Government policy provided strong support for milk prices with no price tag for producers until consumers began to question the program’s cost a decade ago. We are well aware of the price volatility since 2000. Very few of today’s taxpayers and policymakers would support a return to a government-funded dairy price support program, so how can producers manage these volatile markets? A written marketing plan should create a strategy that delivers milk price stability and cash flow security with a discipline that reduces the emotion of marketing decisions.
Emotions are a natural part of life, including business decisions. Pride, fear, greed and hope can make marketing difficult. Dairy producers take pride in their work and products. They do not want to accept a lower price than their neighbor for that product.
When milk prices rise, they sometimes become greedy, afraid to sell because the market did not reach a top yet. When milk prices drop, producers fear that prices will recover after they sell and do nothing. When prices are low, most producers just hope things get better.
Planning is an essential part of a profitable dairy farm business, but a plan is worthless until a producer acts to implement it. A synchronized breeding plan is worthless if the setup shots and breeding times do not match the plan.
What is the value in knowing the amount of corn silage in the bunk if you don’t adjust the rations to allocate that inventory to the right animals with the correct ration all year? Building a marketing plan and not implementing it is no different than the deer hunter from town that buys an expensive rifle and tree stand but doesn’t pull the trigger when the buck walks under it.
Last May, the average estimated value of Class III futures contract for May 2013 was $15.65 per hundredweight according to the buyers and sellers on the Chicago Mercantile Exchange . In September, only four months later, that projected value improved to $19.12.
What will milk really be worth in May? The past 10 years taught us that these projections can change quickly and dramatically with little notice. Writing down a marketing plan provides strategy and price goals that indicate when to “pull the trigger” as markets swing up and down.
To reduce the effect of both milk and feed price volatility, construct a marketing plan around a “margin.” Your margin is just the value of 100 pounds of milk remaining after subtracting the cost of the feed to produce it.
A plan could be as simple as purchasing a Livestock Gross Margin for Dairy insurance policy (LGM-Dairy) from a crop insurance agent, buying a Class III put option, along with a corn and soybean meal call option through a commodity broker or, perhaps in the future, buying higher levels of the “Dairy Security Act” margin insurance coverage, if that proposal is passed.
To take the emotion out of the decision-making process, stagger these sales across different time periods (monthly or quarterly) as futures markets present profitable opportunities, regardless of the outlook.
Any of these tools could build a simple floor for milk prices and a feed cost ceiling that protects a profitable margin for some or all of a dairyman’s anticipated 2013 production. None of these tools will prevent producers from participating in an unforeseen price upswing because they do not “lock in” a price for the milk check.
As managers become more comfortable with forward pricing, they will apply these margin protection tools as a conservative base for their marketing plan. This base could be 30 percent of a particular month’s production for some and 90 percent for others.
A producer’s risk tolerance and debt commitments will determine the correct proportion of his total sales that should be committed to protect the base price for his business.
The base portion levels out the price valleys, but it will also reduce the price peaks. The goal of this base is to assure that there will always be enough money in the checkbook to preserve cash flow, not to maximize income.
Maximizing income could be the goal for the remaining portion of the plan’s sales by considering customary price outlook fundamentals. Set realistic sales price targets for every month or quarter of next year and when the market reaches those targets, “pull the trigger.”
Your plan could allow you to “do nothing” or to speculate that closing prices will meet your price targets for some months, so long as the base portion of the marketing plan maintains cash flow if markets unexpectedly crash. Every farm will have a different risk comfort level and market outlook, so each marketing plan will be different.
Cost control is a crucial part of all successful dairy farms, so how can you justify spending hard-earned money to protect a milk price? Turn the clock back to June of 2008. How much would producers have spent on price protection to guarantee there would have been money in the checkbook in March of 2009?
Unlike support prices from 20 and 30 years ago, producers must pay for these market-based risk management tools, but they need not be expensive. Purchasing “out of the money” option contracts or using a higher deductible with LGM-Dairy can still provide a reasonable price floor at a low cost when Class III prices are strong.
During the valleys of weak milk prices, you may need more expensive “at the money” options or a zero-deductible LGM-Dairy policy to obtain adequate price protection for the plan base.
Understand the mechanics of these risk management tools to anticipate and minimize potential problems. If that Class III contract you sold through a broker for $20 keeps climbing to $22, the margin calls would total $10,000, which must be deposited in your margin account long before the milk check for that production arrives.
Be sure your banker has a hedge line of credit structured to avoid inadvertently creating the cash flow problems the marketing plan is designed to prevent.
Basis changes can also distort a well-constructed plan, especially in parts of the country where cheese is not the dominant product, because the Class III price may not reflect the farm price.
Some markets are driven by the sparsely traded Class IV butter/powder price, which does not always trend with the Class III price. Class III tools do not always reflect farm milk prices in fluid milk markets with low Class III utilization like the East Coast when producer price differentials fall to near or below $0.00, minimizing the basis.
Market volatility is a fact of life in the dairy business both today and tomorrow. Policymakers are encouraging dairy producers, not the government, to manage price risk as part of the way they do business.
Consider a marketing plan as a way to make rational sales decisions that maintain cash flow during the margin valleys but allow you to participate when price peaks occur. Planning ahead will help to identify profitable prices and encourage producers to do something now rather than “waiting until things get better.” PD
Alan Zepp
Risk Management Program Coordinator
Center for Dairy Excellence
