The most common question asked by a dairy farmer to his or her broker is some variation of, “Should I lock in my milk price?”
At face value, this seems like a simple question. By analyzing the current fundamental and technical indicators, people often attempt to gauge the current market direction. With an opinion established, a price point can be determined and an order placed.
However, by just locking in a milk price, the producer is only securing a portion of one variable in the profit equation (revenue – cost = profit). Hedging milk production is a great first step in mitigating price risk, but there are other factors that can have a significant impact on a producer’s bottom line to be considered.
Milk sales represent a massive percent of a dairy’s revenue, on average, anywhere from 85 to 95 percent. A majority of the remaining revenue is generated through cull cows, which can be hedged using live-cattle futures and options, and over-the-counter (OTC) tools.
Culling revenue may not seem like a lot, but consider this. Live-cattle futures have moved some 30 percent since October 2016. If cull sales account for 15 percent of revenue, a 30-percent shift in price alters total revenue by 4.5 percent. In the current environment of decreasing milk prices, hedging other revenues – such as cull cows – can help provide some financial stability needed to weather the storm.
The variables in the cost portion of the profit equation are slightly less skewed. Feed makes up the majority, accounting for roughly 60 percent of total costs, on average, and can be hedged using various tools such as flat-price forward contracting, basis contracts, futures and options, and OTC tools.
Often, however, the cost of feed is overlooked when deciding whether or not to hedge milk production. Like the age-old saying goes, “Don’t judge a book by its cover.” Even if the price of milk seems suppressed, favorable margins may be attainable if the cost of feed is low enough.
If a dairy farmer is growing most of his or her feed, fluctuations in the grain markets may be less of a concern, but changes in the price of diesel will have a greater impact on the bottom line. Fuel companies will more often than not provide fixed-forward contracting, providing price stability. Heating oil futures can also be used as a cross hedge for diesel.
Due to the low interest rate environment of the last decade, the cost of money has almost seemed like a fixed cost. Since October 2008, the Federal Reserve Bank Fund interest rate has been below 1 percent. As the outlook on the economy has started to become more promising, the Fed has slowly started raising rates. Financial markets have been more aggressively increasing interest rates in the deferred futures months.
High interest rates have a direct impact on dairy producers’ revolving lines of credit. Most banks will allow producers to lock in a fixed rate on that line of credit, but there may still be some basis risk, and many contracts are hard to get out of in the event of wanting to change banks. An alternative strategy would be using interest rate swaps (derivative contracts) through OTC financial markets.
Not all portions of the profit equation can be hedged, such as labor costs. However, there are many tools available to stabilize cash flow, mitigate price risk and secure profitability. Some of those tools may not fit into the business plan of every farm. Knowing where your risks lie, and how they can impact your bottom line, is the first step in risk management.
With volatility here to stay, the importance of risk management looks to only increase. The implementation of a strategic plan that weighs all of the risks will help your operation thrive in the ever-changing dairy landscape. 
Comments in this article are market commentary and are not to be construed as market advice. Trading is risky and not suitable for all individuals.
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Daniel Zelazik
- Risk Management Associate
- FCM Division of INTL FCStone Financial Inc.
- Email Daniel Zelazik
