As we welcome in 2012, we remember the seasons of the year and how winter will become spring and then summer and so on. In this well-understood annual cycle of seasons and the weather patterns and traditions that accompany each one, we know with some certainty that during winter we will probably need a coat, in the spring an umbrella, in the summer an air conditioner and in the fall a leaf rake. In agriculture, we have traditionally had price cycles that could be compared to the cycle of seasons – but they tend to be less certain and predictable.
In general, we go through periods of high prices that lead to expansion and increased production, and then eventually to lower prices and periods of contraction. Historically in the dairy industry, these cycles lasted three years, with two years of rising or stable prices followed by a year of declining low prices.
For example, we had rising prices in 2007 and 2008, followed by a crash in prices in 2009. This period was followed by steady and rising prices in 2010 and 2011.
So given this history, what will happen in 2012 with milk prices?
Will they decline and follow the same pattern as 2009, or have we entered a different price cycle? More importantly, how do your responses to these questions impact your operation as a progressive dairyman?
For many years, domestic milk production could increase about 2 percent per year and maintain a fairly stable price. In years when production increased less than 2 percent, we would see milk prices rise – and in years when production increased more than 2 percent, prices would decline.
So, over a three-year period, on average, we could see a year of recovering or stable prices, a year of rising prices and a year of declining prices – based on the growth rate of production relative to 2 percent.
However, over the last five years, we have seen significant changes in worldwide demand, changes which have impacted the traditional price cycle that we are still trying to understand.
Up until about 2007, U.S. dairy products were primarily consumed in the U.S., with very little production exported. Today, about one-eighth of our domestic milk production (about 13 percent) is exported.
This increase came about through increased world demand, especially from China and other developing countries, while a decrease in the value of the dollar relative to other currencies made U.S. dairy products more competitive on the world market.
This dynamic has changed our historical milk price cycle, so we can no longer focus solely on domestic production and demand. We now have to look at the demand in international markets to understand and forecast price cycles.
With significant growth occurring in China and other developing countries, the overall rate of growth in demand is challenging to predict, as we saw in late 2008 and 2009.
Clearly, due to these changes in the worldwide market, our traditional price cycles have changed as well as the underlying variables which created them in the past. The questions raised earlier about the direction of milk prices in 2012 become more complex and more difficult to answer.
However, the more important question is: Given this new backdrop, how should a progressive dairyman manage in 2012 to position his operation properly and respond to these new dynamics which will impact prices in the future?
Here are the areas a progressive dairy operation should consider in positioning for future price volatility in 2012:
1. Pricing of feed commodities – Whether an operation raises its own feed, buys feed or does a combination, there are strategies to hedge against price volatility. As a banker, I would encourage producers to evaluate whether forward contracting or hedging feed commodities or crop inputs makes good financial logic.
Normally, this type of price management could be used in harmony with milk pricing, as described below.
2. Procurement and purchase of replacement animals – Generally, as milk prices increase, so does the cost of replacement animals. A dairy operation must evaluate replacement needs, whether for expansion or general replacement purposes.
Such factors as feed cost, feed availability, price of cows, price of open heifers and price of bred heifers will influence a producer’s decision on replacements.
For example, if feed costs are known to be very low and replacements are needed 12 to 18 months into the future, it may make financial logic to purchase young heifers; however, if feed costs are high and replacements are needed very soon, procuring bred heifers or milking cows may be the correct choice.
3. Facility improvements – Expanding and/or upgrading facilities are long-term decisions and should be planned in advance with a clear view of the operation’s long-term goals. However, once the construction decision is made, there may be opportunities to contract the project and secure competitive pricing, perhaps dependent on the timing of construction.
In addition, numerous websites offer insights on volume purchasing of construction materials and options for vendors and contractors.
4. Milk pricing – Most milk marketing cooperatives provide options for forward contracting/hedging of milk production. Evaluating this strategy as an effective tool in managing volatility requires a good understanding of an operation’s cost of production.
An operation needs to understand what feed variables will most significantly impact the cost of production and consider forward contracting these parts along with milk. Generally speaking, contracting from 30 to 70 percent of a farm’s production would be considered prudent.
However, this area of pricing must be very carefully considered, actively managed and evaluated frequently, allowing for corrections, if necessary.
5. Interest rate cost – While interest rates can also fluctuate, the trend has been downward in recent years. As the economy improves, rates will begin to edge up. Therefore, this is a good time to refinance and consolidate term debt and obtain a fixed rate on that structure.
Operating loans and revolving loans typically are variable in nature because they are short term. Look carefully at your operating needs and projected cash flow to ensure you have the right financing in place moving forward.
This is by no means a complete list, or even the most important areas to every operation. However, these are generally the decisions which seem to come to mind first when thinking about the volatility of dairy prices and what operations can do to minimize risk to bottom-line results. PD