There is a parable that Christians are familiar with that concerns two builders, one wise, the other foolish. The book of Matthew quotes Jesus as saying, “And the rain descended, and the floods came, and the winds blew, and beat upon that house; and it fell not: for it was founded upon a rock.”

Anyone who has built a house can appreciate the significance of this analogy. A weak foundation inevitably leads to the destruction of the whole structure.

The same can be said of milk markets and more specifically milk marketing. As we are very well aware, the milk market is a shifting and volatile environment. Prices travel quickly and are prone to frequent changes in direction. What may look good today may be gone tomorrow. How do you “build” on this? The answer is simple – options. I am not talking about alternatives or choices, but rather puts and calls. They are a rock on which solid milk marketing strategies can be built.

Why options? The answer is flexibility. How many times have you come across someone who has contracted milk and later cursed the very existence of the contract they made? Was this “terrible disaster” the fault of the contract? … the buyer? …the market? No, no and no. What was missing was the element of flexibility. What seemed like a good decision at the time was later overshadowed by market movement. The contract, by design, limits price to what is established at its inception. To make a contract solely on the belief that the market is going down takes a great deal of arrogance. The initiator of that contract is saying that the market cannot and will not go higher. But is that always the case? As your neighbors and friends have detailed the symptoms of their “woulda, coulda, shoulda” disorder, you have witnessed firsthand the answer to that question.

You have read my discussions about the volatility profile of milk. To condense this discussion, let’s review the facts. Milk prices over the past 30 years have tended to average near $12.50 per hundredweight on a Class III basis. Eighty percent of the monthly price announcements have been at or below $13 per hundredweight. When milk departs from these levels, it often heads to higher ground. As we have seen in recent years, it has the stamina to reach prices over $21 per hundredweight. However, it frequently runs out of steam quickly and returns to levels much lower than average (and without much compassion). February 2009 Class III milk prices settled at $9.28 per hundredweight. As emotional creatures, humans have a hard time enduring the roller coaster of price that the milk market is characterized by. Options provide the flexibility and staying power to overcome these abrupt movements and effectively manage price opportunity.

If options match perfectly with the make-up of the milk market’s volatility profile, why then does any producer avoid using them? One common retort to the use of options is that they often expire worthless (more accurately described as out of the money). Let’s look at the facts. According to Chicago Board Options Exchange (CBOE) data, approximately 10 percent of options are exercised, 50 to 60 percent are closed prior to expiration, and the remaining 30 to 40 percent are held to expiration. The facts remain that options do provide returns to their users, just not all the time.

Then again, they are nothing more than price insurance. How many policies do you own that create an annual return? Of those that have, were you excited to contact your agent with the claim? Would you like to collect on your life insurance policy next year? … Or would you rather renew and pay the premium? The discussion becomes quite simple when applying proper perspective to the use of options in milk marketing. We do not desire a claim. However, the incidence rate is high that a claim will occur, especially after prices reach historically lofty levels.

Have you built an addition on your home, remodeled or realized an increase in the equity of that property? How did you manage that change? Did you sit back idly and insure the value of that investment with the same levels of insurance that you had before the realized increase? Of course not! You increased your coverage levels and spent a bit more premium to do so. With milk options, we can create defined minimum values for our production without being bound to prices after markets move higher. We simply adjust our minimums to accommodate the change. Again, options provide the flexibility you desire and deserve.

Let’s take a look at the last couple of years and examine how options have worked for producers who employed them in their milk marketing strategies. After a very trying 2006, many producers were encouraged by the late fall activity. A rally had begun that would eventually peak in July 2007, but would linger for an additional year. Many producers viewed the near-$15 per hundredweight average values offered in early 2007 as an opportunity to market milk and effectively avoid the prices that bruised them so badly the year before. At the time, $14 puts were available from March through December of that year for $0.45 per hundredweight. Producers could build a foundation in their budget at $14 per hundredweight. They could not receive less than $13.55 per hundredweight ($14 per hundredweight of milk minus $0.45 per hundredweight option cost). They would not have to revisit the $10 prices of 2006.

However, if the market continued to move upward, they would receive the higher prices. As mentioned a moment ago, the market did rally. The end result was a loss of premium and a gain in their bottom line. The options expired without any value, but milk was valued at levels at $16, $18 and $20-plus.

While at these elevated levels, producers were offered opportunities to purchase additional coverage through 2008 and 2009. As an example, $18 puts for the last half of 2008 were selling for $0.50 per hundredweight by mid-May 2008. We are all very painfully aware of what transpired in the last half of 2008. Because of the rapid descent of price, the cost of these options was returned by the end of October and producers yielded an additional $5.79 per hundredweight on a month’s worth of hedged production. Already in 2009, we have witnessed similar opportunities to what was offered in 2007. As we await the outcome of our economy’s impact on milk prices in the third and fourth quarter, we will learn how simple protection, like that offered by a $14 put, will create predictable revenue streams and marginalize any adverse price movements that may occur. If prices move higher, they will serve as an insurance policy on which there was no claim. However, if prices move lower, producers who employ such a strategy will accept nothing less. That is a strategy you can build on. 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
Milk Marketing Specialist
First Capitol AG