Managing Milk Price Risk

 by Matt Mattke, Market360 Dairy Advisor, Stewart-Peterson, Inc.

 

 

Milk prices have been above $18.00 per cwt. for the longest span of time in the history of the Class III market.  January will be the eighth consecutive month of an $18.00 or higher price.  In the past, bull markets in milk have not lasted long.  Going back to the beginning of Class III futures trading in 1996, there have been a total of six months of $18.00 or higher prices.  In the past year, we have witnessed more months of $18.00 milk than in the prior ten years of Class III futures trading.  There is no doubt that market fundamentals justified these prices, but milk producers need to be careful not to get lulled into a false sense of security that milk prices will remain high or have to remain high in the foreseeable future.  In every bull market, no matter what the commodity, there is always talk that we've entered into a "new era" of prices.  But as always, each bull market is followed by a bear market.  Therefore, now is the perfect time to revisit the basic principles of milk price risk management.  The following discussion will address the when, why, and how of successful milk marketing.

 

When?
In order to be successful at managing both the price risks and the price opportunities the market serves out, you have to be committed to milk price risk management for the long haul.  You have to decide it is an endeavor you are willing to undertake, and an endeavor that you will be committed to for the life of your business.  The biggest mistake that can be made is to be inactive with price risk management at high prices, but let the bottom fall out and then get proactive at low prices.  It will be hard, likely impossible, to see the benefits of milk marketing if this is the approach.  The paramount time to begin undertaking milk price risk management is when milk prices are high.  So, the "when" is right now.

 

Why?
One primary goal of milk marketing and risk management is to remove the volatility from your revenue, and provide your dairy operation with stable cash flow and profitability.  While protecting the bottom line from risk of low prices, your dairy also has to be in a position to capitalize on higher prices so as not to get into a situation where your business is at a competitive disadvantage to other producers.  Prices offered by the market over the years tend to average near producers' breakevens.  Thus, the objective is to maximize the separation between the average price you receive for your milk and the final market price in a bear market, and to minimize the separation between the average price you receive and the final market price in a bull market (this is visually shown in Figure 1). 

 

 


In bear markets you will have a competitive advantage over other dairy producers.  You will be able to expand your herd and business for the next bull market, while other producers that did not implement any price risk management strategies are selling their milk at lower prices and are likely in cash conservation mode.  You will be counter cyclical to other dairy producers, and you will be expanding at the right time, not at high prices in front of the next bear market like other producers.

 

How?
This is the most difficult part of managing milk price risk.  You have to devote the time to develop a strategy, and then devote the time to watch the markets to execute that strategy.  Several principles should be adhered to when implementing milk price risk management:
        
Base your marketing decisions on a strategy, not on outlook.  All of the fundamentals in the world may point to higher prices, but then prices end up falling.  Conversely, the fundamentals may point to lower prices, but then prices end up rallying.  The only thing that is for certain in the milk market is that prices will rise and fall, and you need to be positioned and ready for both.
   
Be positioned for the unexpected.  There are no "cannots" in commodity markets.  Anything is possible price-wise, and an open mind is a necessity to implementing successful price risk management.
 

  • Using futures and options is a necessity.  Futures and options address being positioned for the unexpected.   If you sell your milk to the plant on a forward contract, how are you going to protect that sale if the milk price rallies?  Having knowledge of futures and options and how each works is extremely important to successful price risk management.
     

  • Focus on building a weighted average price for your milk that keeps pace with a rising market, but that separates from the market price in a falling market (see diagram above again).  Do not try to pick tops and sell your milk there.   The chance of picking a top is slim to nil. The key is running different price scenarios so that you can see the costs and/or benefits of every decision that you make.  For example, if you sell 20% of your production at $15.00 and the milk price goes to $20.00, what is your average price?  If your average price would get too far from the market price, then maybe call options or an alternative strategy is needed.
     

  • Having discipline to execute.  The best price risk management plan is useless if it is not executed.  Discipline requires not only pulling the trigger when targets are hit, but also being committed to watching the market daily to know if any targets are hit.  A daily strategy review is critical to staying in sync with extremely volatile markets.

    Price risk and opportunity management are more important than ever.  It is important not only for the revenue side, but also for the input side of your business.  Feed costs have been skyrocketing, and if there are any production glitches this summer, we may have seen nothing yet.  You should be implementing an opportunity and risk management strategy that provides your business with a profitable margin.  This will protect you against the worst case scenario: rising feed costs and falling milk prices.

 

 

About Stewart-Peterson:

Stewart-Peterson, Inc., offers strategic commodity opportunity and risk management, brokerage services, and advisory publications for commodity markets.  Their customers include ranchers, farmers, and users of commodities.  Stewart-Peterson is one of the largest agricultural publishing firms in the country and has consistently ranked among the nation's top agricultural commodity consultants for more than 20 years.

 

The preceding article was provided by Stewart-Peterson, Inc.  Publication of this material by ADM Alliance Nutrition, Inc., does not constitute an endorsement of the advice given or any information contained therein.  Neither ADM Alliance Nutrition, Inc., nor its employees, agents, or assigns make any warranty whatsoever, including warranty of merchantability, advice, or results, relative to the information contained in this article.

 

 

 

 

 

ADM Alliance Nutrition, Inc. , a wholly owned subsidiary of the Archer Daniels Midland Company