Milk prices were strong at the end of 2019, and 2020 looked like it was going to be smooth sailing. But COVID-19 changed the equation as exports declined, the dollar strengthened and – most crucially – the foodservice channel collapsed. Amid such demand destruction, prices only had one way to go – down.
Nonetheless, even with the pandemic and unprecedented risk and volatility in the dairy markets, we still hear customers trying to predict where they think the market is going. It’s an easy trap to fall into – the “I know the market is going to go up” mode of thinking seems to justify the cost savings of not investing in a risk management plan.
But the fact is, given recent events, this is a great time to focus on managing risk. To begin with, let’s review the alphabet soup of tools available to help producers with price risk management.
Know the terminology
- Dairy Margin Coverage (DMC) – Authorized by the 2018 Farm Bill, DMC protects a margin between the all-milk price and feed costs based on premium alfalfa prices, corn prices and soybean meal prices. Coverage levels are from $4 to $9.50 per hundredweight (cwt). Subsidized premiums cover the first 5 million pounds (averaged equally per month). Operators can purchase additional coverage above 5 million pounds, but it’s generally cost-prohibitive when compared to other strategies.
- Dairy Revenue Protection (Dairy-RP) – Also authorized by the 2018 Farm Bill, Dairy-RP is a milk price insurance tool that sets a quarterly floor milk price. Producers can set multiple variables to customize this coverage.
- Livestock Gross Margin insurance (LGM) – A monthly revenue coverage program based on the margin of milk prices over feed costs. The client selects volumes of coverage, feed costs of coverage and milk prices covered.
- Forward contract – This sets a fixed delivery price for a specific product and volume for a specific period. This may or may not include quality requirements.
The following are used in futures markets to hedge the price movement of an underlying asset, such as milk.
- A futures contract sets a fixed price for a specific product and volume for a specific period. These contracts are available on a monthly basis tied to Class III or Class IV milk. Unlike forward contracts, which can be privately negotiated, futures contracts are highly standardized and traded on an exchange.
- A put option gives the owner the right (but not the obligation) to sell a futures contract at a set price. This is used to set a floor price on milk.
- A call option gives the owner the right (but not the obligation) to buy a futures contract at a set price. This provides a protection against rising prices.
Each of these tools, by themselves or in combination, can help you manage price risk. The most effective strategies we’ve seen are deployed consistently, taking into account market conditions, your cost of production and your margins. Some, like DMC, because of their value in relationship to their cost, are often best deployed on the first 5 million pounds of production as the first step in building that plan. Afterward, you can layer in other tools that you’re comfortable deploying, involving your brokers and advisers in the process to help build a robust plan.
Bridging the valley
It’s important to note that a price risk management strategy is not a profit maximization strategy. You may not be able to take full advantage of market peaks because of the costs involved in transferring the risk – whether it’s paying an option premium or the cost of an insurance premium to buy Dairy Revenue Protection.
Milk prices go through peaks and valleys, and the risks for your business reside in the valleys. Price risk management programs are designed to help you build a bridge across the valley. If you’re in a leveraged position with tight working capital, you need to be more aggressive in your price risk management strategy.
Doing nothing is a popular strategy, but that increases your risk exposure in normal times, let alone during a pandemic that’s disrupted global markets and supply chains. And that’s the point: You never know when a black swan event like a pandemic will occur.
After the initial COVID-19 shock, milk prices rallied significantly, so this is the time to make decisions that could impact your operation later this year and early 2021. You can’t do anything about where you are now, or even next month. Price risk management is about looking forward. Understanding the tools available is the first step.
Note: The opinions, estimates and projections, if any, contained in this article are those of the author. 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 that are accurate and complete. However, the author 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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