Out the window of our Twin Falls, Idaho, office we have a privileged view of both Perrine Bridge/Snake River base jumpers, as well as the evolution of dairy market hedge plans. Some may consider a leap into dairy marketing as frightening as a jump off a bridge to the canyon floor nearly 500 feet below.
Hedging practices in dairy markets often get a bad rap as being “behind the curve” compared to grain hedging. This seems to be one of those inertia-driven notions that began 15 years ago and because it seems to be the path of least resistance, the idea lingers. But should it? Is it an accurate appraisal for modern dairy markets? Not by a long shot.
The markets and the manner in which dairy producers hedge today continues to evolve with more sophistication. Let’s take a quick look at the ever-evolving world of dairy price risk management.
Let’s start with the basics. Many co-ops and creameries offer forward contracting programs on Class III and Class IV fixed prices via the futures markets. In some cases, they also allow dairy producers to agree on flat prices between end users on non-fat dry milk, butter, cheese and whey powders, which will then be translated into a fixed milk price.
If available, working with your co-op or creamery is an excellent avenue to reduce your market risk and manage your cash flows without worrying about margin calls.
Sometimes, the more “real life” transactions you do with an end user, food company or restaurant group, the more comfortable you will be navigating the markets. Are the phones ringing off the hook with buyers screaming for offers on product?
Or when you ask for a bid, are buyers noncommittal or not aggressive with their bids? You can make your own informed decisions when you are consistently and directly involved in the market.
Grain farmers are always shopping for the best prices for their corn and soybeans. They deal in storable commodities and eventually will be forced to sell.
In contrast, dairy producers passively sell a perishable product every day and are less apt to be aggressive marketers.
Another emerging tool is a cost-plus model. Under this scenario, a dairy producer negotiates with milk buyers on fixed profit margins, on top of feed and operating costs. The attractive feature here is consistent profit margins and pricing transparency. This could be a great idea for those producers looking to add an additional dairy operation.
Savvy hedgers could possibly enhance their profit margins by trading options on milk or grains to take advantage of lost opportunity costs of receiving higher profit margins available in the open market.
Under the “outside the box” category, we have vertical integration. Over the past few decades, numerous small groups of dairy producers have joined to start their own vertically integrated dairy plants. Although it’s something to consider as an aggressive alternative to the traditional dairy business model, there are significant barriers to entry, and not everyone is in the position to take this step.
In my view, becoming a partner in a dairy plant forces you to become a true marketer of dairy products, and in turn, could foster a more advanced hedging program.
More ubiquitous and likely more useful than becoming vertically integrated, would be to utilize the growing over-the-counter (OTC) markets. These markets offer products tailored to fit your unique risk exposure. For example, if your milk check is based on Chicago Mercantile Exchange (CME) block cheese, you have basis risk with using the cheese or Class III futures contracts.
You can eliminate the basis risk by hedging CME blocks on the OTC markets. These accounts typically have the additional capability of offering lines of credit to offset some of the margin call exposure involved with hedging. As we move into the future, we expect the role of OTC dairy market tools will continue to grow, offering more liquidity and less basis risk for participants.
There will always be naysayers on the prospects of dairy market opportunities, although they are slowly fading away. Dairy-forward markets and the tools that go with them have only scratched the surface of their future use. The growth potential of these markets is tremendous and will correlate well with the prosperity in the industry.
In a world riddled with discussions of trade wars, economic recessions and increased milk production on the horizon, be sure to assess all available hedging outlets to take advantage of adding certainty to the profit margins in your business.
Comments in this article are market commentary and are not to be construed as market advice. Trading is risky and not suitable for all individuals.
- Risk Management Consultant
- FCM Division of INTL FCStone Financial Inc.
- Email Nick Buyse