“Expect Volatility.” What Does That Mean?
Jan 03, 2011
By Steven Schalla, Stewart-Peterson
“Expect milk price volatility.” Are you getting sick of this line yet? In the discussion of milk prices, whether it’s in a printed article, with a speaker or in conversation with your neighbor, I can just about assure you that price volatility is one of the first topics. However, I personally find the phrase, “expect volatility” to be a vague statement. It’s similar to saying something like, “It’s going to snow.”
An inch? A foot? It makes a big difference, especially in how you prepare and plan for such weather.
Many dairies I work with continue to put together their 2011 budgets and have asked me what to plug in for a milk price. The simple answer is the price that the Class III futures are trading, since, based on everything we know today, that is the price that milk buyers and sellers can agree on. However, using some basic historical analysis, we can see that it is not very likely that the prices on the board today, even as close as six months away, will actually materialize.
Of course, any time we use historical data it is important to recognize that what happens in the future is seldom a carbon-copy of history. We can use history as a guide, however, as to “how much” volatility to expect.
Six months from now, June 2011 will be the front month milk contract. On Dec. 15, 2010, the closing price for that contract was $14.62. Looking back over the previous 10 years, what type of change from that price could we expect between mid-December and the actual June milk price? The results are pretty interesting.
Since 2001, in five of those years, the June price rallied, and in five of those years, the price declined. On average, the change was a gain of 94 cents/cwt. However, this average is misleading, and here’s where volatility really comes into play. In eight of the past 10 years, the final price was at least $2.00/cwt. different than in December of the previous year. In fact, in years when prices rallied, the average gain was $4.25/cwt., while in years when prices declined the average loss was $2.35/cwt.
Needless to say, these are sizable changes. What this discrepancy shows us is that small and unpredictable changes in the supply/demand balance, both domestically and globally, can have a dramatic impact on your mailbox price. (Economists call this “Price Elasticity”--the analysis of changes in supply or demand relative to price.)
This is not to say the prices that appear on the board of trade are unreliable. As we mentioned, market participants are using the best information available today to arrive at a fair price. As milk hedgers, the marketplace gives you the opportunity to move risk away from your price instead of seeing the big changes.
So, if recent history suggests that prices could move $2.00/cwt. from $14.62, do we actually think that both $12.62 and $16.62 are potential final prices for June 2011? Absolutely. In either case, the right series of fortunate or unfortunate events needs to take place, and each of us may have a different opinion of which is more likely to play out.
What to do now?
Preparing for uncertain weather—such as how much snow or rain we will get—offers a good analogy to preparing for uncertain markets. In that light, a British adventurer once said, “There is no such thing as bad weather, only inappropriate clothing.”
In other words, if you are prepared for the weather, you’ll weather it better.
Similarly, our advice to clients is not to judge the good or bad of what is happening in the market, or try to predict it. Rather, always have your operation prepared for both scenarios:
· If prices continue to trend up, you’ll use Plan A. We see $16.42 (or generally higher prices) for next year if exports can continue to be strong and domestic cheese inventory growth remains at a moderate pace.
· If prices start to trend down, then use Plan B. Milk-per-cow has been very strong over the last year, and a moderate increase in cow numbers could result in heavy milk production growth, resulting in slumping prices.
These plans can be as simple or complex as you’re comfortable with, based on the tools in your marketing toolbox.
From everyone at Stewart-Peterson, we’d like to wish a Happy New Year to you and your family. While the past several years have been challenging to those in the dairy industry, we’d like to wish your operation the best success in 2011. As for our forecast: Expect volatility. And be appropriately prepared.
The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2010 Stewart-Peterson Inc. All rights reserved.