The milk price risk management landscape has changed immensely over the last few years. This article takes a brief look at available programs and highlights what to consider when evaluating how to manage that risk.
Let’s start with the risk: your milk check. For the most part, you must start by understanding how your milk check works and its moving parts: the blend price and the producer price differential (PPD). By no means is this a perfect science, but there are some best practices when it comes to understanding your underlying milk price risk.
A simple way to see your milk class utilization and PPDs is to view monthly Federal Milk Marketing Order (FMMO) reports. Look into your blend price formula, do your homework or work with someone who understands how milk is priced and pooled in your area. Don’t get caught only in a Class III hedge because you didn’t know you had Class IV risk.
There has been tremendous attention on PPDs, which have been drastically negative across many FMMOs this summer. For the most part, these negative PPDs have been due to the difference between your blend price and Class III milk price, resulting from:
- The record Class III – Class IV price spread, with Class IV valued far less than Class III.
- A Class I pricing formula change made in the 2018 Farm Bill, which no longer uses the higher of the Class III – Class IV price but rather the average of Class III and Class IV prices, plus 74 cents, resulting in a Class I value much less than Class III.
There are two important things to know about PPDs when it comes to managing price risk.
- Generally speaking, the PPD represents the value of Class I, II and IV milk versus Class III. From a risk management perspective, PPD primarily represents your Class IV risk. When you hedge the Class IV part of your blend price, you are hedging a good chunk of your PPD risk.
- When the Class III – Class IV spread trades at extremes, you take on new risk due to depooling, as plants keep the Class III dollars instead of pooling them. If you are in a FMMO that has a lot of Class IV risk, your milk check will not track well with Class III. If you are in an aggressive Class III hedge (futures, forward sales or sold calls), it could end up being detrimental to your business. Make sure you understand the potential collateral damage of depooling.
Editor's note: There are several risk management tools available to dairy farmers (see Learn to use milk price risk management). One may be a better option than another based on your dairy.
Dairy margin coverage (DMC)
Dairy Margin Coverage (DMC) is the one program that should be used by every dairy every year at the $9.50 coverage level for up to the 5 million pounds of milk. (For a review of DMC margin and payment calculations, see pages 14-15.)
Dairy Revenue Protection (Dairy-RP)
Dairy Revenue Protection (Dairy-RP) should also be in every dairy’s milk price risk management arsenal. Focused on just the milk check side of the equation, it is a subsidized, market-based crop insurance product. Simply put, Dairy-RP is a subsidized floor (put) on your milk revenue (milk price X yield factor). You have flexibility to protect Class III and Class IV milk with no production limitations. And, like the CME, you can protect increments of milk revenue. Premiums are not due until the end of each quarter, making it cash-flow friendly.
The last point to make on Dairy-RP is liquidity. Dairy-RP coverage levels and premiums are set off the CME prices from that day (closed on USDA report days). On any given day, a dairy can protect all or some of their expected milk production going up to five quarters out. Going to the CME and hedging millions of pounds of milk, especially in Class IV, four to five quarters out, requires loads of patience, creativity and often willingness to pay up to get your coverage bought. For many dairies, Dairy-RP can easily be the cornerstone of a hedge program. Currently around 30% of U.S. milk is hedged under Dairy-RP.
Livestock Gross Margin for Dairy (LGM-Dairy)
LGM-Dairy is another subsidized market-based crop insurance program. It is similar to DMC in that it protects the margin between Class III milk and feed cost (corn and soybean meal) but, like Dairy-RP, it prices off current markets. LGM-Dairy is offered once a month, and you can hedge 11 months forward. A key recent change to LGM-Dairy is that there are no longer production limitations. Currently, the biggest issues with LGM-Dairy are that you cannot hold it and Dairy-RP in the same quarter, it’s only offered once a month, and you are not allowed to protect Class IV milk. For dairies with Class IV risk, it is hard to find a place to use this program.
On a positive note, the program allows you to protect a month at a time, more flexible than the quarterly averages used in Dairy-RP. For Class III producers, it can be good hedge against Class III milk by lowering the weight of the feed calculation, or a good way to protect Class III, corn and soybean meal if you are heavily exposed in your feed risk. In summary, LGM-Dairy should be in your toolbox, but for the majority of dairies (especially in heavy Class IV markets) it will be harder to implement.
Chicago Mercantile Exchange (CME)
The CME is the oldest and most widely used marketplace for managing milk and dairy product price risk. There are no subsidies, quarterly averages or production constraints. The exchange represents a place where buyers and sellers can meet to exchange/remove risk. The CME provides futures and options not just on Class III and IV milk but also on cheese, block cheese, whey, butter and nonfat. The CME is the most flexible tool, with the ability to execute complex futures/options strategies and alter risk position as markets change. The CME has no restrictions on what other programs you use, allowing you to stack CME structures on top of the other insurance products.
Since the release of DMC and Dairy-RP, the CME is a place to take aggressive hedge positions (selling futures), better your hedge position (use CME to protect higher prices if you have already maxed out your Dairy-RP and DMC) and to protect gains on existing Dairy-RP coverage.
Remember, Dairy-RP is settled quarterly, creating risk if a month rallies strong enough to pull the three-month average up. This is what happened in June 2020, when Class III rallied from $11 to $21 per hundredweight in just a few weeks. By using the CME, a dairy could have locked in their Dairy-RP gain and mitigated that risk by buying a simple call option to protect the price from rallying.
On the flip side, if you bought Dairy-RP in the panic of the COVID-19 break, you might have some very low coverage and now want to roll your coverage up to find a way to pay for the Dairy-RP. In that scenario, you may use the CME to sell calls against the Dairy-RP or do a collar to establish higher puts and use sold calls to offset the premiums.
Last, if you’re ready to just straight sell milk or get aggressive with options, there is no more direct way to get that done than to use the CME. This can also be accomplished by using your processor’s forward desk and sometimes done over the counter (OTC). The CME is a tool dairies must have in the toolbox. If you are more than just a put buyer, you will find the CME will be a big part of your hedge program, using it to supplement your base hedge positions established under DMC, Dairy-RP or LGM-Dairy.
The risk of loss trading commodity futures and options can be substantial. Investors should carefully consider the inherent risks in light of their financial condition. The information contained herein has been obtained from sources deemed to be reliable, however, no independent verification has been made. The information contained herein is strictly the opinion of its author and not necessarily of Rice Dairy and is intended to be a solicitation. Past performance is not indicative of future results.
