There has been much talk about the lack of profitability among dairy producers lately, with milk prices below most operators’ cost of production. The negative profit margins have certainly put quite a bit of strain on the industry for the past year and led to a new round of the CWT’s herd retirement program in an effort to further reduce production and boost prices.

What is lost in this discussion is the fact that profitable margins for all of this year could have been locked in well ahead of when profitability began to deteriorate during Q4 2008.

Before looking at these opportunities, let’s take a step back and explore the concept of a dairy producer’s profit margin first. While somewhat simplistic, the value of milk minus the cost of feed and other expenses equals the operating margin.

The futures exchange allows us to discover the best market-based estimate of what forward values will be for both milk based on the Class III contract as well as corn and soybean meal based on those corresponding futures contracts, all of which trade at the CME Group.

Why is this important? Because the projected forward profit margin that you can identify in the market may change over time and your final physically-realized return might be different than what you identify today. This is a key concept to grasp because it is often the case that the best profit margin opportunities for your dairy may occur well ahead of the physical delivery month.

Looking back on this past year, we can clearly see that the profit margin for the recently finished third quarter was abysmal for dairy producers. While this is true, it was only true during the actual calendar quarter of June through August if a producer was completely exposed to feed costs and milk prices.

Figure 1* shows that the “open market” margin for this just-finished period ranged from about a $2.00 per hundredweight loss to a loss of more than $4.50 per hundredweight if left exposed without protection. A closer look at the chart reveals that there were at least two separate opportunities to protect a profitable margin for this period in April 2009 as well as late 2008 – a period when the Q4 spot profit margin was absolutely horrendous given the sharp drop in milk prices late last year.

In the current fourth quarter of 2009, we can see from the Figure 2* that the spot profit margin is projecting a loss of about $0.50 per hundredweight. Looking back however, you will notice that similar to Q3 2009, there were opportunities in both April as well as July to protect a profitable margin for this period.

While looking back at lost opportunities probably isn’t much solace for most readers suffering spot losses in the cash market, the purpose of showing these graphs is to reinforce the importance of monitoring forward profit margins for opportunities in the present.

Fortunately, these opportunities still exist when we look ahead to projected margins for 2010. The recent rally in CME Class III milk futures prices following stronger cash trade in the cheese markets along with the optimism surrounding the new round of herd reductions under the CWT program has increased premiums of forward futures contracts relative to spot values.

While feed costs have likewise risen recently with the rally in corn and soybean meal futures contracts, the overall projected profit margin is still above breakeven through all of 2010.

Figure 3* shows the projected profit margin for a model dairy operation for Q1-Q4 2010, based upon the respective futures prices for those different periods as well as certain cost assumptions for an Upper Midwest dairy farm. Once a forward profit margin has been identified, the next step in the process is to determine how to protect it.

As we can see from the first set of charts, just because a forward margin is projected to be profitable, that does not mean that the actual margin will generate a profit for us once we reach that spot period of marketing. Because conditions and prices change over time so does the profit margin, and it is important to seize the opportunity to protect that margin when it first presents itself.

There are various contracting choices available to dairymen both in the physical cash market as well as through exchange-traded derivatives using futures and options. Some strategies will simply “lock-in” the margin. Here, the only thing that will change are some variable costs that have a smaller impact on profitability relative to feed expenses.

As an example, if feed costs are firmly established in the cash market and milk sales are secured with the processor (the basis will remain a variable until we receive our mailbox price), then a margin has effectively been locked-in. This may be acceptable if the margin is at a very profitable level.

As an alternative to locking in the margin through cash contracts in the physical market, futures contracts could be used where Class III milk is sold while simultaneously both corn and soybean meal futures are purchased – representing our corn silage, haylage and other protein equivalents.

Here, we have also secured a margin, although there is a risk of basis variation where the cash price received for our milk from the processor may deviate from CME futures while similarly, there may be some variation between the movement of corn and soybean meal futures relative to our feed ingredient prices in the local cash market. What if margins are merely breakeven, or even negative?

Other strategies offer more flexible price features where a “minimum” margin can be protected while allowing the opportunity for that profit margin to improve over time through a combination of lower feed costs and/or higher milk prices. Here, option contracts on futures can be utilized to “unlock” the fixed price features of long or short futures positions.

Similarly, option contracts can also be employed to create this flexibility around fixed-price commitments in the physical market where cash contracts have been used. In the current market, strategies to protect a minimum price of forward milk values while preserving the opportunity for a maximum price sale at higher levels looks attractive.

This involves purchasing a put option to provide you the right to sell milk futures at one level, while simultaneously selling a call option which obligates you to sell at a higher level. The difference between the two price levels is effectively the “window” of opportunity you have for your milk price to improve in a rising market. This strategy is sometimes referred to as a window for that reason.

Looking at strategies to protect feed costs, both corn and soybean meal futures have posted significant rallies since early October. Purchasing a call option would provide you the right, but not the obligation, to purchase the commodity at a particular strike price for a premium.

Your maximum cost would therefore be the strike price plus the premium, plus or minus your local basis against that particular futures contract. Because forward call premiums are expensive, an alternative might be to protect a range of higher prices, by buying a call option at one strike price and simultaneously selling a call option at a higher strike price.

For a reduced cost, this gives you the right to buy the commodity at the price at which you purchase the call; however, this right effectively ends above the strike price of the call option you sell. Regardless of the strategy chosen, it is important to first know what your projected profit margin will be in a given period.

This will provide significant guidance on what strategies to consider, what costs you can endure and what limitations you are willing to accept given your projected profitability. One common fallacy is to focus on either feed costs or milk prices in isolation of one another.

Margins can be quite favorable when it would otherwise not be so obvious looking at individual commodity prices independently. Regardless of the individual commodity prices, the relationship between them measured by the input costs relative to the outbound revenue is ultimately what determines profit.

Managing margin is the right approach to achieving long-term success. Having such a marketing plan based on a margin approach to managing risk will also greatly assist with lender discussions when securing operating lines as well as forward planning for your dairy operation. PD

*Figures omitted but are available upon request to editor@progressivedairy.com

Chip Whalen
Senior Risk Manager for Commodity & Ingredient Hedging
cwhalen@cihedging.com