It’s fair to say that most of us are glad to put 2020 behind us. Dairy operators had to navigate multiple challenges that impacted their bottom lines. But, as we move forward, there are some important lessons dairy operators can learn from the experience.
Volatility
We experienced volatility in the extreme in 2020. Milk prices swung from $16.25 per hundredweight (cwt) in March to $12.14 cwt in May to $24.54 cwt in July. But, it wasn’t just milk prices. Corn and bean prices have jumped since late summer, which means operators’ biggest expense – feed – took a hit last year, too. Having a plan in place that allows you to withstand that kind of whiplash will likely be a crucial strategy moving forward.
That strategy should include scenario planning – that is, how much working capital do you need to get through the base-, best- and worst-case scenarios. What happens if prices fall below what you expected? What happens if yields are above what you expected? What do you do with unexpected government payments?
Price risk management is another drum we constantly beat, but it's more important than ever as volatility becomes the norm. Among the companies we track, their success correlated with how well they protected their downside. Also, when you’ve protected your downside, instead of running three scenario plans (base, best and worst), you can just perform two – base and best – because the base case is now your floor.
Operators who had downside protection were not only in a better position to withstand a collapse in milk prices, but they were able to thrive when they recovered, as well. Another lesson from 2020 was that the added cost of being open on the upside was worth it on a go-forward basis. Tools such as Dairy Revenue Protection (Dairy-RP), Dairy Margin Coverage (DMC) and other options come with an additional cost, but in a volatile market, you may find it’s worth the cost of having the flexibility of protecting your downside while leaving you open for opportunities on the upside.
From what we observed, dairies that didn’t have these types of protections were on an emotional and financial roller coaster. When you have the proper safety nets in place, you can reduce the need to be Nostradamus when dealing with market fluctuations.
Supplier contracts
Volatility isn’t the only lesson to come out of 2020. A national trend that’s starting to make its way into regional markets is the implementation of formal supplier contracts. Whereas many supplier arrangements were largely informal, we’re seeing more formal agreements. In this new environment, it’s essential to make sure you have a slot with a plant that will accept your offtake. In other words, you shouldn’t just produce it and expect somebody to buy it. Going forward, you’ll likely need to make sure you've got a formal arrangement lined up.
Trade developments
The COVID-19 pandemic wasn’t the only issue that impacted dairy operators. China is rebuilding its swine herd, and on the heels of the U.S.-China Phase One agreement, they're buying a lot of whey protein from U.S. operators. That's a longer-term structural change that benefits the dairy industry with increased exports. But, it’s a double-edged sword because the strength or weakness of the dollar – as well as prices in other parts of the world – will have an impact on prices.
Long-term versus short-term impacts
Some of the shocks from 2020 are likely to be long lasting. On the other hand, because many of the effects were so immediate and dramatic, it can be easy to overreact to certain events that are more likely to be short term.
One lesson you may not want to take away from 2020 is that the government is always going to save the day. The dairy market experienced a V-shaped recovery, but that was largely because the federal government stepped in with relief programs. Can we expect every black swan event to result in that same type of comeback? Or, when running your contingency plans, should you think about a longer, U-shaped recovery instead?
Similarly, dairies may be at risk of overreacting to the rise in milk prices that began mid-year. Income over feed costs were incredibly high this summer, and those higher margins spurred operators to increase production. Now, milk prices are lower and feed costs are higher, so margins are compressed again. And, if some of those demand sources go away, it could lead to an oversupply, which is a perfect recipe for lower prices. That’s why it’s important to look at the longer-term demand drivers to keep supply and demand in balance.
Be resilient
If 2020 has shown us anything, it’s that resilience will likely be an essential attribute for dairy operators. Having the flexibility to withstand short-term impacts while being positioned for a future recovery requires a great deal of resilience. If you have excess cash, whether from market forces or from government programs, it may be time to shore up your working capital and build resilience for the next time margin compression hits you in the mouth.
The industry showed its resilience in 2020. Here’s to a stronger, safer 2021.
Note: The opinions, estimates and projections, if any, contained in this article are those of the authors. BMO Harris Bank endeavors to ensure that the contents have been compiled or derived from sources that it believes to be reliable and which it believes contain information and opinions which are accurate and complete. However, the authors and BMO Harris Bank take no responsibility for any errors or omissions and accepts no liability whatsoever for any loss (whether direct or consequential) arising from any use of or reliance on this article or its contents. This article is for informational purposes only.
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