As a dairy producer, you are faced with a dilemma: feed price increases typically precede milk price increases. That means your profitability and margins on your milk are squeezed when feed prices go up. Eventually, the higher input costs typically translate into a higher milk price and your bottom line margins recover. However, in the short run, it is a painful experience. As we look out into the decade or two ahead of us, I expect substantially increased market volatility, substantially higher feed prices and the risk of substantial feed shortages. Why do I expect this volatility, higher prices and potential shortages? Because we are already using our feed inputs at a record pace. World demand for feed grains has been growing rapidly. The ending stocks-to-usage ratio is very low, increasing the risk of price volatility.

It has been nearly 20 years since we had a significant drought throughout the key growing areas of the U.S. This is unprecedented. In fact, Iowa State Professor Elwynn Taylor’s research shows that we have gone through a 20-year pattern of historically improved growing conditions for our crops. His research further shows that typically, this favorable weather pattern shifts after a major hurricane event in the Southeast like we had over a year ago. Once this shift occurs, the next 20 years brings increasing unfavorable growing conditions. Each drought that occurs within that 20-year period, on average, is worse than the previous drought. We are due!

Once a drought occurs, we are going to see substantially higher feed input prices throughout the livestock and dairy industries. Based on my historical analysis, typically, when a commodity goes to a new high price level, it will exceed previous highs by a minimum of between 120 to 140 percent of its previous high.

For corn, that means we could expect a price in the upper $6 to low $7 area. Corn prices like this would easily translate into prices in soybean and meal prices that will at least test previous highs if not go into new highs. In other words, your feed input prices are going to be high – very high! This means red ink and low profitability. Think about what would occur if we had a second drought within two or three years of the first drought.

Forward pricing and properly hedging your milk in the years ahead will be highly important. However, managing your milk marketing without managing your feed marketing is like carefully managing your nutrition with no manure management plan. You have to do both to be successful. If you ignore one or the other, you are sunk.

So what can you do to manage this kind of risk and price volatility? Obviously, when prices are low and basis is wide, forward purchasing your cash commodity inputs as aggressively as possible is advised. The challenge will come when prices go to historical highs. Even after the high is made and prices collapse, the resulting price level can still be substantially above your break-even level. That is why forward pricing your needs three or six months out may not be enough to truly protect you. When prices offer the opportunity, forward pricing your feed needs 12 to 24 months out may be advisable.

What tools should you use to accomplish this forward pricing? There is a wide variety of tools that can work. A lot depends on your knowledge of the tools, your cash flow and market conditions.

Forward contracts that don’t require margin or additional decision-making are the most simple and most worry-free. Futures hedges can work, but with extreme market volatility, futures hedges can require a great deal of margin money. That margin money needs to be accompanied by an iron stomach, a great deal of discipline and more to be successful. Options on futures offer a much better alternative for most producers. The fixed up-front cost takes much of the worry out.

The problem with call options in volatile markets is that they get to be very expensive. That makes it difficult to write out the check to purchase them even when you know you should. To avoid the high cost of options, more advanced option strategies can be employed. These strategies go by the names of bull calls, fence strategies or ratio spreads. All of these strategies have some positive features and benefits, but they also have drawbacks that you need to understand before you venture into the advanced option strategy arena.

Speaking of strategy, as markets become more volatile and the upward price risk for your feed inputs becomes greater, approaching the market from the right perspective is more important than ever before. I advocate a strategic approach. A strategic approach involves making decisions today about what you will do in the market – whether prices go up slightly or greatly or whether they fall slightly or greatly; whether these price moves occur over a day, a week, a month or years.

A strategic approach involves always having a strategy laid out, in advance, defining:

•How you will react

•The tools you will use

•What percentage of your feed needs you will take action on

I contrast this with an outlook approach that is so commonly used. Most industry participants approach the market by trying to predict if prices are going to go up or down, and then making decisions accordingly. I believe this approach is highly flawed.

Who can predict whether it’s going to rain or not? Who can actually predict whether there will be a drought or not? Once you know enough to be able to accurately predict a price move, that move is over. A colleague of mine once stated that, “A known fundamental factor is a worthless fundamental factor.” Oh, how true! Once everyone knows something and can confidently make a decision based on that knowledge, the price move is over. That is why outlook-based approaches to the market do not work.

A strategic approach takes the emotion out of your feed purchasing decisions and puts the professionalism in. It takes a lot of time, effort and discipline to develop and implement a strategic approach, but the payoff is substantial.

While I believe a strategic approach is critical to managing both feed hedging and milk marketing, discipline is even more critical. You can come up with the greatest strategy in the world, but you have to implement that strategy with discipline. Without discipline, your whole program will fall apart.

After more than a few years of unprofitable milk prices in the past, I am sure that many of you fear declining milk prices more than anything. However, in the decade or two ahead, I believe the threat of increasing feed costs may be more of a threat to your profitability than low milk prices ever were.

As we move into these new times, you need to aggressively prepare to hedge against those higher feed costs. At the same time, you may need to reset the parameters that you considered good value on milk. Milk at $16 may sound good today, but with $7 or $12 corn, how attractive is $16 milk? PD