Know Your Market
2014: What a Year It Can Be!
May 01, 2014
While this year’s January-to-June stretch will prove fantastic for dairy producers, it’s important to focus time and money on protecting yourselves for July to December. Here’s simple advice for milk and feed price protection.
By Katie Krupa, Rice Dairy
We have closed out the first third of 2014, and milk prices reached record high levels. As we move further into spring, many producers look to the fields wondering if the summer will bring more good fortune. While we all wish for only good things, the list of possibilities is endless: drought, floods, record high heat, damaging storms, high milk production, low milk production, etc. So what is a producer to do? Here are some of my thoughts on protecting yourself for the remainder of the year.
The Class III milk price for the first third of 2014 was a record high average of $23.04 per cwt., and the average for the first half of 2014, based on current Chicago Mercantile Exchange (CME) futures prices, is $22.66. If the prices for May and June settle at or around current trading prices, that will be a record-high Class III milk price for any six-month period. My point in showing you these numbers is to point out that the first half of 2014 will be fantastic, with little opportunity for a drastic downturn for the January-June average. Therefore, I recommend producers focus their time and money on protecting themselves for July-December.
Protect your milk price
After coming off of these record high prices, I understand many producers are hesitant to hedge July-December because the current futures price of $19.54 is much lower than the first half of the year (January-June average of $22.66). The "Why would I hedge prices so much lower than the current price I am receiving" mentality kicks in, and many producers remain in the cash market. The problem with that mentality is that today’s high prices are in no way a guarantee of higher prices in the future. As we know from experience the dairy market can be fragile and drop quickly.
A simple hedging strategy that I really like in today’s market is simply buying put options to protect your milk price. The nice thing about buying put options is that you are able to protect the downside of the market but not limit the upside potential of the market. Currently the premium cost for an $18.00 Class III put option for July-December is about 50 cents per hundredweight, and the $18.00 Class IV put option is about 30 cents. I am encouraging many producers I work with to simply buy put options for the remainder of the year for up to 100% of their production because the net hedge price meets or exceeds their expected cost of production for July-December.
Let’s walk through a quick example, assuming you purchase the Class III $18.00 puts for a total cost of 50 cents per hundredweight. Given the Class III average for the first half of the year at $22.66 (based on current CME futures) let’s assume that the milk price drops drastically for the second half of the year. Regardless of how low the price goes, your lowest price for July-December will be $17.50 ($18.00 put option - $0.50 cost). That equates to an annual Class III average of just over $20.00. That would be the highest 12-month average in the Class III market – and because you purchased put options, if the price should remain high, you will benefit from the higher prices (less your 50 cent cost).
If you need a higher net price than the $17.50 discussed above, then you will have to review different strategies such as selling futures, or utilizing a risk reversal (min/max) to get a higher net floor price. The potential disadvantage of those strategies is that you are limiting your upside potential. If that is necessary for your financials, I often recommend this type of strategy so that your business can be profitable. But given the current high prices, if you can get a level of protection that satisfies your business’s needs without limiting your upside, I would keep the upside open.
Protect your feed price
Do you know what the weather will be in July? Me neither. In fact, no one does. So hedge your feed price along with your milk price so you do not get stuck paying extremely high feed prices. And if you grow a large portion of your feed needs, you may still need to hedge some to cover what crop insurance would not if there was a loss.
I don’t make blanket statements about hedging because all producers are different and their needs are diverse. With that being said, there has never been another time when I thought producers should hedge to this extent to take advantage of the current market prices. You have the opportunity to protect a record high price for 2014, and still leave the upside open. As always, do what is best for your unique business and don’t overlook your feed risks.
Katie Krupa is a broker with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. You can reach Katie at firstname.lastname@example.org or 312-492-4195.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.