The concept of a margin is not new. Simply put, revenues minus expenses equal the operating margin of a business. Many dairies do not look at their enterprise in margin terms. We assert that following a margin approach can significantly improve your dairy’s profitability and help your business through the inevitable lean times, such as we are experiencing right now, that are part of any cyclical industry.

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 today may change over time and your actually realized return might be different than what you originally identified. 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.

As an example to help illustrate this point, Figure 1 shows the historical tendency of a profit margin for a sample dairy in the fourth quarter. The chart is indexed from zero to 100, meaning that values near zero indicate points of the year when the profit margin tends to be weakest and points near 100 when the margin tends to be strongest. While seasonality in margins is certainly not the only tool to help make price management decisions, it is clear looking at the chart that the profit margin for fourth quarter tends to be much weaker in the actual October/November/December period than earlier in the summer around July and August.

In the following charts, we can see both the current and projected forward profit margins for a model dairy operation through the first half of 2010. Making some realistic assumptions regarding fixed costs for this enterprise, the floating variables of feed costs (represented by a matrix of corn and soybean meal futures) and milk revenue (driven by Class III milk futures) reveal where these margins are currently at. The light beige shaded area of the graph indicates where these margins have been since we began tracking them while the red area of the graph represents the most recent observations for the month of June.

It will come as no surprise to anyone reading this that profit margins are quite poor right now. However, this was not always the case. In the current third quarter (Q3) period for example, our model operation is losing about $4.00 per hundredweight on milk to be marketed next month relative to prevailing feed costs. As recently as April though, this profit margin was actually a positive $2.00 per hundredweight. In other words, this particular model dairy could have locked in a positive profit margin for the July/Aug/Sep time frame just two months ago!

Looking beyond the nearby period, we can see that similar opportunities presented themselves quite recently in the fourth quarter (Q4) as well as in the first quarter (Q1) of 2010. In order to achieve a profitable forward margin, you should follow these two steps.

We first need to identify whether a profit margin exists. This can be achieved by modeling our operation around these variables in order to make forward projections.

The second step in the process is managing that margin. 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 (both price and basis), 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 not profitable, but rather 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 environment, flexible margin strategies are critical to understand and command. The charts reveal that this model dairy is projected to operate in the red through most of the first half of next year. While we cannot do anything to change the economic reality of the margin situation, we can change our approach to managing the forward margin. For example, we can presently project that the loss for Q3 and Q4 of 2009 might be worse than for Q1 and Q2 of 2010 given current prices.

Most dairies are experiencing negative margins right now and losing money. Some forward pricing strategies allow you to limit this projected loss by protecting a “minimum margin.” This flexibility allows you to preserve the opportunity to wait for better prices while at least establishing a minimum sale price for milk as well as a maximum purchase price for feed. While there will be a premium to pay for this margin certainty, there will be no obligation to lock ourselves into a loss – we simply are preventing the loss from becoming any greater.

Given the recent volatility we have experienced in commodity prices, the extraordinary economic environment we are operating in both locally and globally and the changing landscape of the dairy industry, it is essential for dairymen to take control of their enterprises by actively managing profit margin. It will not be sufficient going forward to simply have modern production techniques and achieve greater operational efficiency. Following a passive marketing strategy of accepting whatever costs and revenues the market provides is assuming too much risk.

Also risky is trying 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. PD

This information is not intended to be used to make financial decisions. Discuss options and actual investment plans with a certified financial adviser.

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