Why is a risk management plan necessary?
One word: Volatility. Volatility in the milk market is a “new normal” as much as it is in any other commodity market. This means greater risk that a dairy business’ cash flow will be negative in any given month in the future.
The specific risk for any particular dairy depends on a number of variables, including equity position, tolerance for risk and the relationship with the lender. While it may be true that doing nothing might net as good or better a price in the long run, your business may not be able to handle a stretch of several months in negative cash flow.
Having a risk management plan allows a producer to hedge their milk production. A good definition of hedging is: “To utilize futures markets to remove price risk on product that will be bought from or sold to the cash market.”
This is a different strategy than simply trying to pick a better price than the cash market will yield. For this discussion, that qualifies as speculation, and it is a far different approach than hedging.
Where do I start?
To develop a risk management plan, the risk must first be defined. An accurate balance sheet and a good discussion with the lender will give some perspective on how much is at risk.
Because risk centers on cash flow, the cash flow needed to break even will be the zero mark. The breakeven Class III price comes from projecting this year’s cash flow using a budget. It is also very important to understand the difference between your mailbox price and the Class III price and to remove the basis to make sure a Class III breakeven price is used to develop the plan.
This cash flow analysis/budgeting process certainly has much more benefit and application than simply assisting the development of a risk management plan – it is essential in many aspects of business management.
I’ve got my breakeven projection, what next?
While several brokerages offer full-service plans that require very little knowledge or participation on the producer’s part, beginning marketers are encouraged to start slowly and only take positions they fully understand.
Case in point, several producers that took 2008 milk futures positions in 2007 learned about margin calls the hard way when prices moved significantly higher than their positions. They now realize that those price moves were good for their businesses – they just did not understand some of the possible consequences of taking those initial positions.
One possible market position a hedging dairy producer can use is a futures contract. By selling a futures contract, you are essentially fixing the price that you will receive for that unit of milk production (2,000 cwt).
If this is done with a brokerage on the Chicago Mercantile Exchange (CME), action on this contract will take place in your brokerage account, not on the milk check. The brokerage account and the milk check must be considered together to understand how a futures contract on the CME can fix a milk price.
Because the Class III milk contract is not a “deliverable” contract, the difference between the contract price and the cash price is “settled.” This difference is either collected or made up by the producer in his brokerage account.
An example (see Table 1): In June, Dairy A sells a $17 December futures contract through its brokerage account. The December Class III price ends up at $19 per cwt. They must buy $19 milk to fill their $17 contract – a $2-per-cwt loss.
Dairy A still receives $19 per cwt base price on their milk check, but when the $2-per-cwt loss on the brokerage account is considered, the net base milk price for December is $17, exactly what it was sold for in June.
A complicating factor is that the brokerage account is marked to the market every day. If the December milk contract had moved to $19 in July, the $2 per cwt would have to be paid into the brokerage account in July (a margin call) – long before the $19 base check for December milk would arrive.
Some of these losses can be substantial. In 2008, many $16 contracts were out of the money by $4 to $5. This brings up the possibility of having to borrow money to finance market positions. Many lenders are ready and willing to set up special hedging lines of credit used specifically for this purpose.
A futures position can also be established with the help of a milk processor. In this case, the future price is actually settled on the milk check and the processor typically carries all of the margin risk. Processors usually have more flexible volume increments when compared to the CME’s 2000 cwt increments.
A put option is another tool that can be used to hedge the future price of milk. It is a contract on the CME that gives the buyer the option to “put” milk on the buyer at the agreed-upon price. In effect, this allows a hedging dairy producer to buy a floor price for their milk.
An example (see Table 2): In June, Dairy B purchases a $16 December put option for $0.50. They bought a $16 floor for $0.50, so their net floor is $15.50 per cwt. The December Class III price is announced at $15.
Because the final price is lower than the strike price of my put, Dairy B will buy $15 milk from the market and exercise their option to put milk on the option buyer for $16. This is a $1-per-cwt gain (paid for by the seller’s margin call). But because the initial option contract cost $0.50, the net gain is actually only $0.50 in the brokerage account.
Again, Dairy B’s milk check will still reflect the announced base price of $15 per cwt, but the $0.50 gain from the brokerage account brings the net base price up to the net floor price of $15.50. If the December price had gone up to $20 per cwt, the put option will be worthless, but no margin calls are incurred – the maximum lost on the transaction is the $0.50 premium that was paid for the option initially.
The last tool considered here is LGM Insurance for Dairy (LGM). This insurance program is offered through most crop insurance providers by the Risk Management Administration of the USDA. It allows producers to look into the future and insure a gross margin value as implied by the CME futures markets.
The producer must input their milk production, corn purchases and soybean meal purchases into the program. The gross margin takes these quantities and the futures prices to come up with a predicted gross margin (Milk$$ - Corn$$ - SBM$$ = Gross Margin).
The insurance policy can then be written to insure this amount. A lesser amount can be insured (by using a deductible) in exchange for a decreased premium (subsidized by the USDA).
This program is similar to buying options, but combines milk and feed in the same tool. The volumes and time periods allowed in LGM are very flexible as long as they are within the program’s rules. Smaller operations will have more volume flexibility in this program than any other available to them.
Like any government program, the details can get a bit confusing, but the cost advantages could make it worth the effort. LGM saw a huge increase in popularity after some rule changes this winter.
This caused the program to run out of underwriting capacity for this fiscal year. Most sources predict the next offering won’t be until October of this year, pending government funding.
The tools available to hedging dairy producers are not limited to the ones covered in this article. Most of this discussion dealt with outputs. Inputs also represent a significant amount of risk to a dairy’s cash flow.
Certainly much more advanced strategies can be constructed with the help of qualified professionals, but starting slow is recommended. Making an effort to understand a business’ equity position and projected cash flow are a necessary starting point to managing risk. PD