by John Ellsworth
At the most recent World Ag Expo, I had the opportunity to moderate a panel of agricultural lenders in a discussion of the availability of financing. One of the recurring themes that seemed to surface was the issue of whether or not a producer should be using milk options, also known as puts and calls, in the management of their dairy business. I’ll cover their relatively unanimous response in a moment.
Put, call wisdom
Coincidentally, this past week I was asked to describe a scenario when I felt it would be smart to make use of a call option. When would it be wise to make use of a put option? In a moment, I’ll share my response to those two questions as well.
However, I feel it is important to consider what all “options” are about. Who, in fact, needs them? The key to successfully using milk options revolves around a task known as “margin management.” You may know this as “risk management.” Several of our lenders on the panel emphasized how important they felt that was for any borrower. Their explanation covered some of the aspects of how you can use options to almost ensure that your margin (revenue less expenses) is more positive.
Burn rates important
Our lenders also talked about a term called your “burn rate.” This is the rate at which you will eliminate your entire Net Worth if you continue to lose money each month. For example, if you milk 1,000 cows that produce 70 pounds per cow per day, you will produce about 21,000 hundredweights in a thirty day month (1,000 X 70 X 30 / 100). If you have a net worth of $1,000,000 and are losing $2.00 per cwt, your burn rate is about 24 months ($1,000,000 / $42,000). In other words, you could potentially operate for about two years at that rate of loss until you run out of “lendable equity.” Your lender would much prefer that you consider making reductions in your costs or somehow place a “floor” under your milk price.
Aha! That, my friends, is what you can accomplish by using a “put option.” The put places a floor under the price you receive. Puts are all priced using Class 3 federal prices, which can create some issues in California due to the difference in basis. The California pricing system is somewhat correlated with the federal pricing system. However, it does not match it. By purchasing put options through a broker affiliated with the Chicago Mercantile Exchange (CME), you essentially put a floor under your milk receipts/cwt on the portion of your milk you cover. If you buy a put option for $15/cwt milk for June 2010 and federal order milk prices in June land at $14/cwt, you will still receive the $14/cwt from your cooperative. However, you will also receive the difference in a separate check from the CME ($1/cwt e.g.). If, on the other hand, the market price comes in higher than your put option is set, it expires unused, and you are only out the cost of the premium you paid for your put.
This is an extremely simplified example of how put options work. You can only purchase these through licensed, qualified brokers, for good reason, but there are many great firms out there for you to access. Why would you use puts? Let me give you four reasons: 1) Your loan renewal is coming up, and your banker is worried about your projected returns/cwt. 2) Your “burn rate” is looking rather small, particularly after last year. 3) You are a young producer just getting started. 4) You are highly leveraged, either as a result of losses incurred or due to an expansion you’ve undertaken recently.
How about the use of “call options” in your dairy business? These allow you to “buy” milk at the CME (not literally) at a pre-set price. Primarily, I see these used when a milk buyer offers a “fixed price contract” for your milk. Say, for example, you agreed to a $15/cwt price with your milk buyer for the next 12 months. If during that same time period the federal Class 3 milk price climbed to $18/cwt, you would still only get $15 from the buyer of your milk. What to do? If you simultaneously have call options in place for some level such as $15, they will allow you to buy milk at $15 when it is worth $18/cwt, allowing you to collect the difference from the CME.
Critical to your future
This article only skims the surface of what you need to know before using milk options. Yet, I think it is important to consider how they might benefit you by smoothing out the highs and lows of the dairy industry. Be assured, the easy days of managing dairy prices are over. It will be critical to your future success that you master the art of margin management, which requires knowing your true cost of production, particularly on feed, with which you can also use options. If you have a better system, I hope you succeed greatly. However, for most producers, options offer the best insurance against devastating losses. Talk to some brokers and producers who have actually used them and develop a plan. I think you’ll be glad you did!
■ John Ellsworth of Modesto, Calif., is a consultant with the financial and strategic consulting firm Success Strategies. He can be reached at 209-988-8960, or by e-mail: email@example.com.