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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 today’s 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 Insurance?

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

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 call.

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 producer’s individual needs, not because the producer feels it is the only option.

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 unexpected costs.

It’s 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 producer’s 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 producer’s individual needs.

When times are good, as in today’s 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 family’s 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 it’s kind of like they say in Vegas, “Its all a gamble and nothing’s ever a sure bet.” But the use of futures, forward, and options contracts can help today’s dairy producers ensure their profitability and allow them to stay at the table a lot longer.

Editor’s 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 emetzger@usjersey.com or visit http://www.USJersey.com/#NAJ.