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, 2019, 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%. 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 2018, 2017, and 2016, we sold approximately 66.9 million gallons, 64.0 million gallons, and 61.4 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.
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Ethanol Production. Based on the nature of the products and production process and the expected financial results, the Company’s operations at its ethanol plant, including the production and sale of ethanol and its co-products, are aggregated into one financial reporting segment.
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Natural Gas Pipeline. The Company has majority ownership in Agrinatural, through its wholly owned subsidiary, HLBE Pipeline, LLC, and operations of Agrinatural’s natural gas pipeline are aggregated into another financial reporting segment.
Before intercompany eliminations, revenues from our natural gas pipeline segment represented 3.2%, 2.7%, and 2.5% of our total consolidated revenues in the years ended October 31, 2018, 2017, and 2016, 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 1.5%, 1.1%, and 0.9% of our consolidated revenues for the fiscal years ended October 31, 2018, 2017, and 2016, 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 98.5%, 98.9%, and 99.1% of our revenues in the years ended October 31, 2018, 2017, and 2016, 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, 2018.
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:
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an octane enhancer in fuels;
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an oxygenated fuel additive that can reduce ozone and carbon monoxide vehicle emissions;
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a non-petroleum-based gasoline substitute; and
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as a renewable fuel to displace consumption of imported oil.
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, China, Netherlands, South Korea, and Philippines 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 substantially increased during 2016 over 2015, China imported comparatively negligible volumes during both 2017 and 2018. This reduction is due to China’s increase of the tariff on ethanol imported from the U.S. to 45% as of April 2, 2018, compared to the previous 30% tariff imposed in 2017, and the subsequent increase of the 45% tariff to 70% as of July 6, 2018. Notably, 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. It is unclear whether China will be able to meet the 10% target without importing US ethanol. However, 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 negatively impacted U.S. exports to Brazil. The import quota imposed a 20% tariff on U.S. ethanol imports in excess of 150 million liters, or 39.6 million gallons per quarter. The tariff is valid for two years, which means that it is due to expire in September 2019. U.S. exports to Brazil have remained steady from our 2017 fiscal year to our 2018 fiscal year. However, this tariff may continue to have a negative impact on the export market demand and prices for ethanol produced in the United States.
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. According to the U.S. Grains Council, total U.S. distiller’s grains exports through October 2018 were approximately 7.7% higher than distiller’s grains exports for the same period last year. Top export markets include Mexico, the European Union, Vietnam, Thailand, and South Korea.
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, China 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. Exports to China within the last year have grown markedly but are still substantially below the pre-tariff export levels. There is no guarantee that distillers’ grains exports to Chinese will resume.
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 the 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, as well as 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 lower during fiscal year 2018 compared to fiscal year 2017. Ethanol prices were lower during the fiscal year ended October 31, 2018 due to increased ethanol output and excess supply. Management expects additional volatility for the price of ethanol in 2019. Ethanol supply is projected to level out in 2019, and demand is expected to increase in 2019. However, there is no guarantee that either of these patterns will occur. Due to low ethanol and feedstock prices, exports grew in 2018 and are projected to continue to grow in 2019. 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 2018, while ethanol as a percentage of the fuel supply remained steady. Ethanol consumption is projected to increase slightly in 2019; however, there is no guarantee that this projection will be accurate. 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 71.8%, 72.9%, and 74.4% of our cost of sales for the years ended October 31, 2018, 2017, and 2016, respectively. At our current production rate of approximately 65 million gallons of ethanol per year, we need to consume 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 the first quarter of our 2018 fiscal year as a result of several consecutive years of favorable corn crops. Corn prices were higher during the second, third, and fourth quarters of our 2018 fiscal year due to strong demand and potential weather threats. If we experience a drought or other unfavorable weather condition during our 2019 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 6.4%, 6.7%, and 5.6% of our cost of sales for the years ended October 31, 2018, 2017, and 2016, respectively.
We do not anticipate any problems securing the natural gas we require to continue to operate our plant at capacity during our 2019 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, 2022.
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. Our plant obtains its electricity from Federal Rural Electric. We do not anticipate any problems securing the electricity that we require to continue to operate our plant at capacity during our 2019 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 2019 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 Renewable Fuels Association (the “RFA”), as of November 15, 2018, there are approximately 217 biorefineries with a total nameplate capacity of approximately 16.5 billion gallons of ethanol per year, with an additional eight plants under expansion or construction with capacity to produce an additional 258 million gallons. However, the RFA estimates that approximately 3.2% of the ethanol production capacity in the U.S. was not operating as of November 15, 2018.
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 November 15, 2018, Minnesota is one of the top producers of ethanol in the U.S. with 22 ethanol plants producing an aggregate of approximately 1.3 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 30, 2017, the EPA announced the final rule for 2018 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. The 2018 final rule also set advanced biofuels at 4.29 billion gallons, for overall RVOs of 19.29 billion gallons for 2018.
On November 30, 2018, the EPA announced the final 2019 RVOs, setting the RVOs for conventional ethanol at 15.0 billion gallons, advanced biofuels at 4.92 billion gallons and cellulosic ethanol at 0.42 billion gallons, for overall RVOs of 19.92 billion gallons for 2019. 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.
(3)Final EPA RFS RVOs for 2019 issued November 2018.
Current ethanol production capacity exceeds the EPA’s 2018 and 2019 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. In October 2018, the Office of Management and Budget announced that the 20% thresholds “have been met or are expected to be met in the near future.” As a result, the EPA is proposing a rulemaking that will propose modifying the applicable volumes targets for cellulosic biofuel, advanced biofuel, and total renewable fuels for the years 2020-2022. Additionally, the EPA will be proposing volume requirements for biomass-based diesel for 2021 and 2022. Because the timetable for the rulemaking overlaps with the annual standard-setting rulemakings, the rulemaking will also include the applicable percentage standards for 2020. 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, 2018, and 2019. 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 in vehicles model year 2001 and newer. However, widespread 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. However, in October 2018, President Trump directed the EPA to promulgate a regulation making E15 available year-round. The Office of Management and Budget expects that the EPA will release a proposed rule in February 2019, with the final rule scheduled to be issued in May 2019. Notably, much of the EPA’s staff was subject to furlough due to a
			
		
partial government shutdown in January 2019. It is also important to note that the oil industry is expected to challenge this rulemaking. As a result, there is no guarantee that the year-round E15 rule will be finalized pursuant to the proposed timeline, nor is there a guarantee that the rule will ever be finalized.
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. Under the RFS, small refineries may petition for and be granted temporary exemptions from the RVOs if they can demonstrate that compliance with the RVOs would cause disproportionate economic hardship. Waivers granted in 2016 and 2017 effectively lowered the RVOs by at least 1.6 billion gallons, according to the Renewable Fuels Association. On December 20, 2018, the EPA released data on the number of waivers filed, which indicated that, as of December 18, 2018, 22 petitions for waivers for the 2018 compliance year have been received. For the 2017 compliance year, 37 petitions have been received. To date, the EPA has approved 29 of those petitions, with 7 currently pending and 1 declared ineligible or withdrawn. The 29 approved petitions have exempted approximately 1.46 billion RINs, which is approximately 13.62 billion gallons of gasoline and diesel, from meeting the RFS blending targets. It is expected that additional petitions for waivers for the 2018 compliance year will be received by the EPA. It is also expected that the EPA will approve a significant number of these waiver petitions, thereby exempting a substantial number of gallons of gasoline and diesel from meeting the RFS blending targets. These exemptions decrease demand for our products, which negatively impacts ethanol prices and our profitability.
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. For the fiscal year ended October 31, 2018, we incurred costs and expenses of approximately $133,000 complying with environmental laws.
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 greenhouse gas (“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, 2018, the Company paid SEI approximately $38,000 of monthly base fees and approximately $161,000 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, 2018, the Company paid SEI approximately $77,000 for project management and capital work fees.
The Company has two intercompany credit facilities with Agrinatural: a July 2014 credit facility (the “Original Credit Facility”) and a 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 20.1%, 18.1%, and 19.9% of our consolidated total assets in the years ended October 31, 2018, 2017, and 2016, 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 3.2%, 2.7%, and 2.5% of our total consolidated revenues in the years ended October 31, 2018, 2017, and 2016, respectively. After accounting for intercompany eliminations for fees from the Company for natural gas transportation services, Agrinatural’s revenues represented 1.5%,
			
		
1.1%, and 0.9% of our consolidated revenues for the fiscal years ended October 31, 2018, 2017, and 2016, 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, 2018, 2017, and 2016 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.
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 2019. Ethanol supply is expected to level out or increase in 2019, and demand is expected to increase in 2019, which may lead to market imbalances. Due to low ethanol and feedstock prices, exports grew in 2018 and are projected to continue to grow in 2019. 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 2018, while ethanol as a percentage of the fuel supply remained steady. 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 2018 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, such as the tariffs currently in effect, 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 Archer Daniels Midland, POET Biorefining, 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:
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additional rail capacity;
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additional storage facilities for ethanol;
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increases in truck fleets capable of transporting ethanol within localized markets;
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expansion of refining and blending facilities to handle ethanol; and
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growth in service stations equipped to handle ethanol fuels.
			
		
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.
Failures of our information technology infrastructure could have a material adverse effect on operations.
We utilize various software applications and other information technology that are critically important to our business operations. We rely on information technology networks and systems, including the Internet, to process, transmit and store electronic and financial information, to manage a variety of business processes and activities, including production, manufacturing, financial, logistics, sales, marketing and administrative functions. We depend on our information technology infrastructure to communicate internally and externally with employees, customers, suppliers and others. We also use information technology networks and systems to comply with regulatory, legal and tax requirements. These information technology systems, some of which are managed by third parties, may be susceptible to damage, disruptions or shutdowns due to failures during the process of upgrading or replacing software, databases or components thereof, power outages, hardware failures, computer viruses, attacks by computer hackers or other cybersecurity risks, telecommunication failures, user errors, natural disasters, terrorist attacks or other catastrophic events. If any of our significant information technology systems suffer severe damage, disruption or shutdown, and our disaster recovery and business continuity plans do not effectively resolve the issues in a timely manner, our product sales, financial condition and results of operations may be materially and adversely affected.
			
		
A cyber attack or other information security breach could have a material adverse effect on our operations and result in financial losses.
We are regularly the target of attempted cyber and other security threats and must continuously monitor and develop our information technology networks and infrastructure to prevent, detect, address and mitigate the risk of unauthorized access, misuse, computer viruses and other events that could have a security impact. If we are unable to prevent cyber attacks and other information security breaches, we may encounter significant disruptions in our operations which could adversely impact our business, financial condition and results of operations or result in the unauthorized disclosure of confidential information. Such breaches may also harm our reputation, result in financial losses or subject us to litigation or other costs or penalties.
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 co-products, distillers’ grains and corn oil to three 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 98.3%, 99.5%, and 98.3% of revenue for the years ended October 31, 2018, 2017, and 2016, respectively, and approximately 95.6% and 98.1% of the outstanding accounts receivable balance at October 31, 2018 and 2017, 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 widespread 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, 2018, the EPA announced final RVO
			
		
requirements for the RFS for calendar year 2019. 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 19.92 billion gallons for 2019, more than 20% below the overall statutory level of 26 billion gallons, due to decreases in the RVOs for cellulosic ethanol and advanced biofuels. The 2018 standard was also more than 20% below the overall statutory level.
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. In October 2018, the Office of Management and Budget announced that the 20% thresholds “have been met or are expected to be met in the near future.” As a result, the EPA is proposing a rulemaking that will propose modifying the applicable volumes targets for cellulosic biofuel, advanced biofuel, and total renewable fuels for the years 2020-2022. Additionally, the EPA will be proposing volume requirements for biomass-based diesel for 2021 and 2022. Because the timetable for the rulemaking overlaps with the annual standard-setting rulemakings, the rulemaking will also include the applicable percentage standards for 2020. 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. 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.
In addition, different gasoline blendstocks may be required at certain times of the year in order to use E15 due to current federal regulations related to fuel evaporative emissions. This may prevent E15 from being used during certain times of the year in various states. However, in October 2018, President Trump directed the EPA to promulgate a regulation making E15 available year-round. The Office of Management and Budget expects that the EPA will release a proposed rule in February 2019, with the final rule scheduled to be issued in May 2019. Notably, much of the EPA’s staff was subject to furlough due to a partial government shutdown during January 2019. It is also important to note that the oil industry is expected to challenge this rulemaking. As a result, there is no guarantee that the year-round E15 rule will be finalized pursuant to the proposed timeline, nor is there a guarantee that the rule will ever be finalized.
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 allows it to control or heavily influence matters requiring member approval, and has additional board rights under our member control agreement.
As of January 29, 2019, 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 2016 and 2018, 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.
Although we expect that a number of our members may qualify for the Qualified Business Income Deduction (“QBID”), you may not qualify for the QBID.
Your ownership of our units may qualify you for the QBID. Pursuant to the Tax Cuts and Jobs Act of 2017, the QBID allows for a deduction of up to 20% of the qualified business income (“QBI”) of an owner of a pass-through entity. QBI generally includes the net amount of qualified income, gain, deduction, and loss from a domestic trade or business in which the taxpayer is an owner. The calculation of the QBID depends on a variety of factors, with the most significant factor being the taxpayer’s taxable income. For married persons filing jointly with taxable income equal to or less than the threshold amount, which is subject to adjustment for inflation, of $315,000 ($157,500 for taxpayers filing single), a taxpayer’s QBID is the lesser of: (1) 20% of the taxpayer’s QBI, or (2) 20% of the taxpayer’s taxable income less their net capital gains. For married persons filing jointly with taxable income exceeding the above-referenced threshold amounts, the QBID is subject to further limitations, such as limitations based on the amount of W-2 wages paid with respect to that entity or business, the unadjusted basis of qualified property in the business, and the type of trade or business. Because the impact of this deduction is dependent upon your particular tax situation, you should consult your own tax advisor as to your eligibility for the QBID. There is no guarantee that you will qualify for the QBID.
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.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
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 20.1%, 18.1%, and 19.9% of our consolidated total assets in the years ended October 31, 2018, 2017, and 2016, 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.
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.
ITEM 4. MINE SAFETY DISCLOSURES
None.
PART II
ITEM 5.
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 2018.
Holders of Record
As of January 29, 2019, there were 62,932,107 Class A units outstanding held of record by 1,190 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, 2019, 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, 2018, and January 29, 2019, 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 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 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 January 29, 2018.
No additional distributions were either declared or paid in 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 2018.
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, 2013, 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, 2013. 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.
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, 2018 and 2017 and the consolidated statements of operations data for the years ended October 31, 2018, 2017, and 2016 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, 2016, 2015 and 2014 and the consolidated statements of operations data for the years ended October 31, 2015 and 2014 were derived from audited consolidated financial statements filed previously. This selected consolidated financial data should be read in conjunction with “ITEM 7
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, 2018. 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 3.2%, 2.7%, and 2.5% of our total consolidated revenues in the years ended October 31, 2018, 2017, and 2016, 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 1.5%, 1.1%, and 0.9% of our consolidated revenues for the fiscal years ended October 31, 2018, 2017, and 2016 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, 2018 compared to fiscal year ended October 31, 2017, our average price per gallon of ethanol sold decreased 10.9%. There has been an increased domestic supply of ethanol and gasoline demand has been flat. While export demand has slightly increased, the increased domestic supply of ethanol overshadows any increase in export demand. Additionally, the increase in approved economic hardship exemptions from the RVOs has recently effectively lowered the RVOs by a significant number of gallons of domestic demand. If this trend continues, it may continue to negatively impact the U.S. ethanol market. Management believes that the ethanol outlook moving into fiscal year 2019 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. fuel ethanol on January 1, 2017 (which was subsequently increased to 45% in April 2018, and then again increased to 70% in July 2018). 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 tariff is valid for two years, which means that it is due to expire in September 2019. However, U.S. exports to Brazil have remained steady from our 2017 fiscal year to our 2018 fiscal year. This tariff may still have a negative impact on the export market demand and prices for ethanol produced in the United States. 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 2018, becoming more volatile and trending down during the latter part of fiscal year 2018 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 1.8 billion bushels, and project the 2018-19 corn supply at approximately 16.8 billion bushels with corn consumption for ethanol and co-products steady at approximately 5.6 billion bushels, suggesting lower corn prices into the first half of fiscal 2019. 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.
Distillers’ grains prices increased in 2018 over 2017, due to export demand and resource availability. Top export markets include Mexico, the European Union, Vietnam, Thailand, and South Korea. Of note, however, is that export demand from China, historically one of the largest importers of U.S. produced distillers grains, has significantly declined. In 2017, 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. Exports to China within the last year have grown markedly but are still substantially below the pre-tariff export levels. There is no guarantee that distillers’ grains exports to China will resume at pre-tariff levels.
Management anticipates distillers’ grains prices will remain steady during our 2019 fiscal year, unless additional domestic demand or other foreign markets develop. Domestic demand for distillers’ grains could remain low if corn prices decline and end-users switch to lower priced alternatives.
			
		
Corn oil prices have 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, 2018 and 2017
The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our audited consolidated statements of operations for the fiscal years ended October 31, 2018 and 2017 (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, 2018:
			
		
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, 2017:
Our total consolidated revenues decreased by approximately 1.3% for the fiscal year ended October 31, 2018, as compared to the fiscal year 2017 primarily due to decreases in the average price realized for our ethanol and corn oil which were partially mitigated by increases 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, 2018 and 2017:
Ethanol
Total revenues from sales of ethanol decreased by approximately 6.9% for fiscal year 2018 compared to the fiscal year 2017 due primarily to an approximately 10.9% decrease in the average price per gallon we received for our ethanol, offset by an approximate 4.5% increase in the volumes sold from period to period. We sold more ethanol gallons during fiscal year 2018 as compared to fiscal year 2017 primarily due to the timing of ethanol shipments and an increase in ethanol production. Ethanol production was higher at our plant 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 2019 fiscal year.
The decrease in the price of ethanol was due to excess supply of ethanol, in addition to lessened demand due to the increase in the approval of small refinery hardship waivers. In addition, because ethanol prices are typically directionally consistent with changes in corn prices, lower corn prices kept the price of ethanol lower.
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, 2018, we had fixed and basis contracts for forward ethanol sales for delivery periods through December 2018 valued at approximately $10.9 million. Separately, ethanol derivative instruments resulted in a gain of approximately $54,000 for the fiscal year ended October 31, 2018 and a loss of approximately $219,000 for the fiscal year ended October 31, 2017.
Distillers’ Grains
Total revenues from sales of distillers’ grains for our 2018 fiscal year increased approximately 33.6% compared to fiscal year 2017. The increase in distillers’ grains revenues is primarily attributable to an approximately 30.0% increase in the average price per ton we received for our distillers’ grains from period to period, coupled with a 2.8% increase in the tons of distillers’ grains sold during fiscal year 2018 compared to fiscal year 2017.
			
		
The increase in the market price of distillers’ grains is due to higher demand, particularly from Vietnam, the European Union, Thailand, and South Korea. Management anticipates that distillers’ grains prices will remain steady during our 2019 fiscal year unless export markets shrink or otherwise discontinue growth.
We sold more tons of distillers’ grains during fiscal year 2018 as compared to 2017 due primarily to an increase in distillers’ grains yield at the plant. Management anticipates relatively stable distillers’ grains production going forward.
At October 31, 2018, we had forward distillers’ grains sales contracts to sell approximately $561,000 for various delivery periods through November 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 decreased by approximately 18.0% for fiscal year 2018 compared to the fiscal year 2017. This decrease is attributable to an approximately 12.7% decrease in the average price we received per pound of corn oil sold, coupled with a 6.2% decrease in the number of pounds sold during fiscal year 2018 compared to fiscal year 2017.
Management attributes the decrease in corn oil prices during fiscal year 2018 to a leveling out of the increased demand from the biodiesel industry and the expansion of the RFS advanced biofuel mandate in fiscal year 2017. The RVO for advanced biofuels in EPA’s final rules for 2018 and 2019 was significantly reduced in comparison to the statutory mandate. Additionally, if the biodiesel blenders' tax credit, which expired on December 31, 2018, is not extended, demand may continue to fall. Due to the recent uncertainty in Congress, management cannot predict whether the tax credit will be extended.
Although management believes that corn oil prices will remain relatively steady, prices may decrease if there is an oversupply of corn oil production resulting from increased production rates at ethanol plants or if biodiesel producers begin to utilize lower-priced alternatives such as soybean oil or if biodiesel blenders’ tax credit is not renewed and biodiesel production declines.
The decrease in corn oil volume sold for fiscal year 2018 compared to 2017 is attributable to reduced oil yield. Management expects our corn oil production will be relatively stable going forward.
At October 31, 2018, we had forward corn oil sales contracts to sell approximately $721,000 for various delivery periods through December 2018.
Cost of Goods Sold
Our cost of goods sold increased by approximately 4.9% for the fiscal year ended October 31, 2018, as compared to the fiscal year ended October 31, 2017. Cost of goods sold, as a percentage of revenues, also increased to approximately 96.2% for the fiscal year ended October 31, 2018, as compared to approximately 90.5% for the 2017 fiscal year due to a narrower margin between the price of ethanol and the price of corn. Approximately 90% of our total costs of goods sold is attributable to ethanol production.
			
		
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, 2018:
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, 2017:
Corn Costs
Our cost of goods sold related to corn increased approximately 3.3% for our 2018 fiscal year compared to our 2017 fiscal year, due primarily to a 2.3% increase in the number of bushels of corn processed and a 0.9% increase in the average price per bushel paid for corn from period to period. The corn-ethanol price spread (the difference between the price per gallon of ethanol and the price per bushel of grain divided by 2.8) for our 2018 fiscal year was approximately $0.16 less than the corn-ethanol price spread we experienced for fiscal year 2017.
The increase in our cost per bushel of corn was primarily related to higher market corn prices due to strong demand and potential weather threats. Due to projected decreased corn stocks and strong demand, management anticipates that corn prices will remain steady during our first half of 2019 fiscal year.
For our fiscal years ended October 31, 2018 and 2017, we processed approximately 23.0 million and 22.5 million bushels of corn, respectively. Our corn conversion efficiency decreased slightly during our 2018 fiscal year compared to 2017. Management anticipates consistent corn consumption during our 2019 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, 2018, we had forward corn purchase contracts for approximately 2.3 million bushels for various delivery periods through October 2019. Comparatively, at October 31, 2017, we had forward corn purchase contracts for approximately 1.8 million bushels for various delivery periods through October 2018.
Our corn derivative positions resulted in gains of approximately $1.2 million and $962,000 for the fiscal years ended October 31, 2018 and 2017, 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 2018 fiscal year, we experienced an increase of approximately 0.2% in our overall natural gas costs compared to our 2017 fiscal year. During the past two fiscal years, there has been an increase in cost of natural gas,
			
		
primarily as a result of an increase in the average price per MMBTU of natural gas due to increased domestic and export demand and lower production. Management also anticipates higher natural gas prices as we move through the winter months due to the typical seasonal natural gas cost increases experienced during the winter months.
From time to time we enter into forward purchase contracts for our natural gas purchases. Our natural gas derivative positions resulted in a loss of approximately $1,600 for the fiscal year ended October 31, 2018, which increased cost of goods sold. Comparatively, 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. 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 2.9% of revenues for our fiscal year ended October 31, 2018 compared to 2.8% of revenues for our fiscal year ended October 31, 2017. This increase is due primarily to fixed production expenses that were higher compared to fiscal year 2017.
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 2019 fiscal year.
Operating Income
For our fiscal year ended October 31, 2018, we reported operating income of approximately $894,000 compared to operating income of approximately $7.3 million for our fiscal year ended October 31, 2017. This decrease resulted largely from decreased prices for our ethanol, relative to the price of corn and the narrowing of margins of our ethanol production segment.
Other Income (Expense), Net
We had net other income of approximately $273,000 during fiscal year 2018 compared to net other income of approximately $211,000 for fiscal year 2017. We had more other income during fiscal year 2018 compared to fiscal year 2017 due to patronage income and decreased interest expense as a result of fewer borrowings under our credit facilities during the 2018 fiscal year.
			
		
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 approximately 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 compared to the prior year due to capital improvements we are making at our plant designed to increase ethanol production and improve efficiencies.
Ethanol derivative instruments resulted in a loss of approximately $219,000 during the fiscal year ended October 31, 2017, which decreased our revenue. In comparison, during the fiscal year ended October 31, 2016, we had a gain of approximately $118,000 on our ethanol derivative instruments.
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. We sold more total tons of distillers’ grains during our 2017 fiscal year compared to the same period of 2016 due to an increase in distillers’ grains yield at the plant.
Corn Oil
Total revenues from sales of corn oil increased by approximately 2.8% for fiscal year 2017 compared to the fiscal year 2016. This increase was 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.
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. This decrease was due primarily to a 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 our 2016 fiscal year. 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 and relatively lower corn demand.
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.
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.
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. The increase in cost of natural gas from period to period was primarily the result of an increase in the average price per MMBTU of natural gas due to increased domestic and export demand and lower production which used up natural gas stocks that built up in 2015.
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 derivate positions resulted in a gain of approximately $22,000 for the fiscal year ended October 31, 2016, which decreased cost of goods sold.
			
		
Operating Expense
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.
Operating Income
For our fiscal year ended October 31, 2017, we reported operating income of approximately $7.3 million and for our fiscal year ended October 31, 2016, we had operating income of approximately $5.5 million. 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 for our fiscal year ended October 31, 2017 of approximately $211,000 compared to other expense, net of approximately $300,000 for our fiscal year ended October 31, 2016. This decrease in other expenses is due to patronage income and decreased interest expense during our fiscal year ended October 31, 2017 compared to the same period of 2016 as a result of fewer borrowings under our credit facilities during the 2017 fiscal year.
Changes in Financial Condition at October 31, 2018 and 2017
The following table highlights the changes in our financial condition from our audited consolidated balance sheet for the periods presented (amounts in thousands):
The $6.9 million decrease in total assets is due to a $4.2 million decrease in current assets, which is primarily attributable to decreases in cash on hand of approximately $4.0 million and inventory of approximately $666,000 at October 31, 2018 compared to October 31, 2017. Offsetting the decreases in cash on hand and inventory were increases the value of our commodity derivative instruments of approximately $284,000 at October 31, 2018 compared to October 31, 2017. The decrease in our current assets was coupled with an approximately $2.4 million decrease in property and equipment primarily due to current year depreciation expense of approximately $5.0 million, offset by capital expenditures of approximately $2.5 million.
Current liabilities at October 31, 2018 increased by approximately $1.0 million compared to October 31, 2017. This increase was primarily due to increases of accrued expenses by approximately $429,000 and accounts payable of approximately $643,000 at October 31, 2018 compared to October 31, 2017.
Our long-term debt decreased approximately $398,000 at October 31, 2018 compared to October 31, 2017. The decrease is due to payments on the note payable to the minority owner of Agrinatural, the note payable to the electric company and assessments paid under industrial water supply treatment agreement with the City of Heron Lake and Jackson County.
Members’ equity attributable to Heron Lake BioEnergy, LLC decreased approximately $7.7 million at October 31, 2018 compared to October 31, 2017. This decrease was primarily due to approximately $8.6 million in member distributions, partially offset by approximately $0.9 million in net income attributable to HLBE. Non-controlling interest totaled approximately $1.7 million at October 31, 2018 compared to approximately $1.5 million at October 31, 2017. This is directly related to recognition of the 27.0% non-controlling interest in Agrinatural, LLC.
			
		
Liquidity and Capital Resources
Our principal sources of liquidity consist of cash provided by operations, cash on hand, and available borrowings under our credit facility with Compeer. Our principal uses of cash are to pay operating expenses of the plant, to make debt service payments on our long-term debt, and to make distribution payments to our members. We expect to have sufficient cash generated by continuing operations and current lines of credit to fund our operations for the next twelve months.
We do not currently anticipate any significant purchases of property and equipment that would require us to secure additional capital in the next twelve months. For our 2019 fiscal year, we anticipate completion of several small capital projects and to maintain current plant infrastructure and improve operating efficiency. We expect to have sufficient cash generated by continuing operations and current lines of credit to fund our operations and complete our capital expenditures during our 2019 fiscal year and beyond.
Management continues to evaluate conditions in the ethanol industry and explore opportunities to improve the efficiency and profitability of our operations which may require additional capital to supplement cash generated from operations and available for borrowing under our revolving term loan.
Year Ended October 31, 2018 Compared to Year Ended October 31, 2017
The following table summarizes our sources and uses of cash from our audited consolidated statements of cash flows for the periods presented (amounts in thousands):
Operating Cash Flows
During the fiscal year ended October 31, 2018, net cash provided by operating activities decreased by approximately $4.7 million compared to the fiscal year ended October 31, 2017. The decrease resulted largely from an approximately $6.3 million decrease in our net income in the current year, offset by increases of approximately $1.6 million from period to period in various working capital items. Net income decreased for fiscal year 2018 due to decreased revenues and higher costs of goods sold.
Investing Cash Flows
During the fiscal year ended October 31, 2018, net cash used in investing activities increased by approximately $1.4 million due to increased capital expenditures compared to the fiscal year ended October 31, 2017.
Financing Cash Flows
We used approximately $6.7 million more for financing activities for the fiscal year ended October 31, 2018 compared to the fiscal year ended October 31, 2017. During the fiscal year ended October 31, 2018, we used cash to make payments of approximately $438,000 on our long-term debt and made distributions to Heron Lake BioEnergy members of approximately $8.6 million and to non-controlling interests of approximately $81,000.
For the same period of 2017, we used cash to make payments of approximately $486,000 on our long-term debt and decreased approximately $1.9 million on checks drawn in excess of bank balance.
			
		
Year Ended October 31, 2017 Compared to Year Ended October 31, 2016
The following table summarizes our sources and uses of cash from our audited consolidated statements of cash flows for the periods presented (amounts in thousands):
Operating Cash Flows
During the fiscal year ended October 31, 2017, net cash provided by operating activities increased by approximately $300,000 compared to the fiscal year ended October 31, 2016. The increase resulted largely from an approximately $2.3 million increase in our net income in fiscal year 2017, offset by a decrease of approximately $2.0 million from period to period in various working capital items.
Investing Cash Flows
During the fiscal year ended October 31, 2017, capital expenditures decreased compared to the fiscal year ended October 31, 2016 due to less property and equipment acquired for the ethanol plant, as well as proceeds from disposal of property and equipment. During fiscal year 2016, we used cash primarily to complete our RTO replacement project.
Financing Cash Flows
We used approximately $6.9 million less for financing activities for the fiscal year ended October 31, 2017 compared to the fiscal year ended October 31, 2016. During fiscal year 2017, we used cash to make payments of approximately $486,000 on our long-term debt and decreased approximately and decreased $1.9 million on checks drawn in excess of bank balance. For the same period of 2016, we used cash to make payments of approximately $3.9 million in distributions to our unit holders, and payments of approximately $15.2 million on our long-term debt, offset by proceeds of approximately $9.8 million from our long-term debt and approximately $30,000 from checks drawn in excess of bank balance.
Contractual Obligations
The following table provides information regarding the consolidated contractual obligations of the Company as of October 31, 2018 (amounts in thousands):
(1)
Long-term debt obligations include principal and estimated interest under our credit facilities based on the interest rates in effect as of October 31, 2018, assuming contractual maturities.
(2)
The operating lease obligations in the table above include our rail car leases.
(3)
Purchase obligations consist of forward contracted corn deliveries. The amounts were determined assuming prices, including freight costs, at current market prices as of October 31, 2018 for basis contracts that had not yet been fixed.
			
		
Credit Arrangements
Revolving Term Note
We had a revolving term note payable to Compeer Financial, formerly known as AgStar Financial Services, FCLA (“Compeer”) under which we could borrow, repay, and re-borrow in an amount up to the original aggregate principal commitment at any time prior to maturity at March 1, 2022. The original aggregate principal commitment was $28,000,000, which reduced by $3,500,000 annually, starting March 1, 2015 and continuing each anniversary thereafter until maturity. In December 2017, the Company and its lender orally agreed to reduce the aggregate principal commitment of the revolving term loan to $8,000,000. On April 6, 2018, the Company finalized loan agreements with an effective date of March 29, 2018 for an amended credit facility with Compeer.
Amended Credit Facility with Compeer
We had a comprehensive credit facility with Compeer Financial, FLCA and Compeer Financial, PCA, collectively formerly known as AgStar Financial Services, FCLA (“Compeer”) for which CoBank, ACP (“CoBank”) served as the administrative agent. This credit facility originally consisted of a revolving term loan with a maturity date of March 1, 2022. However, on April 6, 2018, we entered into an amended credit facility with Compeer. The amended credit facility includes an amended and restated revolving term loan with a $4.0 million principal commitment and a revolving seasonal line of credit with a $4.0 million principal commitment. CoBank will continue to act as Compeer's administrative agent with respect to our amended credit facility and has a participation interest in the loans. The Company agreed to pay CoBank an annual fee of $2,500 for its services as administrative agent.
Under the terms of the amended revolving term loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of $4.0 million. Final payment of amounts borrowed under amended revolving term loan is due December 1, 2021. Interest on the amended revolving term loan accrues at a variable weekly rate equal to 3.10% above the One-Month London Interbank Offered Rate (“LIBOR”) Index rate, which was 5.41% at October 31, 2018.
We agreed to pay an unused commitment fee on the unused available portion of the amended revolving term loan commitment at the rate of 0.500% per annum, payable monthly in arrears.
The aggregate principal amount available to the Company for borrowing under the revolving term loan at October 31, 2017 was $17.5 million and was $4.0 million under the amended revolving term loan at October 31, 2018.
Under the terms of the seasonal revolving loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of $4.0 million until its maturing on February 1, 2019. Amounts borrowed under the seasonal revolving loan bear interest at a variable weekly rate equal to 2.850% above the LIBOR Index rate, which was 5.16% at October 31, 2018.
The Company also agreed to pay an unused commitment fee on the unused portion of the seasonal revolving loan commitment at the rate of 0.250% per annum
The amended revolving term loan and seasonal revolving loan are secured by substantially all of our assets, including a subsidiary guarantee.
Under the amended credit facility, the Company is subject to certain financial and non-financial covenants that limit the Company’s distributions and debt and require minimum working capital, minimum local net worth, and debt service coverage ratio. We agreed to a debt service coverage ratio of 1.15 to 1.0, to maintain minimum working capital $8.0 million through September 30, 2018 and $10.0 million thereafter, and to maintain net worth of $32.0 million. We are permitted to pay distributions to our members up to 75% of our net income for the year in which the distributions are paid provided that immediately prior to the distribution and after giving effect to the distribution, no default exists and we are in compliance with all of our loan covenants. Further, we agreed not to make loans or advances to Agrinatural that exceed an aggregate principal amount of approximately $6.6 million without the consent of Compeer.
In October 2018, the Company had an event of non-compliance related to the debt service coverage ratio as defined in the amended credit facility. In December 2018, the Company received a waiver from its lender waiving this
			
		
event of noncompliance. If market conditions deteriorate in the future, circumstances may develop which could result in the Company violating the financial covenants or other terms of its amended credit facility. Should unfavorable market conditions result in our violation of the terms or covenants of the amended credit facility and we fail to obtain a waiver of any such term or covenant, Compeer could deem the Company in default, impose fees, charges and penalties, terminate any commitment to loan funds and require the Company to immediately repay a significant portion or possibly the entire outstanding balance of the revolving term loan. In the event of a default, Compeer could also elect to proceed with a foreclosure action on our plant.
Other Credit Arrangements
In addition to our primary credit arrangement with Compeer, we have other material credit arrangements and debt obligations.
In October 2003, we entered into an industrial water supply development and distribution agreement with the City of Heron Lake, Jackson County, and Minnesota Soybean Processors, an unrelated company. In consideration of this agreement, we and Minnesota Soybean Processors are allocated equally the debt service on $735,000 in water revenue bonds that were issued by the City to support this project that mature in February 2019. The parties have agreed that prior to the scheduled expiration of the agreement, they will negotiate in good faith to replace the agreement with a further agreement regarding the wells and related facilities.
In May 2006, we entered into an industrial water supply treatment agreement with the City of Heron Lake and Jackson County. Under this agreement, we pay monthly installments over 24 months starting January 1, 2007 equal to one years’ debt service on approximately $3.6 million in water revenue bonds, which will be returned to us if any funds remain after final payment in full on the bonds and assuming we comply with all payment obligations under the agreement.
As of October 31, 2018 and 2017, there was a total of approximately $960,000 and $1.3 million in outstanding water revenue bonds, respectively. We classify our obligations under these bonds as assessments payable. The interest rates on the bonds range from 0.50% to 8.73%.
To fund the purchase of the distribution system and substation for the plant, we entered into a loan agreement with Federated Rural Electric Association pursuant to which we borrowed $600,000 under a secured promissory note secured by the distribution system and substation for the plant. Under the note we were required to make monthly payments to Federated Rural Electric Association of $6,250 consisting of principal and an annual maintenance fee of 1% beginning on October 10, 2009. We paid the balance of this loan in full in September 2017.
We also had a note payable to the minority owner of Agrinatural Gas, LLC in the amount of $100,000 at October 31, 2017. We paid the balance of this loan in full in January 2018.
Loans to Agrinatural
Original Agrinatural Credit Facility
On July 29, 2014, HLBE entered into an intercompany loan agreement and related loan documents with Agrinatural (the “Original Agrinatural Credit Facility”). Under the Original Agrinatural Credit Facility, HLBE agreed to make a five-year term loan in the principal amount of $3.05 million to Agrinatural for use by Agrinatural to repay approximately $1.4 million of its outstanding debt and provide approximately $1.6 million of working capital to Agrinatural. The Original Agrinatural Credit Facility contains customary financial and non-financial affirmative covenants and negative covenants for loans of this type and size.
On March 30, 2015, HLBE entered into an allonge (the “Allonge”) to the July 29, 2014 note with Agrinatural. Under the terms of the Allonge, HLBE and Agrinatural agreed to increase the principal amount of the Original Agrinatural Credit Facility to approximately $3.06 million, defer commencement of repayment of principal until May 1, 2015, decrease the monthly principal payment to $36,000 per month and shorten maturity of the Original Agrinatural Credit Facility to May 1, 2019.
			
		
Interest on the Original Agrinatural Credit Facility was not amended and accrues at a variable rate equal to the One-Month LIBOR rate plus 4.0%, with the interest rate capped and not to exceed 6.0% per annum. Accrued interest is due and payable on a monthly basis. Except as otherwise provided in the Allonge, all of the terms and conditions contained in the Original Agrinatural Credit Facility remain in full force and effect.
In exchange for the Loan Agreement, the Agrinatural executed a security agreement granting HLBE a first lien security interest in all of Agrinatural’s equipment and assets and a collateral assignment assigning HLBE all of Agrinatural’s interests in its contracts, leases, easements and other agreements. In addition, RES, the minority owner of Agrinatural, executed a guarantee under which RES guaranteed full payment and performance of 27% of Agrinatural’s obligations to HLBE.
The balance of this loan was approximately $1.5 million and $2.0 million at October 31, 2018 and 2017, respectively.
Additional Agrinatural Credit Facility
On March 30, 2015, HLBE entered into a second intercompany loan agreement and related loan documents (the “Additional Agrinatural Credit Facility”) with Agrinatural. Under the Additional Agrinatural Credit Facility, HLBE agreed to make a four-year term loan in the principal amount of $3.5 million to Agrinatural for use by Agrinatural to repay its outstanding trade debt and provide working capital. The Additional Agrinatural Credit Facility contains customary financial and non-financial affirmative covenants and negative covenants for loans of this type and size.
Interest on the additional term loan accrues at a variable rate equal to the One-Month LIBOR rate plus 4.0%, with the interest rate capped and not to exceed 6.0% per annum. Prior to May 1, 2015, Agrinatural is required to pay only monthly interest on the term loan. Commencing May 1, 2015, Agrinatural is required to make monthly installments of principal plus accrued interest. The entire principal balance and accrued and unpaid interest on the term loan is due and payable in full on May 1, 2019.
On May 19, 2016, HLBE and Agrinatural amended the Additional Agrinatural Credit Facility, entering into amendment to the loan agreement dated March 30, 2015 (the “Amendment”). Additionally, HLBE and Agrignatural entered into an allonge to the negotiable promissory note dated March 30, 2015 issued by Agrinatural to HLBE (the “Additional Allonge”) to increase the amount of the capital expenditures allowed by Agrinatural during the term of the facility and deferred a portion of the principal payments required for 2016.
The Amendment provides that the portion of principal payments deferred in calendar year 2016 to continue to accrue interest at the rate set forth in the Note and become a part of the balloon payment due at maturity. Additionally, for calendar years, 2017, 2018 and 2019, the Amendment provides that Agrinatural may, without consent of HLBE, proceed with and pay for capital expenditures in an amount up to $100,000 plus the amount of contributions in aid of construction received by Agrinatural from customers for capital improvements (“CIAC”), less a reserve for distribution to the Agrinatural members to cover the income or other taxes imposed as a result of receipt of CIAC in an amount equal to 40% of CIAC. Prior to the Amendment, Agrinatural’s capital expenditures were restricted to $100,000 per year.
In exchange for the Additional Agrinatural Credit Facility, Agrinatural executed a security agreement granting HLBE a first lien security interest in all of Agrinatural’s equipment and assets and a collateral assignment assigning HLBE all of Agrinatural’s interests in its contracts, leases, easements and other agreements. In addition, RES executed a guarantee under which RES guaranteed full payment and performance of 27% of Agrinatural’s obligations to HLBE under the Additional Agrinatural Credit Facility.
The balance of this loan was approximately $2.0 million and $2.5 million at October 31, 2018 and 2017, respectively.
Off Balance-Sheet Arrangements
We have no off balance-sheet arrangements.
			
		
Critical Accounting Estimates
Note 1 to our consolidated financial statements contains a summary of our significant accounting policies, many of which require management to use estimates and assumptions. Accounting estimates are an integral part of the preparation of financial statements and are based upon management’s current judgment. We use our knowledge and experience about past events and certain future assumptions to make estimates and judgments involving matters that are inherently uncertain and that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. We believe that of our significant accounting policies, the following are most noteworthy because changes in these estimates or assumptions could materially affect our financial position and results of operations:
Revenue Recognition
The Company generally sells ethanol and related products pursuant to marketing agreements. Revenues from the production of ethanol and its co-products are recorded when the customer has taken title and assumed the risks and rewards of ownership, prices are fixed or determinable and collectability is reasonably assured. Title is generally assumed by the buyer at the Company’s shipping point. The Company believes there are no ethanol sales, during any given month, which should be considered contingent and recorded as deferred revenue.
In accordance with the Company’s agreements for the marketing and sale of ethanol and related products, marketing fees and commissions due to the marketers are deducted from the gross sales price as earned. Shipping costs incurred by the Company in the sale of ethanol are not specifically identifiable and as a result, are recorded based on the net selling price reported to the Company from the marketer. Shipping costs incurred by the Company in the sale of co-products are included in cost of goods sold.
Agrinatural recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee for the arrangement is fixed or determinable and collectability is reasonably assured.
Derivative Instruments
From time to time, we enter into forward sales contracts for ethanol, distillers and corn oil, and purchase contracts for corn and natural gas to hedge our exposure to commodity price fluctuations. These contracts provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold over a reasonable period in the normal course of business. Accordingly, we classify these sales and purchase contracts as normal sales and purchase contracts and as a result, these contracts are not marked to market in our consolidated financial statements.
On occasion, in order to reduce the risks caused by market fluctuations, the Company hedges its anticipated corn, natural gas, and denaturant purchases and ethanol sales by entering into options and futures contracts. These contracts are used with the intention to fix the purchase price of anticipated requirements for corn in the Company’s ethanol production activities and the related sales price of ethanol. The fair value of these contracts is based on quoted prices in active exchange-traded or over-the-counter market conditions.
Although the Company believes its commodity derivative positions are economic hedges, none have been formally designated as a hedge for accounting purposes and derivative positions are recorded on the balance sheet at their fair market value, with changes in fair value recognized in current period earnings or losses. The Company does not enter into financial instruments for trading or speculative purposes.
Inventory
We value our inventory at the lower of cost or net realizable value using the first in first out method or net realized value. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management’s assumptions which do not reflect unanticipated events and circumstances that may occur. In our analysis, we consider future corn costs and ethanol prices, break-even points for our plant and our risk management strategies in place through our use of derivative instruments. Given the significant assumptions required and the possibility that actual conditions will differ, we consider the valuation of the lower of cost or net realized value on inventory to be a critical accounting estimate.
			
		
Property and Equipment
Management’s estimate of the depreciable lives of property and equipment is based on the estimated useful lives. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Impairment testing for assets requires various estimates and assumptions, including an allocation of cash flows to those assets and, if required, an estimate of the fair value of those assets. The Company tests for impairment at the asset group level, which is the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities.
Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management’s assumptions, which do not reflect unanticipated events and circumstances that may occur. In our analysis, we consider future corn costs and ethanol prices, break-even points for our plant and our risk management strategies in place through our derivative instruments and forward contracts. Given the significant assumptions required and the possibility that actual conditions will differ, we consider the assessment of impairment of our long-lived assets to be a critical accounting estimate.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to the impact of market fluctuations associated commodity prices as discussed below. We have no exposure to foreign currency risk as all of our business is conducted in U.S. Dollars. We use derivative financial instruments as part of an overall strategy to manage market risk. We use cash, futures and option contracts to hedge changes to the commodity prices of corn, ethanol, and natural gas. We do not enter into these derivative financial instruments for trading or speculative purposes, nor do we designate these contracts as hedges for accounting purposes pursuant to the requirements of FASB ASC 815, Derivatives and Hedging.
Interest Rate Risk
We are exposed to market risk from changes in interest rates. Exposure to interest rate risk results primarily from our credit facilities with Compeer. The specifics of these credit facilities are discussed in greater detail in “PART II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources; Indebtedness”.
The interest rate on the revolving term loan is equal to 3.10% above the One-Month LIBOR, which was 5.41% at October 31, 2018. The interest rate on the seasonal revolving loan is equal to 2.85% above the One-Month LIBOR, which was 5.16% at October 31, 2018. There were no borrowings on either the revolving term loan or the seasonal revolving loan at October 31, 2018. However, if there were borrowings on either or both loan, and we were to experience a 10% adverse change in interest rates, the effect of such change could be substantial and material.
Commodity Price Risk
We seek to minimize the risks from fluctuations in the prices of raw material inputs, such as corn and natural gas, and finished products, such as ethanol and distillers’ grains, through the use of hedging instruments. In practice, as markets move, we actively manage our risk and adjust hedging strategies as appropriate. Although we believe our hedge positions accomplish an economic hedge against our future purchases and sales, management has chosen not to use hedge accounting, which would match the gain or loss on our hedge positions to the specific commodity purchase being hedged. We are using fair value accounting for our hedge positions, which means as the current market price of our hedge positions changes, the realized or unrealized gains and losses are immediately recognized in our cost of goods sold or as an offset to revenues. The immediate recognition of hedging gains and losses under fair value accounting can 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 of October 31, 2018, we had price protection in place for approximately 11% and 8% of our anticipated corn and natural gas needs, respectively, and 22%, 3% and 16% of our ethanol, distillers’ grains and corn oil sales, respectively, for the next 12 months. Through these contracts we hope to minimize risk from future market price fluctuations and basis fluctuations. As input 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. Depending on market movements, crop prospects and weather, these price protection positions may cause immediate adverse effects, but are expected to produce long-term positive growth for us.
A sensitivity analysis has been prepared to estimate our exposure to ethanol, corn, and natural gas price risk. Market risk related to these factors is estimated as the potential change in income resulting from a hypothetical 10% adverse change in the average ethanol price and the fair value of our corn and natural gas prices as of October 31, 2018, net of the forward and future contracts used to hedge our market risk for corn and natural gas usage requirements. The volumes are based on our expected use and sale of these commodities for a one year period from October 31, 2018. The results of this analysis, which may differ from actual results, are as follows:
			 		
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Governors and Members of
Heron Lake BioEnergy, LLC and Subsidiaries
Heron Lake, Minnesota
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Heron Lake BioEnergy, LLC and Subsidiaries (the Company) as of October 31, 2018 and 2017, and the related consolidated statements of operations, changes in members’ equity, and cash flows for each of the years in the three-year period ended October 31, 2018, and the related notes (collectively referred to as the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of October 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended October 31, 2018, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Boulay PLLP
We have served as the Company’s auditor since 2005.
Minneapolis, Minnesota
January 29, 2019
			 		
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Consolidated Balance Sheets
Notes to Consolidated Financial Statements are an integral part of this Statement.
			
		
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Consolidated Statements of Operations
Notes to Consolidated Financial Statements are an integral part of this Statement.
			
		
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Consolidated Statements of Changes in Members’ Equity
Notes to Consolidated Financial Statements are an integral part of this Statement.
			
		
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements are an integral part of this Statement
			
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
Heron Lake BioEnergy, LLC owns and operates an ethanol plant near Heron Lake, Minnesota with a permitted capacity of approximately 72.3 million gallons per year of undenatured ethanol on a twelve-month rolling sum basis. In addition, Heron Lake BioEnergy, LLC produces and sells distillers’ grains with solubles and corn oil as co-products of ethanol production.
Heron Lake BioEnergy, LLC’s wholly owned subsidiary, HLBE Pipeline Company, LLC (“HLBE Pipeline Company”), owns 73% of Agrinatural Gas, LLC (“Agrinatural”). Agrinatural operates a natural gas pipeline that provides natural gas to Heron Lake BioEnergy, LLC’s ethanol production facility and other customers.
Principles of Consolidation
The consolidated financial statements include the accounts of Heron Lake BioEnergy, LLC and its wholly owned subsidiary, HLBE Pipeline Company (collectively, “the Company”). Given the Company’s control over the operations of Agrinatural and its majority voting interest, the Company consolidates the financial statements of Agrinatural with its consolidated financial statements, with the equity and earnings (loss) attributed to the remaining 27% non-controlling interest identified separately in the accompanying consolidated balance sheets and statements of operations. All significant intercompany balances and transactions are eliminated in consolidation.
Fiscal Reporting Period
The Company’s fiscal year end for reporting financial operations is October 31.
Accounting Estimates
Management uses estimates and assumptions in preparing these consolidated financial statements in accordance with U.S. generally accepted accounting principles. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. The Company uses estimates and assumptions in accounting for significant matters including, among others, the economic lives of property and equipment, valuation of commodity derivative instruments and inventory, evaluation of rail car damages contingency, the assumptions used in the impairment analysis of long-lived assets, and inventory purchase and sale commitments. The Company periodically reviews estimates and assumptions, and the effects of revisions are reflected in the period in which the revision is made. Actual results could differ from those estimates.
Non-controlling Interest
Amounts recorded as non-controlling interest relate to the net investment by an unrelated party in Agrinatural. Income and losses are allocated to the members of Agrinatural based on their respective percentage of membership units held. Pursuant to the firm natural gas transportation agreement with Agrinatural, Agrinatural will provide natural gas to Heron Lake BioEnergy’s plant with a specified price per MMBTU with a term ending on October 31, 2021, with one automatic renewal option to extend the term for an additional five years period.
Revenue Recognition
The Company generally sells ethanol and related products pursuant to marketing agreements. Revenues from the production of ethanol and the related products are recorded when the customer has taken title and assumed the risks and rewards of ownership, prices are fixed or determinable and collectability is reasonably assured. Title is generally assumed by the buyer at the Company’s shipping point.
In accordance with the Company’s agreements for the marketing and sale of ethanol and related products, marketing fees and commissions due to the marketers are deducted from the gross sales price as earned. These fees and commissions are recorded net of revenues as they do not provide an identifiable benefit that is sufficiently separable from the sale of ethanol and related products. Shipping costs incurred by the Company in the sale of ethanol are not specifically
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
identifiable and as a result, are recorded based on the net selling price reported to the Company from the marketer. Shipping costs incurred by the Company in the sale of ethanol related products are included in cost of goods sold.
Agrinatural recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee for the arrangement is fixed or determinable and collectability is reasonably assured.
Cost of Goods Sold
The primary components of cost of goods sold for the production of ethanol and related co-products are corn, energy, raw materials, overhead, depreciation, and direct labor.
Operating Expenses
The primary components of operating expenses are salaries and expenses for administrative employees, professional fees, board of governor expenses and property taxes.
Cash
The Company maintains its accounts at multiple financial institutions. At times throughout the year, the Company’s cash balances may exceed amounts insured by the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation. The Company does not believe it is exposed to any significant credit risk on its cash balances.
Restricted Cash
The Company is periodically required to maintain cash balances at its broker related to derivative instrument positions as discussed in Note 6.
Accounts Receivable
Credit terms are extended to customers in the normal course of business. The Company performs ongoing credit evaluations of its customers’ financial condition and, generally, requires no collateral.
Accounts receivable are recorded at their estimated net realizable value. Accounts are considered past due if payment is not made on a timely basis in accordance with the Company’s credit terms. Accounts considered uncollectible are written off. The Company follows a policy of providing an allowance for doubtful accounts; however, based on historical experience, and its evaluation of the current status of receivables, the Company is of the belief that such accounts will be collectible in all material respects and thus an allowance was not necessary at October 31, 2018 or 2017. It is at least possible this estimate will change in the future.
Inventory
Inventory is stated at the lower of cost or net realizable value. Cost for all inventories is determined using the first in first out method (FIFO). Net realizable value is the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation. Inventory consists of raw materials, work in process, finished goods, and supplies. Corn is the primary raw material along with other raw materials. Finished goods consist of ethanol, distillers’ grains, and corn oil.
Derivative Instruments
From time to time, the Company enters into derivative transactions to hedge its exposures to commodity price fluctuations. The Company is required to record these derivatives in the balance sheets at fair value.
In order for a derivative to qualify as a hedge, specific criteria must be met and appropriate documentation maintained. Gains and losses from derivatives that do not qualify as hedges, or are undesignated, must be recognized immediately in earnings. If the derivative does qualify as a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will be either offset against the change in fair value of the hedged assets, liabilities, or firm commitments
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. Changes in the fair value of undesignated derivatives are recorded in earnings.
Additionally, the Company is required to evaluate its contracts to determine whether the contracts are derivatives. Certain contracts that literally meet the definition of a derivative may be exempted as “normal purchases or normal sales”. Normal purchases and normal sales are contracts that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold over a reasonable period in the normal course of business.
Contracts that meet the requirements of normal purchases or sales are documented as normal and exempted from accounting and reporting requirements, and therefore, are not marked to market in our consolidated financial statements.
In order to reduce the risks caused by market fluctuations, the Company occasionally hedges its anticipated corn, natural gas, and denaturant purchases and ethanol sales by entering into options and futures contracts. These contracts are used with the intention to fix the purchase price of anticipated requirements for corn in the Company’s ethanol production activities and the related sales price of ethanol. The fair value of these contracts is based on quoted prices in active exchange-traded or over-the-counter market conditions. Although the Company believes its commodity derivative positions are economic hedges, none have been formally designated as a hedge for accounting purposes and derivative positions are recorded on the balance sheet at their fair market value, with changes in fair value recognized in current period earnings or losses. The Company does not enter into financial instruments for trading or speculative purposes.
The Company has adopted authoritative guidance related to “Derivatives and Hedging,” and has included the required enhanced quantitative and qualitative disclosure about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses from derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. See further discussion in Note 6.
Other Intangibles
Other intangibles are stated at cost and include road improvements located near the plant in which the Company has a beneficial interest in but does not own the road. The Company amortizes the assets over the economic useful life of 15 years. The Company recorded amortization expense in the amount of approximately $38,000 for each of the fiscal years ended October 31, 2018, 2017, and 2016.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is provided over an estimated useful life by use of the straight-line deprecation method. Maintenance and repairs are expensed as incurred; major improvements and betterments are capitalized. Construction in progress expenditures will be depreciated using the straight-line method over their estimated useful lives once the assets are placed into service.
Depreciable useful lives are as follows:
Long-Lived Assets
Long-lived assets, such as property and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When determining impairment losses, a long lived asset should be grouped with other assets or liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets or liabilities. If circumstances require a long-lived asset to be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by an asset to the carrying value of the asset. If the carrying value of the long-lived asset is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques including, but not limited to, discounted cash flow models,
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
quoted market values and third-party independent appraisals, as considered necessary. No impairment expense was recorded during fiscal 2018, 2017, and 2016.
Fair Value of Financial Instruments
The Company follows guidance for accounting for fair value measurements of financial assets and liabilities and for fair value measurements of nonfinancial items that are recognized or disclosed at fair value in the consolidated financial statements on a recurring and nonrecurring basis. The guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to measurements involving significant unobservable inputs (Level 3 measurements).
The three levels of the fair value hierarchy are as follows:
·
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
·
Level 2 inputs include:
1.
Quoted prices in active markets for similar assets or liabilities.
2.
Quoted prices in markets that are observable for the asset or liability either directly or indirectly, for substantially the full term of the asset or liability.
3.
Inputs that derived primarily from or corroborated by observable market date by correlation or other means.
·
Level 3 inputs are unobservable inputs for the asset or liability.
The level in the fair value hierarchy within which a fair measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety.
Except for those assets and liabilities which are required by authoritative accounting guidance to be recorded at fair value in our balance sheets, the Company has elected not to record any other assets or liabilities at fair value. No events occurred during the fiscal years ended October 31, 2018, 2017, and 2016 that required adjustment to the recognized balances of assets or liabilities, which are recorded at fair value on a nonrecurring basis.
The carrying value of cash, accounts receivable, accounts payable and accrued liabilities approximates fair value due to the short maturity of these instruments. The fair value of debt has been estimated using discounted cash flow analysis based upon the Company’s current incremental borrowing rates for similar types of financing arrangements. The fair value of outstanding debt will fluctuate with changes in applicable interest rates. Fair value will exceed carrying value when the current market interest rate is lower than the interest rate at which the debt was originally issued. The Company believes the carrying amount of its debt facilities approximates the fair value.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
Income Taxes
The Company is treated as a partnership for federal and state income tax purposes and generally does not incur income taxes. Instead, its earnings and losses are included in the income tax returns of the members. Therefore, no provision or liability for federal or state income taxes has been included in these financial statements. Differences between financial statement basis of assets and tax basis of assets is related to capitalization and amortization of organization and start-up costs for tax purposes, whereas these costs are expensed for financial statement purposes. In addition, the Company uses the alternative depreciation system (ADS) for tax depreciation instead of the straight-line method that is used for book depreciation, which also causes temporary differences. The Company’s tax year end is December 31.
The Company had no significant uncertain tax positions as of October 31, 2018 or 2017 that would require disclosure, primarily due to the partnership tax status. The Company recognizes and measures tax benefits when realization of the benefits is uncertain under a two-step approach. The first step is to determine whether the benefit meets the more-likely-than-not condition for recognition and the second step is to determine the amount to be recognized based on the cumulative probability that exceeds 50%. Primarily due to the Company’s tax status as a partnership, the adoption of this guidance had no material impact on the Company’s financial condition or results of operations.
The Company files income tax returns in the U.S. federal and Minnesota state jurisdictions. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2015.
Net Income per Unit
Basic net income per unit is computed by dividing net income by the weighted average number of members’ units outstanding during the period. Diluted net income or loss per unit is computed by dividing net income by the weighted average number of members’ units and members’ unit equivalents outstanding during the period.
Environmental Liabilities
The Company’s operations are subject to environmental laws and regulations adopted by various governmental entities in the jurisdiction in which it operates. These laws require the Company to investigate and remediate the effects of the release or disposal of materials at its location. Accordingly, the Company has adopted policies, practices, and procedures in the areas of pollution control, occupational health, and the production, handling, storage and use of hazardous materials to prevent material environmental or other damage, and to limit the financial liability, which could result from such events. Environmental liabilities are recorded when the liability is probable and the costs can be reasonably estimated.
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.
·
Ethanol Production. Based on the nature of the products and production process and the expected financial results, the Company’s operations at its ethanol plant, including the production and sale of ethanol and its co-products, are aggregated into one financial reporting segment.
·
Natural Gas Pipeline. The Company has majority ownership in Agrinatural, through its wholly owned subsidiary, HLBE Pipeline, LLC, and operations of Agrinatural’s natural gas pipeline are aggregated into another financial reporting segment.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
Recently Issued Accounting Pronouncements
Contract Revenue Recognition (Evaluated)
In May 2014 and amended in August 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09 which amended the Revenue from Contracts with Customers (Topic 606) of the Accounting Standards Codification. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company beginning November 1, 2018. The Company has evaluated the impact of the standard on the consolidated financial statements and believes there will be no material effect aside from additional disclosures.
Leases (Evaluating)
In February 2016, the FASB adopted ASU No. 2016-02, Leases (Topic 842), which provides guidance for accounting for leases. The new guidance requires companies to recognize the assets and liabilities for the rights and obligations created by leased assets, initially measured at the present value of the lease payments. The accounting guidance for lessors is largely unchanged. The guidance will be effective for the Company beginning November 1, 2019. It is to be adopted using a modified retrospective approach. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements and anticipates the new guidance will significantly impact its consolidated financial statements given the Company leases a significant number of rail cars for transporting ethanol and dried distillers grains with solubles to its end customers.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
Restricted Cash (Evaluated)
In November 2016, the FASB issued ASU No. 2016-18, Restricted Cash, which amended Statement of Cash Flows (Topic 230) of the Accounting Standards Codification. The new guidance will require amounts generally described as restricted cash and restricted cash equivalents to be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the consolidated statement of cash flows. The amendments will be effective for the Company beginning November 1, 2018. The Company has evaluated the impact that adoption of this guidance will have on its consolidated financial statements, and upon adoption, the Company will apply this standard retrospectively.
2. RISKS AND UNCERTAINTIES
The Company has certain risks and uncertainties that it experienced during volatile market conditions. These volatilities can have a severe impact on operations. The Company’s revenues are primarily derived from the sale and distribution of ethanol, distillers’ grains and corn oil to customers primarily located in the U.S. Corn for the production process is supplied to the plant primarily from local agricultural producers. Ethanol sales average 75%-85% of total revenues and corn costs average 70%-90% of cost of goods sold.
The Company’s operating and financial performance is largely driven by the prices at which it sells ethanol, distillers’ grains and corn oil, and the related costs of corn. The price of ethanol is influenced by factors such as supply and demand, the weather, government policies and programs, unleaded gasoline prices and the petroleum markets as a whole. Excess ethanol supply in the market, in particular, puts downward pressure on the price of ethanol. The largest cost of production is corn. The cost of corn is generally impacted by factors such as supply and demand, the weather, government policies and programs, and a risk management program used to protect against the price volatility of these commodities. Market fluctuations in the price of and demand for these products may have a significant adverse effect on the Company’s operations, profitability and the availability and adequacy of cash flow to meet the Company’s working capital requirements. The Company’s risk management program is used to protect against the price volatility of these commodities.
The supply and demand for ethanol are impacted by federal and state legislation and regulation, most significantly the Renewable Fuels Standard (“RFS”), and any changes in legislation or regulation could cause the demand for ethanol to decline or its supply to increase, which could have a material adverse effect on our business, results of operations and financial condition, and the ability to operate at a profit.
On November 30, 2018, the EPA announced the final 2019 RVOs, setting the RVOs for conventional ethanol at 15.0 billion gallons, advanced biofuels at 4.92 billion gallons and cellulosic ethanol at 0.42 billion gallons, for overall RVOs of 19.92 billion gallons for 2019. 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.
Current ethanol production capacity exceeds the EPA’s 2018 and 2019 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. In October 2018, the Office of Management and Budget announced that the 20% thresholds “have been met or are expected to be met in the near future.” As a result, the EPA is proposing a rulemaking that will propose modifying the applicable volumes targets for cellulosic biofuel, advanced biofuel, and total renewable fuels for the years 2020-2022. Additionally, the EPA will be proposing volume requirements for biomass-based diesel for 2021 and 2022. Because the timetable for the rulemaking overlaps with the annual standard-setting rulemakings, the rulemaking will also include the applicable percentage standards for 2020. 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.
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 result in a significant decrease in ethanol demand.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
3. FAIR VALUE MEASUREMENTS
The Company follows accounting guidance related to fair value disclosures. For the Company, this guidance applies to certain derivative investments. The authoritative guidance also clarifies the definition of fair value for financial reporting, establishes a framework for measuring fair value and requires additional disclosures about the use of fair measurements.
The following table sets forth, by level, the Company assets that were accounted for at fair value on a recurring basis at October 31, 2018:
The following table sets forth, by level, the Company assets that were accounted for at fair value on a recurring basis at October 31, 2017:
We determine the fair value of commodity derivative instruments by obtaining fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes and live trading levels from the Chicago Board of Trade market and New York Mercantile Exchange. We determine the fair value of ethanol, corn, and natural gas Level 2 instruments by model-based techniques in which all significant inputs are observable in the markets noted above.
4. CONCENTRATIONS
The Company sold all of the ethanol, distillers’ grains, and corn oil produced at its plant to three customers under marketing agreements during the fiscal years ended October 31, 2018, 2017, and 2016.
The percentage of total revenues attributable to each of the Company’s three major customers for the fiscal years ended October 31, 2018, 2017, and 2016 were as follows:
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
The percentage of total accounts receivable attributable to each of the Company’s three major customers at October 31, 2018 and 2017 were as follows:
5. INVENTORY
Inventory consists of the following at October 31:
The Company performs a lower cost or net realizable value analysis on inventory to determine if the market values of certain inventories are less than their carrying value, which is attributable primarily to decreases in market prices of corn and ethanol. Based on the lower of cost or net realizable value analysis, the Company recorded a loss on ethanol and corn inventories, as a component of cost of goods sold, of approximately $669,000 and $101,000 for the fiscal year ended October 31, 2018. The Company did not record a loss on ethanol or corn inventories for the fiscal year ended October 31, 2017.
6. DERIVATIVE INSTRUMENTS
The Company enters into corn, ethanol, and natural gas derivatives in order to protect cash flows from fluctuations caused by volatility in commodity prices for periods up to 24 months. These derivatives are put in place to protect gross profit margins from potentially adverse effects of market and price volatility on ethanol sales and corn purchase commitments where the prices are set at a future date. Although these derivative instruments serve the Company’s purpose as an economic hedge, they are not designated as effective hedges for accounting purposes. For derivative instruments that are not accounted for as hedges, or for the ineffective portions of qualifying hedges, the change in fair value is recorded through earnings in the period of change.
As of October 31, 2018, the total notional amount of the Company’s outstanding corn derivative instruments was approximately 2,685,000 bushels, comprised of long corn positions on 510,000 bushels that were entered into to hedge forecasted ethanol sales through July 2019, and short corn positions on 2,175,000 bushels that were entered into to hedge forecasted corn purchases through March 2020. There may be offsetting positions that are not shown on a net basis that could lower the notional amount of positions outstanding.
As of October 31, 2018, the Company had no cash collateral (restricted cash) related to derivates held by a broker.
The following table provides detail regarding the Company’s derivative financial instruments at October 31, 2018, none of which were designated as hedging instruments:
As of October 31, 2017, the total notional amount of the Company’s outstanding corn derivative instruments was approximately 1,120,000 bushels, comprised of long corn positions on 215,000 bushels that were entered into to hedge forecasted ethanol sales through December 2017, and short corn positions on 905,000 bushels that were entered into to
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
hedge forecasted corn purchases through July 2018. There may be offsetting positions that are not shown on a net basis that could lower the notional amount of positions outstanding.
As of October 31, 2017, the Company had outstanding natural gas derivative instruments totaling 120,000 MMBTU entered into to hedge forecasted natural gas purchases through February 2018.
As of October 31, 2017, the total notional amount of the Company’s outstanding ethanol derivative instruments was approximately 420,000 gallons that were entered into to hedge forecasted ethanol sales through November 2017.
As of October 31, 2017, the Company had no cash collateral (restricted cash) and approximately $12,000 due to broker related to derivatives held by a broker, recorded as a component of accounts payable.
The following table provides detail regarding the Company’s derivative financial instruments at October 31, 2017, none of which were designated as hedging instruments:
The following tables provide details regarding the gains (losses) from the Company’s derivative instruments in its condensed consolidated unaudited statements of operations, none of which are designated as hedging instruments:
7. PROPERTY AND EQUIPMENT
A summary of property and equipment is as follows:
Depreciation expense totaled approximately $4,999,000, $4,984,000 and $4,744,000 during the fiscal years ended October 31, 2018, 2017, and 2016, respectively.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
8. DEBT FACILITIES
Long-term debt consists of the following:
Revolving Term Note
The Company had a revolving term note payable under which the Company could borrow, repay, and re-borrow in an amount up to the original aggregate principal commitment at any time prior to maturity at March 1, 2022. The original aggregate principal commitment was $28,000,000, which reduced by $3,500,000 annually, starting March 1, 2015 and continuing each anniversary thereafter until maturity. In December 2017, the Company and its lender orally agreed to reduce the aggregate principal commitment of the revolving term loan to $8,000,000. On April 6, 2018, the Company finalized loan agreements with an effective date of March 29, 2018 for an amended credit facility with its lender.
Amended Credit Facility
The amended credit facility includes an amended and restated revolving term loan with a $4,000,000 principal commitment and a revolving seasonal line of credit with a $4,000,000 principal commitment. The loans are secured by substantially all of the Company’s assets, including a subsidiary guarantee. The amended credit facility contains customary covenants, including restrictions on the payment of dividends and loans and advances to Agrinatural, and maintenance of certain financial ratios including minimum working capital, minimum net worth and a debt service coverage ratio as defined by the credit facility. Failure to comply with the protective loan covenants or maintain the required financial ratios may cause acceleration of the outstanding principal balances on the revolving term loan and/or the imposition of fees, charges, or penalties. In October 2018, The Company had an event of non-compliance related to the debt service coverage ratio as defined in the amended credit facility. In December 2018, The Company received a waiver from its lender waiving this event of noncompliance.
As part of the amended credit facility closing, the Company entered into an amended administrative agency agreement with CoBank, ACP (“CoBank”). As a result, CoBank will continue act as the agent for the lender with respect to the amended credit facility. The Company agreed to pay CoBank an annual fee of $2,500 for its services as administrative agent.
Amended Revolving Term Note
Under the terms of the amended revolving term loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of $4,000,000. Final payment of amounts borrowed under amended revolving term loan is due December 1, 2021. Interest on the amended revolving term loan accrues at a variable weekly rate equal to 3.10% above the One-Month London Interbank Offered Rate (“LIBOR”) Index rate, which was 5.41% at October 31, 2018.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
The Company also agreed to pay an unused commitment fee on the unused available portion of the amended revolving term loan commitment at the rate of 0.500% per annum, payable monthly in arrears.
The aggregate principal amount available to the Company for borrowing under the revolving term loan at October 31, 2017 was $17,500,000, and under the amended revolving term loan at October 31, 2018 was $4,000,000.
Seasonal Revolving Loan
Under the terms of the seasonal revolving loan, the Company may borrow, repay, and reborrow up to the aggregate principal commitment amount of $4,000,000 until its maturing on February 1, 2019. Amounts borrowed under the seasonal revolving loan bear interest at a variable weekly rate equal to 2.850% above the rate quoted by LIBOR Index rate, which was 5.16% at October 31, 2018. The aggregate principal amount available under the seasonal revolving loan was $4,000,000 at October 31, 2018.
The Company also agreed to pay an unused commitment fee on the unused portion of the seasonal revolving loan commitment at the rate of 0.250% per annum.
Estimated annual maturities of long-term debt at October 31, 2018 are as follows based on the most recent debt agreements:
9. MEMBERS’ EQUITY
The Company is authorized to issue 80,000,000 capital units, of which 65,000,000 have been designated Class A units and 15,000,000 have been designated as Class B units. Members of the Company are holders of units who have been admitted as members and who hold at least 2,500 units. Any holder of units who is not a member will not have voting rights. Transferees of units must be approved by our board of governors to become members. Members are entitled to one vote for each unit held. Subject to the Member Control Agreement, all units share equally in the profits and losses and distributions of assets on a per unit basis.
On December 17, 2015, the Company’s board of governors declared a distribution of $0.05 per membership unit for a total of approximately $3,897,000 to be paid to members of record as of December 18, 2015. The distribution was paid in January 2016. Based on the covenants contained in the Company’s credit facilities, the foregoing distribution was approved by its lender prior to distribution.
On December 21, 2017, the Company’s board of governors declared a distribution of $0.11 per membership unit for a total of approximately $8,573,000 to be paid to members of record as of December 21, 2017. The distribution was paid in January 2018. Based on the covenants contained in the Company’s lender credit facilities, the foregoing distribution was approved by its lender prior to distribution.
10. LEASES
The Company has lease agreements with leasing companies for 138 rail cars for the transportation of the Company’s ethanol with various maturity dates through January 2027. The rail car lease payments are due monthly in the aggregate amount of approximately $122,000.
The Company has lease agreements with leasing companies for 110 hopper cars to assist in with the transport of the distillers’ grains by rail with various maturity dates through May 2027. The rail car lease payments are due monthly in the amount of approximately $64,000.
Rent expense for the Company’s leases was approximately $2,339,000, $2,170,000 and $2,571,000 for the fiscal years ended October 31, 2018, 2017, and 2016, respectively.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
At October 31, 2018, the Company had the following minimum future lease payments, which at inception had non-cancelable terms of more than one year:
11. INCOME TAXES
The differences between consolidated financial statement basis and tax basis of assets and liabilities are estimated as follows at October 31:
There were no significant differences between the consolidated financial statement basis of liabilities and the income tax basis of liabilities at October 31, 2018 and 2017.
12. EMPLOYEE BENEFIT PLANS
The Company has a defined contribution plan available to all of its qualified employees. The Company contributes a match of 50% of the participant’s salary deferral up to a maximum of 4% of the employee’s salary. The Company contributions totaled approximately $98,000, $90,000, and $85,000 for the fiscal years ended October 31, 2018, 2017, and 2016, respectively.
13. RELATED PARTY TRANSACTIONS
Granite Falls Energy, LLC
The Company has a management services agreement with Granite Falls Energy, LLC (“GFE”), a related party. Under the terms of the agreement, GFE supplies its own personnel to act as part-time officers and managers of the Company for the positions of Chief Executive Officer, Chief Financial Officer, and Commodity Risk Manager and the Company pays GFE 50% of the total salary, bonuses and other expenses and costs for the three management positions. The management services agreement automatically renews for successive one-year terms unless the Company or GFE gives the other party 90-day 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.
Total expenses under this agreement were $449,000, $406,000 and $375,000 for fiscal years ended October 31, 2018, 2017, and 2016, respectively.
Corn Purchase - Members
The Company purchased corn from members of its Board of Governors of approximately $14,483,000 in fiscal year 2018, of which approximately $348,000 is included in accounts payable at October 31, 2018, $9,811,000 in fiscal year 2017, of which approximately $602,000 is included in accounts payable at October 31, 2017, and $15,008,000 in fiscal year 2016 of which approximately $232,000 is included in accounts payable at October 31, 2016.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
Swan Engineering
Agrinatural has a management and operating agreement with Swan Engineering, Inc. (“SEI”). SEI, together with an unrelated third party owns Rural Energy Solutions, LLC (“RES”), the 27% minority owner of Agrinatural. Under the management and operating agreement, SEI provides Agrinatural with day-to-day management and operation of Agrinatural’s pipeline distribution business. In exchange for these services, Agrinatural pays SEI an aggregate management fee equal to the fixed monthly base fee plus the variable customer management fee based on the number of customers served on the pipeline less the agreed monthly fee reduction of $4,500. For the year ended October 31, 2018, the Company paid approximately $38,000 and $161,000 for the monthly base fee and variable customer management fee, respectively. For the year ended October 31, 2017, the Company paid approximately $36,000 and $157,000 for the monthly base fee and variable customer management fee, respectively. For the year ended October 31, 2016, the Company paid approximately $32,000 and $149,000 for the monthly base fee and variable customer management fee, respectively. The management and operating agreement with SEI expires July 1, 2019 unless earlier terminated for cause as defined in the agreement.
Agrinatural also has a project management agreement with SEI. Pursuant to the project management agreement, SEI supervises all of Agrinatural’s pipeline construction projects. These projects are constructed by unrelated third-party pipeline construction companies. Under the project management agreement, Agrinatural pays SEI a total of 10% of the actual capital expenditures for construction projects approved by Agrinatural’s Board of Directors, excluding capitalized marketing costs. For the year ended October 31, 2018, the Company incurred approximately $77,000 for project management and capital work fees. For the year ended October 31, 2017, the Company incurred approximately $44,000 for project management and capital work fees. For the year ended October 31, 2016, the Company paid approximately $28,000 for project management fees. The project management with SEI expires June 30, 2019 unless earlier terminated for cause as defined in the agreement.
14. COMMITMENTS AND CONTINGENCIES
Water Agreements
In October 2003, the Company entered into an industrial water supply development and distribution agreement with the City of Heron Lake for 15 years. The Company has the exclusive rights to the first 6,000 gallons per minute of capacity that is available from the well, and provides for the Company, combined with an unrelated company, to approve any other supply contracts that the City may enter into. In consideration, the Company will pay one half of the City’s water well bond payments of $735,000, plus a 5% administrative fee, totaling approximately $594,000, and operating costs, relative to the Company’s water usage, plus a 10% profit. These costs will be paid as water usage fees. The Company recorded an assessment of approximately $367,000 with long-term debt as described in Note 8. The Company pays operating and administrative expenses of approximately $12,000 per year.
In May 2006, the Company entered into a water treatment agreement with the City of Heron Lake and Jackson County for 30 years. The Company will pay for operating and maintenance costs of the plant in exchange for receiving treated water. In addition, the Company agreed to an assessment for a portion of the capital costs of the water treatment plant.
The Company recorded assessments with long-term debt of $500,000 and $3,550,000 in fiscal 2007 and 2006, respectively, as described in Note 8. The Company paid operating and maintenance expenses of approximately $47,000, $92,000, and $24,000 in fiscal 2018, 2017, and 2016, respectively.
Ethanol Marketing Agreement
The Company has a marketing agreement (“Eco Agreement”) with Eco-Energy, Inc., an unrelated party (“Eco-Energy”) for the sale of ethanol. Under this ethanol agreement, Eco-Energy purchases, markets and resells 100% of the ethanol produced at the Company’s ethanol production facility and arranges for the transportation of ethanol. The Company pays Eco-Energy a marketing fee per gallon of ethanol sold in consideration of Eco-Energy’s services, as well as a fixed lease fee for rail cars leased from Eco-Energy to the Company. The marketing fee was negotiated based on prevailing market-rate conditions for comparable ethanol marketing services.
The initial term of Eco Agreement continued through December 31, 2016, with automatic renewals for additional three terms of three year periods unless terminated by either party by providing written notice to the other party at least 3 months prior to the end of the then current term. During the third fiscal quarter of 2016, the Company amended the Eco
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
Agreement. As amended, the term of the Eco Agreement expires on December 31, 2019, with automatic renewals for additional consecutive terms of three years unless either party provides written notice to the other at least 90 days prior to the end of the then-current term. Additionally, the amended Eco Agreement provides for certain negotiated changes to the marketing fees payable to Eco-Energy and payment terms based on prevailing market-rate conditions for comparable ethanol marketed services.
Ethanol marketing fees and commissions totaled approximately $604,000, $587,000, and $637,000 for the fiscal years ended October 31, 2018, 2017, and 2016.
Ethanol Forward Contracts
At October 31, 2018, the Company had fixed and basis contracts to sell approximately $10,908,000 of ethanol for various delivery periods through December 2018, which approximates 85% of its anticipated ethanol sales for that period.
Distillers’ Grains Marketing Agreement
Gavilon Ingredients, LLC, an unrelated party (“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.
Distillers’ grains commissions totaled approximately $252,000, $268,000, and $283,000 for the fiscal years ended October 31, 2018, 2017 and 2016.
Distillers’ Grains Forward Contracts
At October 31, 2018, the Company had forward contracts to sell approximately $561,000 of distillers’ grains for delivery through November 2018, which approximates 30% of its anticipated distillers’ grains sales during that period.
Corn Oil Marketing Agreement
RPMG, Inc., an unrelated party, 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. The contract commenced on November 1, 2013 with an initial term of one year and will continue to remain in effect until terminated by either party at its unqualified option, by providing written notice of not less than 90 days to the other party.
Corn oil commissions totaled approximately $83,000, $89,000, and $96,000 for the fiscal years ended October 31, 2018, 2017, and 2016.
Corn Oil Forward Contracts
At October 31, 2018, the Company had forward contracts to sell approximately $721,000 of corn oil for delivery through December 2018, which approximates 95% of its anticipated corn oil sales for that period.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
Contract for Natural Gas Pipeline to Plant
The Company has a facilities agreement with Northern Border Pipeline Company which allows us access to an existing interstate natural gas pipeline located approximately 16 miles north from the plant. Agrinatural was formed to own and operate the pipeline and transports gas to the Company pursuant to a transportation agreement.
The Company also has a base agreement for the sale and purchase of natural gas with Constellation NewEnergy-Gas Division, LLC (“Constellation”), pursuant to which it buys all of its natural gas from Constellation. This agreement runs until March 31, 2019.
Corn Forward Contracts
At October 31, 2018, the Company had cash and basis contracts for forward corn purchase commitments for approximately 2,334,000 bushels for deliveries through October 2019.
Given the uncertainty of future ethanol and corn prices, the Company could incur a loss on the outstanding corn purchase contracts in future periods. Management has evaluated these forward contracts and its inventories using the lower of cost or net realizable value evaluation, similar to the method used on its inventory, and has determined that an impairment loss existed of approximately $323,000 at October 31, 2018 and no impairment loss existed at October 31, 2017. The impairment expense is recorded as a component of cost of goods sold.
Railcar Damages
In accordance with certain railcar lease agreements, at expiration, the Company is required to return the railcars in good condition, less normal wear and tear. Primarily due to the ongoing maintenance and repair activities performed on its railcars, the Company has determined that no accrual for leased railcar damages is necessary and an estimate of the possible range of loss cannot be made.
15. BUSINESS SEGMENTS
The Company groups its operations into the following two business segments:
Segment reporting is intended to give financial statement users a better view of how the Company manages and evaluates its businesses. The accounting policies for each segment are the same as those described in the summary of significant accounting policies in Note 1. Segment income or loss does not include any allocation of shared-service costs. Segment assets are those that are directly used in or identified with segment operations. Inter-segment balances and transactions have been eliminated.
The following tables summarize financial information by segment and provide a reconciliation of segment revenue, contribution to operating income and total assets for the fiscal years ended October 31:
HERON LAKE BIOENERGY, LLC AND SUBSIDIARIES
Notes to Consolidated Financial Statements
			
		
16. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summary quarterly results are as follows:
The above quarterly financial data is unaudited, but in the opinion of management, all adjustments necessary for a fair presentation of the selected data for these periods presented have been included.
			 		
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit pursuant to the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosures.
Our management, including our Chief Executive Officer and General Manager (the principal executive officer), Steve Christensen, along with our Chief Financial Officer (the principal financial officer), Stacie Schuler, have reviewed and evaluated the effectiveness of our disclosure controls and procedures as of October 31, 2018. Based upon this review and evaluation, these officers have concluded that our consolidated disclosure controls and procedures are effective as of October 31, 2018.
(b) Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a15-(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that:
(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and governors of the Company; and
(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision of our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria set forth in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that the Company’s internal control over financial reporting was effective as of October 31, 2018.
An attestation report from our accounting firm on our internal control over financial reporting is not included in this annual report because an attestation report is only required under the regulations of the Securities and Exchange Commission for accelerated filers and large accelerated filers.
(c) Changes in Internal Controls Over Financial Reporting
There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the fourth fiscal quarter ended October 31, 2018 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
Pursuant to General Instruction G(3), we omit Part III, Items 10, 11, 12, 13 and 14 and incorporate such items by reference to an amendment to this Annual Report on Form 10-K or to a definitive proxy statement (the “2019 Proxy Statement”) to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year (October 31, 2018) covered by this Annual Report.
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The Information required by this Item is incorporated by reference to the 2019 Proxy Statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Information required by this Item is incorporated by reference to the 2019 Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The Information required by this Item is incorporated by reference to the 2019 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The Information required by this Item is incorporated by reference to the 2019 Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The Information required by this Item is incorporated by reference to the 2019 Proxy Statement.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES
The following exhibits and financial statements are filed as part of, or are incorporated by reference into, this report:
(a)Financial Statements
The consolidated financial statements appear beginning at page 55 of this report.
(b)Financial Statement Schedules
All supplemental schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes.
(c)Exhibits
* Indicates compensatory agreement.
† Certain portions of this exhibit have been redacted and filed on a confidential basis with the Commission pursuant to a request for confidential treatment under Rule 24b-2 of under the Exchange Act. Spaces corresponding to the deleted portions are represented by brackets with asterisks [* * *].
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HERON LAKE BIOENERGY, LLC
Date:
January 29, 2019
/s/ Steve Christensen
Steve Christensen
Chief Executive Officer
Date:
January 29, 2019
/s/ Stacie Schuler
Stacie Schuler
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date:
January 29, 2019
/s/ Steve Christensen
Steve Christensen, Chief Executive Officer and General Manager
(Principal Executive Officer)
Date:
January 29, 2019
/s/ Stacie Schuler
Stacie Schuler, Chief Financial Officer
(Principal Financial and Accounting Officer)
Date:
January 29, 2019
/s/ Paul Enstad
Paul Enstad, Governor and Chairman
Date:
January 29, 2019
/s/ Rodney R. Wilkison
Rodney R. Wilkison, Governor and Vice Chairman
Date:
January 29, 2019
/s/ Michael Kunerth
Michael Kunerth, Governor and Secretary
Date:
January 29, 2019
/s/ Dean Buesing
Dean Buesing, Governor
Date:
January 29, 2019
/s/ Robert Ferguson
Robert Ferguson, Governor
Date:
January 29, 2019
/s/ Marten Goulet
Marten Goulet, Governor
Date:
January 29, 2019
/s/ Leslie Bergquist
Leslie Bergquist, Governor
Date:
January 29, 2019
/s/ Doug Schmitz
Doug Schmitz, Governor
Date:
January 29, 2019
/s/ David Westehoff
David Woestehoff, Governor
Date:
January 29, 2019
/s/ Kenton Johnson
Kenton Johnson, Alternate Governor
Date:
January 29, 2019
/s/ Jeremy Janssen
Jeremy Janssen, Alternate Governor