Dairy Margin Manager: Risk & opportunity are opposite sides of same coin
by Chip Whalen
Preserving opportunity and protecting risk will entail a cost, but it may be worth it, given what many producers have recently been through.
One common rejoinder we hear from dairy producers is that their milk value is not high enough relative to the cost of producing it. There is no doubt production costs are up significantly due to the historic drought and shortfall in feed grain production. Even prior to this, costs have been steadily rising over the past several years for all aspects of dairy farming – not just feed.
From a historical standpoint, milk prices are currently quite high, even if most dairy producers would like to receive more. CME Group Class III milk futures prices throughout 2013 are at or above the 90th percentile for their respective months over the past 10 years. This means that for a given contract, current futures prices have only been higher than what the market is now projecting less than 10% of the time.
Historical price ranges
We often like to think of risk and opportunity as being opposite sides of the same coin. From the perspective of historical price ranges, at the 90th percentile, there is opportunity for the price to increase over the next year, although the potential risk of it being lower is much greater. If the price has been higher than current levels less than 10% of the time, but lower 90% of the time, the risk outweighs the opportunity.
While not wanting to commit to a forward milk price is understandable given the opportunity for higher prices, a dairy cannot overlook the risk of lower prices. This is particularly true for operations that have already realized their input costs in the profit margin equation. A dairy that produces their own feed or has committed to feed purchases in the local cash market at harvest faces the risk declining milk prices may erode future profitability.
So how would a dairy farmer approach this risk, given he does not want to commit to a milk sale, expecting higher prices? One way would be to set a milk floor price to address the risk of lower prices. Buying a put option gives the holder the right – without the corresponding obligation – to sell milk at a certain price level, for a cost.
Often likened to an insurance contract, you essentially pay a premium to insure your milk sale price will be no lower than the price level you have the right to sell milk at. This is referred to as the strike price of the put option.
This insurance can be purchased in one of two ways. In the cash market, co-ops, creameries and other intermediaries such as financial institutions may offer these types of minimum price contract alternatives for various forward time periods.
A second alternative would be to use an exchange-traded derivative. Class III milk options can be purchased at the CME Group through a brokerage company.
The common objection we hear in using this contracting alternative is the cost of the option. While it is true that the option has a cost, the corresponding benefit is the flexibility it provides for the opportunity of participating in higher prices.
Simply, you can ask yourself whether or not you believe milk prices will rise by more than the cost of the option over the time remaining in the option’s life. If the answer is yes, then it may be superior to purchase a put option, rather than locking in a fixed sale price for milk in a forward time period.
Just like buying insurance, the point of the contract is not so you can maximize its value by filing a claim. You wouldn’t want to file a claim when purchasing insurance, and the same is true here. You would only exercise your right to sell milk with a put option if the market has moved lower, which means your profitability is deteriorating in the open market.
Given that the option will lose value if the market moves in your favor; i.e., milk prices go up, how do you limit the cost of purchasing the option? There are ways to accomplish this.
First, going back to the insurance analogy, you can select the level at which you wish to purchase a floor. As an example, February Class III milk futures are currently trading at $19.50/cwt. If you want to protect a floor at that level, the cost is about $1 for the right to sell at a price of $19.50/cwt.
If, however, you were willing to take a lower floor, for example $19/cwt., the cost would be 70¢, because the market would have to decline by 50¢ from current levels before that right becomes effective. This is similar to having a higher or lower deductible in an insurance contract, with the premium being more or less expensive, accordingly.
Accept a cap or ceiling
Another way to limit the cost of buying a put option to establish a floor price is to accept a cap or ceiling at a higher level. This involves selling an option to collect a right to sell milk at a certain price, and similarly, you can receive a premium for taking on the obligation to sell milk at a different price.
As an example, if February milk is trading at $19.50/cwt., you may want to place a floor at that level, yet you are not willing to commit to that sale price. You may, however, be willing to sell at a higher price, for instance at $21/cwt. where current spot prices are trading. You would receive a premium for taking on the obligation to sell at $21/cwt., and this will help to offset part of the cost of purchasing the right to sell at $19.50/cwt. Commonly referred to as a collar, window or fence, this essentially is a minimum/maximum price combination, and again may be accomplished either in your local cash market or through exchange-traded derivatives.
Fortunately for many dairies, there is still some profit margin to work with heading into 2013, presenting opportunity for producers to capture and mitigate risk. Measuring the cost against the benefit of limiting risk and maintaining opportunity is worth the time for those who do not want the uncertainty of potentially living through negative margins again next year.
• Chip Whalen is vice president, education & research, Commodity & Ingredient Hedging (CIH) in Chicago, Ill. Visit www.cihedging.com or phone 312-596-7755.