopted import quotas and/or tariffs on the importation of ethanol which are expected to continue to negatively impact U.S. exports. China, the number three importer of U.S. ethanol in 2016, has imported negligible volumes since imposing a 30% tariff on U.S. and Brazil fuel ethanol on January 1, 2017.  On September 1, 2017, Brazil’s Chamber of Foreign Trade imposed a 20% tariff on U.S. ethanol imports in excess of 150 million liters, or 39.6 million gallons per quarter. The ruling is valid for two years. According to the RFA, during September 2017, Brazil fell out of the top two customers of U.S. ethanol exports for the first time in 16 months. 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.

Corn prices trended upward during the first half of fiscal year 2017, becoming more volatile and trending down during the latter part of fiscal year 2017 as harvest was completed.  The latest estimates of supply and demand provided by the U.S. Department of Agriculture (“USDA”) estimate the 2017-18 ending corn stocks at approximately 2.5 billion bushels, and project the 2017/18 corn supply at approximately 14.6 billion bushels with steady corn consumption for ethanol and co-products steady at approximately 5.5 billion bushels, suggesting lower corn prices into the first half of Fiscal 2018. Weather, world supply and demand, current and anticipated stocks, agricultural policy and other factors can contribute to volatility in corn prices. If corn prices rise, it will have a negative effect on our operating margins unless the price of ethanol and distillers grains out paces rising corn prices.

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. In January year, China imposed significant anti-dumping and anti-subsidies on distillers’ grains imported from the U.S. which saw significant declines in exports of U.S. distillers’ grains to China.  

However, in November 2017, the China Ministry of Commerce announced that the anti-subsidy tariffs would be repealed.  While the anti-subsidy tariffs may be removed, the more substantial anti-dumping duties remain.  As a result, we cannot forecast how much demand from China will come back into the marketplace and distillers’ grains prices could remain low unless additional demand can be created from other foreign markets or domestically.

Additionally, exports of U.S. distillers’ grains to Vietnam have 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.  The lift of this suspension may result in increased exports to Vietnam; however, there is no guarantee that the Vietnamese export market will achieve significant growth.  Management anticipates distillers’ grains prices will remain lower during our 2018 fiscal year, unless additional domestic demand or other foreign markets develop. Domestic demand for distillers’ grains could also remain low if corn prices decline and end-users switch to lower priced alternatives.   

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. 

Given the inherent volatility in ethanol, distillers’ grains, non-food grade corn oil, grain and natural gas prices, we cannot predict the likelihood that the spread between ethanol, distillers’ grains, non-food grade corn oil and grain prices in future periods will be consistent compared to historical periods.

Results of Operations for the Fiscal Years Ended October 31, 2017 and 2016

The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our audited consolidated statements of operations for the fiscal years ended October 31, 2017 and 2016 (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. Our remaining consolidated revenues are attributable to incidental sales of corn syrup and Agrinatural revenues, net of eliminations for distribution fees paid by the Company to Agrinatural for natural gas transportation services.

The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our audited consolidated statements of operations for the fiscal year ended October 31, 2017:

The following table shows the sources of our consolidated revenue and the approximate percentage of revenues from those sources to total revenues in our consolidated statements of operations for the fiscal year ended October 31, 2016:

Our total consolidated revenues increased by approximately 0.3% for the fiscal year ended October 31, 2017, as compared to the fiscal year 2016 primarily due to increases in the average price realized for our ethanol and corn oil which were partially mitigated by decreases in average price realized for our distillers’ grains.  The following table reflects quantities of our three primary products sold and the average net prices received for the fiscal years ended October 31, 2017 and 2016:

Ethanol

Total revenues from sales of ethanol increased by approximately 2.4% for fiscal year 2017 compared to the fiscal year 2016 due primarily to an approximately 1.8%  increase in the average price per gallon we received for our ethanol coupled with an approximate 0.6% increase in the volumes sold from period to period. We produced and sold more ethanol gallons during fiscal year 2017 as compared to fiscal year 2016 primarily due to the timing of ethanol shipments and a slight increase in ethanol production. Ethanol production was higher at our plant compared to the prior year due to capital improvements we are making at our plant designed to increase ethanol production and improve efficiency. We are currently operating above our nameplate capacity. Management anticipates relatively stable ethanol production and sales during our 2018 fiscal year. 

The increase in the price of ethanol was due in part to domestic demand as relatively low fuel prices resulted in increased consumers driving and increased export demand. In addition, because ethanol prices are typically directionally consistent with changes in corn and energy prices, lower corn prices were offset by rising crude oil and gasoline prices throughout the fiscal year which had a favorable effect on ethanol prices.

We occasionally engage in hedging activities with respect to our ethanol sales. We recognize the gains or losses that result from the changes in the value of these derivative instruments in revenues as the changes occur. At October 31, 2017, we had fixed and basis contracts for forward ethanol sales for delivery periods through March 2018 valued at approximately $18.4 million.  Separately, ethanol derivative instruments resulted in a loss of approximately $219,000 for the fiscal year ended October 31, 2017 and a gain of approximately $118,000 for the fiscal year ended October 31, 2016.

Distillers’ Grains

Total revenues from sales of distillers’ grains for our 2017 fiscal year were approximately 11.8%  less compared to fiscal year 2016.  The decline in distillers’ grains revenues is primarily attributable to an approximately 16.5%  decrease in the average price per ton we received for our distillers’ grains from period to period, partially offset by an  approximately 5.7% increase in the tons of distillers’ grains sold during fiscal year 2017 compared to fiscal year 2016.   

The decline in the market price of distillers’ grains is due to lower domestic demand and lower export demand, particularly from China, as well as Vietnam. Reduced export demand from China and Vietnam, combined with lower corn and soybean prices, has led to an oversupply of distillers’ grains in the domestic market which has resulted in a decline in the price of distillers’ grains. Domestic demand for distillers’ grains may also remain low due to expansion of production capacity in the ethanol industry and end-users switching to lower priced alternatives. Management anticipates that distillers’ grains prices will remain lower during our 2018 fiscal year unless China reduces or eliminates its tariffs.

We sold more tons of distillers’ grains during fiscal year 2017 as compared to 2016 due primarily to an increase in distillers’ grains yield at the plant. Management anticipates relatively stable distillers’ grains production going forward. 

At October 31, 2017, we had forward distillers’ grains sales contracts valued at approximately $2.0 million for various delivery periods through March 2018.

Corn Oil

Separating the corn oil from our distillers’ grains decreases the total tons of distillers’ grains that we sell; however, our corn oil has a higher per ton value than our distillers’ grains.  Total revenues from sales of corn oil increased by approximately 2.8% for fiscal year 2017 compared to the fiscal year 2016.  This increase is attributable to an approximately 5.9% increase in the average price we received per pound of corn oil sold, offset by a 2.9% decrease in the number of pounds sold during fiscal year 2017 compared to fiscal year 2016. 

Management attributes the increase in corn oil prices during fiscal year 2017, in part, to increased demand from the biodiesel industry and due to the expansion of the RFS advanced biofuel mandate increasing the demand for biodiesel. However, the RVO for advanced biofuels in EPA’s final rule for 2018 is significantly reduced in comparison to the statutory mandate.  As a result, the increased demand for corn oil from the biodiesel industry may not continue during fiscal year 2018, particularly if the biodiesel blenders' tax credit, which expired on December 31, 2016, is not extended. In December 2017, a bill, the Tax Extenders Act of 2017 (S. 2256), was introduced in the Senate which would renew the $1.00-per-gallon biodiesel and renewable diesel tax credits for biodiesel and blending biodiesel retroactively to January 1, 2017, and extending the tax credit through December 31, 2018. Due to the recent uncertainty in Congress, management cannot predict whether the tax credit extender bill will be passed by Congress as presently written or at all.

Although management believes that corn oil prices will remain relatively steady at the increased price levels, prices may decrease if there is an oversupply of corn oil production resulting from increased production rates at ethanol plants or if biodiesel producers begin to utilize lower-priced alternatives such as soybean oil or if biodiesel blenders’ tax credit is not renewed and biodiesel production declines.

The decrease in volume sold for fiscal year 2017 compared to the 2016 is attributable to reduced oil yield.  Management expects our corn oil production will be relatively stable going forward.

At October 31, 2017, we had forward corn oil sales contracts valued at $763,000 for various delivery periods through December 2017.

Cost of Goods Sold

Our cost of goods sold decreased by approximately 1.6% for the fiscal year ended October 31, 2017, as compared to the fiscal year ended October 31, 2016.  Cost of goods sold, as a percentage of revenues, also decreased to approximately 90.5% for the fiscal year ended October 31, 2017, as compared to approximately 92.3% for the 2016 fiscal year due to a wider margin between the price of ethanol and the price of corn.  Approximately 90% of our total costs of goods sold is attributable to ethanol production. As a result, the cost of goods sold per gallon of ethanol produced for the fiscal year ended October 31, 2017 was approximately $1.38 per gallon of ethanol sold compared to approximately $1.42 per gallon of ethanol produced for the fiscal year ended October 31, 2016. 

The following table shows the costs of corn and natural gas (our two largest single components of costs of goods sold), as well as all other components of cost of goods sold, which includes processing ingredients, electricity, and wages, salaries and benefits of production personnel, and the approximate percentage of costs of those components to total costs of goods sold in our audited consolidated statements of operations for the fiscal year ended October 31, 2017:

The following table shows the costs of corn, natural gas and all other components of cost of goods sold and the approximate percentage of costs of those components to total costs of goods sold in our audited consolidated statements of operations for the fiscal year ended October 31, 2016:

Corn Costs

Our cost of goods sold related to corn decreased approximately 2.6% for our 2017 fiscal year compared to our 2016 fiscal year, due primarily to decrease of 4.1% in the average price per bushel paid for corn from period to period,  offset by a 1.6% increase in the number of bushels of corn processed. The corn-ethanol price spread (the difference between the price per gallon of ethanol and the price per bushel of grain divided by 2.8) for our 2017 fiscal year was approximately $0.07 more than the corn-ethanol price spread we experienced for fiscal year 2016.

The decrease in our cost per bushel of corn was primarily related to lower market corn prices due to increased market corn supplies by the strong corn harvest in the fall of 2016, resulting in a sufficient local supply of corn to the market. Due to the strong 2017 harvest, management anticipates that corn prices will remain lower during our first half of 2018 fiscal year.

For our fiscal years ended October 31, 2017 and 2016, we processed approximately 22.5 million and 22.1 million bushels of corn, respectively.  We were able to improve our corn conversion efficiency slightly during our 2017 fiscal year compared to 2016 which allowed us to produce more ethanol per bushel of corn. Management anticipates consistent corn consumption during our 2018 fiscal year provided that we can maintain positive operating margins that allow us to continue to operate the ethanol plant at capacity.

From time to time we enter into forward purchase contracts for our corn purchases. At October 31, 2017, we had forward corn purchase contracts for approximately 1.8 million bushels for various delivery periods through October 2018. Comparatively, at October 31, 2016, we had forward corn purchase contracts for approximately 4.3 million bushels for various delivery periods through August 2017.

Our corn derivative positions resulted in gains of approximately $962,000 and $916,000 for the fiscal years ended October 31, 2017 and 2016, respectively, which decreased cost of goods sold. We recognize the gains or losses that result from the changes in the value of our derivative instruments from corn in cost of goods sold as the changes occur.  As corn prices fluctuate, the value of our derivative instruments are impacted, which affects our financial performance. We anticipate continued volatility in our cost of goods sold due to the timing of the changes in value of the derivative instruments relative to the cost and use of the commodity being hedged. 

Natural Gas Costs

For our 2017 fiscal year, we experienced an increase of approximately 18.0% in our overall natural gas costs compared to our 2016 fiscal year.  This increase in cost of natural gas from period to period as was primarily the result of an increase in the average price per MMBTU of natural gas due to increased domestic and export demand and lower production which used up natural gas stocks that built up in 2015.  Management also anticipates higher natural gas prices during as we move through the winter months due to the typical seasonal natural gas cost increases experienced during the winter months.

From time to time we enter into forward purchase contracts for our natural gas purchases. Our natural gas derivative positions resulted in a loss of approximately $15,000 for the fiscal year ended October 31, 2017, which increased cost of goods sold. Comparatively, our natural gas derivative positions resulted in a gain of approximately $22,000 for the fiscal year ended October 31, 2016, which decreased cost of goods sold. We recognize the gains or losses that result from the changes in the value of our derivative instruments from natural gas in cost of goods sold as the changes occur.

Operating Expense

Operating expenses include wages, salaries and benefits of administrative employees at the plant, insurance, professional fees, property taxes and similar costs.  Operating expenses as a percentage of revenues rose slightly to 2.8% of revenues for our fiscal year ended October 31, 2017 compared to 2.7% of revenues for our fiscal year ended October 31, 2016.  This increase is due primarily to fixed production expenses that were higher compared to fiscal year 2016.   Our higher fixed production expenses are attributable to an increase in our property taxes, which was a result of the expiration of the State of Minnesota’s JOBZ program, which expired on December 31, 2015. Under the JOBZ program, our plant was exempt from property tax.

Our efforts to optimize efficiencies and maximize production may result in a decrease in our operating expenses on a per gallon basis. However, because these expenses generally do not vary with the level of production at the plant, we expect our operating expenses to remain steady into and throughout our 2018 fiscal year.

Operating Income

For our fiscal year ended October 31, 2017, we reported operating income of approximately $7.3 million compared to operating income of approximately $5.5 million for our fiscal year ended October 31, 2016.  This increase resulted largely from increased prices for our ethanol relative to the price of corn and improved operating margin.

Other Income (Expense), Net

We had net other income of approximately $211,000 during fiscal year 2017 compared to net other expense of approximately $300,000 for fiscal year 2016.  We had more other income during fiscal year 2017 compared to fiscal year 2016 due to patronage income and decreased interest expense as a result of fewer borrowings under our credit facilities during the 2017 fiscal year. 

Results of Operations for the Fiscal Years Ended October 31, 2016 and 2015

The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our audited consolidated  statements of operations for the fiscal years ended October 31, 2016 and 2015 (amounts in thousands):