Protecting Your Paycheck in Good Times
September 2004 - by Brooke Core
I will never forget the day. My family
and I had been enjoying record high milk prices for months without
giving a second thought to what would happen when prices returned to
normal or below normal levels.
Then it happened. It was a cold
December day when I made my trip to the mailbox to find our monthly
milk check. I was shocked to discover it had fallen all the way to
$11.72 per hundred. In fact, my entire family was shocked.
We knew prices had been steadily
falling but never expected it to hit this level. As a result of poor
planning and risk management, we were left trying to strike the
difficult balance of paying todayís bills on a much smaller income.
We began to ask ourselves, what if
there was a better way? What if there was a way to capitalize on the
market when times were good, but still have protection when prices
began falling? We were forced to ask ourselves the question, Got Milk
There are four main options for risk
management in the dairy industry; you can do nothing and ride the cash
market, you can sell futures contracts, you can buy option puts, or
you can forward contract. Each option can be a viable risk management
tool, however it is up to the individual producer to decide which
option is best for their needs.
Forward contracting is the simplest
risk management tool, as it allows producers to contract directly with
the buyer with no need for a broker. Forward contracting gives
producers a pre-determined flat price for an extended period of time,
based on Class III milk in the Federal Milk Marketing Order (FMMO).
Producers that utilize forward contracting have decided that the price
level offered for milk is an acceptable balance between the
opportunity for higher prices and the risk of lower ones.
Forward contracting is an appealing
option for many producers as it provides price certainty and is easy
to manage. The contracts are usually offered for a one-year time
period. Once you are locked into a contract there is no additional
upkeep on the contract for a year.
However, this year-long contract does
result in limited flexibility. Once you have signed the contract you
are locked-in at the give price for the next year. This disadvantage
leads to opportunity lost in rising markets.
Hedging with Futures
Futures contracts are traded on the
Chicago Mercantile Exchange (CME) on a monthly basis. Contracts are
available for Class III and Class IV milk for all months. It is also
important to understand that milk futures are cash-settled contracts.
This means no milk actually changes hands when the contract expires,
as with some other futures contracts. Instead, at the end of the
contract if the futures price is higher than the announced Federal
Order (F.O.) price the producer is paid the difference. However, if
the futures price is lower than the announced F.O. price then the
producer pays the difference.
In order to successfully hedge with
futures, the producer takes a short position in the market by selling
a futures contract. This means the producer has the right, but not the
obligation to make delivery of milk at the given futures price. By
holding opposite positions in the cash and futures market the producer
minimizes price risk.
Because futures contracts are traded on
a monthly basis, most producers only use futures to hedge milk on
select months that best fit their needs, not all twelve. Producers
evaluate futures prices for the coming months and if the prices offer
an opportunity to cover the cost of production and make a profit the
producer can lock in that price with a futures contract.
Hedging with futures does provide
downside price protection for milk producers and a level of price
certainty to aid in financial planning. However, once you are locked
into a futures contract there is still opportunity lost in a rising
market. There is also the potential of getting the dreaded margin
Buying Put Options
Very similar to hedging with futures is
buying put options. Options are also traded on the CME for Class III
and IV milk for all contract months. However, with options, the
producer determines a level where they would like to floor their
price. The producer then pays a premium to buy a put option at the
given price, this action gives the producer the right, but not the
obligation to sell a milk futures contract at the given price.
Options are very popular with some
producers as it allows them to floor their price at an appealing level
while still having the option to capitalize on higher milk prices.
There are also no margin calls with options if you do not exercise it.
All of these advantages come at a
price, literally. Option premiums at appealing price levels can be
costly. For example for September 2004, a put option at $12.00 has a
$.09 premium, while an option at $18.00 has a premium of $3.52.
Premium cost is closely related to both price level and the length of
time before the contract expires.
Riding the Cash Market
If none of the above risk management
tools are a good fit for you, there is always the cash market. This
can be a viable option. However, the decision to ride the cash market
must be the result of an active decision making process evaluating the
producerís individual needs, not because the producer feels it is the
The cash market allows the producer to
benefit from higher markets, but provides no price protection in
falling markets and can make it difficult to plan for rising and
Itís All a Gamble
No risk management plan is ever
fool-proof and the decision to implement one should always be as a
result of an evaluation of the producerís individual needs, concerns,
and goals. What works for one producer may not work for the next so
each risk management strategy must be tailored to each producerís
When times are good, as in todayís milk
market, no one wants to think of the possibility of returning to low
prices. However, now is the best time to begin planning for the future
and implementing your own risk management strategy.
In my familyís current situation there
is not an opportunity to forward contract our milk, but we do utilize
hedging with futures and options as an effective risk management tool.
Although current prices have been promising, we have not let that
distract us from the big picture and continue to monitor futures
markets for the opportunity to lock-in our future prices.
In the end itís kind of like they say
in Vegas, ďIts all a gamble and nothingís ever a sure bet.Ē But the
use of futures, forward, and options contracts can help todayís dairy
producers ensure their profitability and allow them to stay at the
table a lot longer.
Editorís note: For more information
on future contracting, hedging or questions regarding the price of
milk contact, National All-Jersey, Inc. General Manager, Erick Metzger
at firstname.lastname@example.org or visit http://www.USJersey.com/#NAJ.