In the movie Pure Country, Grandma Ivy says “… if you follow the roots, you’ll find him.”

In my last article, we spent time understanding how the use of options in the dairy markets gives the producer flexibility in navigating the marketplace and developing perimeters of acceptability given the opportunities at hand. In this piece, we will move from the branches of the tree to its trunk and take a closer look at the futures market and private contracts with your milk buyer.

Let’s start from the beginning. The exchange as we know it today got its start out of necessity. It was founded by a group of merchants looking for innovative solutions to centralize trading. It started by offering “to-arrive” contracts. These early forward contracts allowed buyers and sellers of agricultural commodities to specify delivery of a particular commodity at a predetermined price and date.

From there, futures contracts, and later a margin system, were introduced to instill greater levels of transparency and integrity into the market.

Fast-forward to 2009. Today, exchanges across the globe make available thousands of futures contracts on more things than most can comprehend. There are options (puts and calls) on many of those same contracts. We covered this a few issues ago. In that discussion, we mentioned that the value of puts and calls is a function of the futures market from which it is derived.

How does the futures market establish value?
Simply put, any contract, whether with the Chicago Mercantile Exchange (CME) or the actual buyer of the milk from your farm, is an agreement between a buyer and a seller. You agree on a standard quality for a set delivery period of an identified commodity at a negotiated price. Once established, this negotiated price remains constant regardless of what happens to the marketplace. You will receive no more or less than the contract you set. Value has been identified.

When do we use such a contract? This is perhaps the toughest question for producers to answer. Let me give you a statistical overview of the market you are involved in. Prices settled higher than $16 on a Class III basis only 7 percent of the time since 1980. Settlement prices over $17 are even rarer. They account for only 5 percent of market settlements since Ronald Reagan took the oath to be our 40th president. In that same period, prices settled higher than $18 only 4 percent of the time. To achieve prices greater than $19, you would find yourself in the best 3 percent of prices since the U.S. Olympic hockey team defeated the Russians in the Miracle on Ice. At $20, you are in the top 2 percent of prices since the release of Pac-Man. Are you catching my drift?

The time to use contracts is not when prices are average, and never when prices are below average. The time to use a contract is when prices are strong, in the upper tiers of their price history. You take strong actions when prices are strong.

Futures contracts versus buyer contracts
We’ve discussed how futures contracts are similar to the contracts available through your buyer. How are they different? A Class III futures contract through the CME is standardized to include 200,000 pounds of milk, whereas you may find your buyer willing to write contracts for variable amounts in either smaller or larger quantities.

The contract with your buyer will be settled in your milk check. In other words, your marketing gain or loss will be accounted for during the correlating delivery period of your actual milk. (i.e., If you agreed to sell your milk to the co-op for $19 in July, that contract will be measured against the USDA announced price in July. You will receive the difference as an addition to your “normal” milk check if the announced price is lower or forego the difference if the announced price is higher.)

Rather than settling the final outcome against your milk check, the futures contract that you are party to is “marked to the market.” This means that the price you contracted your milk for is compared to the price that the market closes at on each and every day. If you sell milk using a futures contract and the price goes down, the buyer of that contract is putting money into his account to make sure that your position is made whole. However, if the market moves higher, you will be putting money into your account to make sure that the buyer is made whole on his or her position.

One added comfort in using futures contracts is the protection extended by the Commodity Exchange Act of 1936 through the exchange to eliminate counterparty risk. Anyone who has ever been on the wrong side of a handshake deal that went south understands the peace of mind that comes with such safeguards. At the end of the milk contract’s life, the gain or loss on your futures contract is “cash settled” to your futures account. Any gains now become available cash. Any losses (which have been ultimately covered daily) are now counted as a loss and are fully realized in your cash balance. This frees you from having to deliver milk to any random buyer of your futures contract and rather makes it a simple accounting transaction.

What about margin?
The marketing term margin is often an overused and misunderstood term in the futures industry. Some refer to margin as the “security deposit” that you must set aside to participate in the market. Others refer to it as the amount that you must send in after incurring a market loss. Some use the word interchangeably to refer to both applications.

Here is how it works. If you participate in the futures market, you must first set aside an amount set by the exchange as a good faith sum to ensure that each and every participant is sound. The exchange can and will adjust this amount in accordance with market movement.

Think of it this way. Currently, margin on milk futures for bona fide hedgers is roughly $1,000 per contract or, in current market conditions, about 1/20th of the contract’s face value ($10 per hundredweight multiplied by 2,000 hundredweights). If the price of milk climbs to $20 per hundredweight, the $1,000 margin represents only 1/40th of the face value. The exchange will likely raise margins to maintain a financial balance of leverage in the marketplace.

Regardless of the amount necessary to maintain the position, this amount is returned to the user when the contract is offset (when a buyer sells the same contract that was initially purchased or when a seller buys the same contract that was initially sold).

Since we already discussed the concept of positions being “marked to the market,” I will avoid repeating how that works. But know that if anyone, after experiencing a marketing loss on your futures position, tells you that your account is on a margin call, what they truly mean is that you have incurred a loss of equity in your account which requires you to send additional monies to offset that loss.

Contracts establish a set price
Contracts are a means of setting a price, one of permanence. Whether you decide to use a futures contract or establish a contract with your buyer, the price is set. So give heavy consideration to the price that you are establishing. I suggest you choose prices that are in the upper 10 percent of historical offerings.

Why use one contract over the other? First, consider the fees. The fees charged by a brokerage are often considerably less than what is charged by a processor, co-op, etc.

Secondly, if you contract with the buyer of your physical milk production, you have not only guaranteed a price for yourself, but you have also guaranteed a volume of milk to them. That contract mandates delivery of that milk. Contracting milk through a futures broker establishes a price without the concern of having to actually deliver the milk.

One of the advantages of contracting with your local buyer is that they will often assume any market exposure that comes with the contract. If you sell milk futures contracts, you will shoulder the market exposure. However, you must keep in mind that if you are producing and selling milk on a monthly basis, any upward movement in milk price is also reflected in your milk check.In other words, the losses that you incur in your commodity account are offset by the increase in your milk check.

If you maintain a big-picture view, your real cost in using futures is the cost of your money … interest. How does that interest compare to the fees that you pay to contract with your buyer? The futures contract you use at the exchange, like the contract you would write with your buyer or the options that you may use, are all tools in your marketing toolbox. Like any tool you own, you must spend some time to understand how the tool works and use the tool in accordance with its design. PD

UPDATE: Since the publication of this article, Mike North has left First Capitol Ag and is now the president of Commodity Risk Management Group. Contact him by email.

Mike North
Senior Risk Management Adviser