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September 2012 Archive for Know Your Market

RSS By: Dairy Today: Know Your Market, Dairy Today

Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Know Your Cost of Production Before You Make Marketing Decisions

Sep 27, 2012

This important measurement can create a base selling price for your risk management practices.

Kristen SchulteBy Kristen Schulte, Iowa State University Extension Farm and Agribusiness Management Specialist

Dairy profitability outlook has gained positive ground recently, with futures milk prices holding and commodity feed prices receding from market highs. Milk prices continue to move based on several factors, including an anticipated decrease in domestic supply over the next year due to the number of cows culled in recent months and the anticipated number in coming months.

In contrast, commodity feed futures prices have subsided since harvest has started across the Corn Belt.

Implementing risk management practices -- including futures, options or contracts -- can increase the level of price certainty and secure a profit margin. With continued volatility in the milk futures market, the question of where to buy and sell in the market is often one of the most important questions to ask and calculate prior to entering the market.

One cannot operate a business at a loss for an extended period of time without creating long-term negative financial impacts. Therefore, it is important for producers to be aware of their cost of production (COP) per hundredweight (cwt.) when implementing risk management practices. COP allows a producer to evaluate the breakeven value for production, which can create a base price to sell at and ensure a profit when selling the commodity. COP is one of several measures producers can use to make marketing decisions.

COP allocates the dollar value it takes to produce one commodity unit. For milk production, COP is measured per cwt. of milk produced. To calculate COP, total expenses are divided by total number of cwt. of milk shipped. Expenses included in COP are variable, fixed and labor and management costs.

Variable costs include feed, hauling, marketing, supplies, transportation, utilities and veterinary costs. Fixed costs include depreciation, interest, repairs, taxes, and insurance on facilities and equipment used for the dairy operation. Cost for labor and management is for all labor, paid and unpaid, for the dairy operation. When measuring COP, one should include all costs for the dairy enterprise, including associated cost or value for homegrown feed and heifer replacements. Additionally, accrual adjustments should be included with total costs to adequately measure costs against associated production in a given time frame. Total costs then can be calculated and divided by the total cwt. of milk shipped for a given time frame.

This measure varies between regions of the U.S. and between farms, based on several factors, including feed availability, facility value and associated overhead cost, and level of milk production. Current measures for COP range from $17 to over $24 per cwt. of milk. This range also includes variability in types of management.

COP should be recalculated when making marketing decisions to ensure a positive profit margin. It can be calculated for any given time frame, depending on the comparative analysis being performed. For historical measures, calculation on an annual or quarterly basis may be sufficient for financial analysis and management. For projected profit measures and marketing, however, one may want to measure COP on a shorter time frame, such as on a monthly or quarterly basis, depending on the change of input costs, such as feed purchased and variability in milk production.

Once COP is determined, a producer can evaluate where he or she can enter and exit the commodity markets to reduce price risk and secure a positive profit margin. Managing margins and determining COP are not new concepts for producers, but with futures prices as moving targets, continuous analysis of COP and related profit margins are important to monitor to remain in a positive financial position.

Kristen Schulte is an Iowa State University Extension farm and agribusiness management specialist. She can be reached at 563-547-3001or

Additional Thoughts: Strategies to Manage Your Finances

ron mortensen photo 11 05   CopyBy Ron Mortensen, Dairy Gross Margin, LLC and Advantage Ag Strategies, Ltd.

What to do next? Cost of production, margins, cash flow, balance sheet and just plain managing the checkbook have become an issue. The problem is that this squeeze on profitability has come after the big losses in 2009. The second “squeeze” event is usually the one that causes the big financial issues. That is where we are all at today.

As part of your cash-flow plan or managing your checkbook, here are a few simple strategies:

1. Look at buying puts for the milk and buying corn calls. What does it do? It gives you a minimum amount of cash flow for the milk and leaves the top open. The corn calls will give you a maximum value for your corn. If corn rallies back, you will have value in the options to go buy physical corn. These will need to be paid for upfront, unless your local cooperative or processor will carry the positions.

2. Start looking at the Livestock Gross Margin for Dairy (LGM-Dairy) program that will be available on Oct 26, 2012. Why? It will give you very similar results to Strategy 1, but the bill will not be payable until Oct 1, 2013. The LGM-Dairy will give you a guaranteed margin between milk and feed (corn and soybean meal). One difference is LGM-Dairy uses a weighted average of all of the insured months when calculating gains and losses. Along with the subsidy, this is one of the reasons for the lower premium (versus puts and call options).

People always ask me what they should wish for if they do either of these strategies. You wish for milk to go up and feed to go down. If your wish does not come true, and milk goes down and feed goes up, you will have protection and cash flow.

Ron Mortensen is a principal of Dairy Gross Margin, LLC and president of Advantage Ag Strategies, Ltd., a commodity advisory firm. Email him at


Livestock Gross Margin for Dairy: Pros and Cons

Sep 24, 2012

While this insurance program benefits producers because it helps protect against both milk and feed price volatility, its availability and inflexibility can be problems.

Katie Krupa photoBy Katie Krupa, Rice Dairy

October will start a new year for the government’s Livestock Gross Margin Insurance Program for Dairy (LGM). With the reoffering of the program, many producers want to know if they should purchase LGM, how much coverage they should obtain, and for what timeline. Every producer and business is different, so there is no simple answer, but here are some things to consider.

What is LGM? Simply put, LGM insures producers against a decline in the margin between the Class III milk price and the feed costs (which are corn and soybean meal). The program calculates the margin based on the trading prices of those three commodities on the Chicago Mercantile Exchange, and the actual USDA settlement prices. So, in other words, the insurance is not based on your actual feed costs or milk price. This program is beneficial to producers because it helps protect against both milk and feed price volatility.

Some pros of the program:

• Premium payment due at end. Since this program is insurance, there is a premium payment that producers have to pay to get the coverage. But unlike most insurance, the premium payment is due at the end of the coverage period. That means the premium amount is not tied up but is free to be used on the business until the insurance period has ended.

• Contract size. Producers can insure as little as one cwt. of milk, and the corresponding feed per month. That makes this program a great risk management strategy for smaller producers.

• Doesn’t limit upside potential. Because this is insurance against the margin decreasing, if the margin should increase, you will benefit from that higher margin. The program does not limit upside potential, but you will always have to pay the insurance premium.

Some cons of the program:

• Availability. This has been a big problem in the past year. Firstly, the program is only offered one day per month. Secondly, when the government’s funding runs out (which it did last year), the program is not offered until the new insurance year begins, or they allocate more funds to the program. It is important to note that with a new farm bill and possibly new dairy policies on the horizon, the future availability of LGM is uncertain.

• Not flexible. Unlike hedging on the exchange, once you purchase LGM coverage, you cannot adjust the insurance you already purchased or exit the program.

• Payments made at the end of the insured period. Any possible payments are made at the end of the insured period. So if you insured January–June, and a payment was due, you would not receive any payment until all prices settle for the month of June.

• Settlement based on all months, not each month insured. Unlike hedging on the exchange or with your cooperative or milk plant, possible payments are calculated from the average of all insured months, not each month individually. So if you insure January–June, the payment due is calculated by taking the insured margin and subtracting the January–June average margin. For example, if the margin is low for the first three months, but then recovers so that the average is above the insured margin, no payment would be due. That means your business can experience a cash flow crunch but no payment would be received.

Some thoughts for purchasing LGM:

Think about your cash availability and use this to help insure some of your production for further out months. That enables you to protect your margin without tying up funds. You can then use those funds for shorter-term hedges with a broker.

Since payment is based on the average of all insured months, think about breaking up your coverage to about three months at a time. For example, insure April–June, then later you can purchase another policy for July–September, if you desire.

Risk management does not, and usually should not, need to be a one-size-fits-all solution. LGM should be analyzed as part of your diversified risk management strategy that benefits and protects your business.

Katie Krupa is the Director of Producer Services 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 There is risk of loss trading commodity futures and options. Past results are not indicative of future results.

Is Now the Time for a Three-Way Collar?

Sep 17, 2012

This option hedging strategy is preferred when Class III milk futures are in the upper portion of their historical range.

Carl BablerBy Carl Babler, Atten Babler Commodities

Dairymen who have continued along the milk risk management learning curve have added the three-way collar option strategy to their marketing toolbox. This producer strategy involves the purchase of a put option along with the simultaneous selling of both an “out of the money” call option and put option.

Dairy Producer Three-way Collar example (with Oct ’12 – Mar ’13 Class III trading $19.25):
• Sell the $21.00 call
• Buy $18.50 put
• Sell $16.50 put

So, what’s the story with a three-way option collar? In essence, three-way collars provide producers with a lower premium cost due to the sale of the further out-of-the-money options. However, as usual, there is no free lunch. Thus, this strategy has both an upside price limit (at the price level of the sold call) and a downside hedge protection limit (at the level of the sold put).

In exchange for reducing the cost of the strategy by selling the out-of-the-money put and call, the producer is also taking on additional risks. These risks include:

1) The risk that prices could go lower than the out-of-the-money-sold put option; and
2) The risk that prices could go above the sold call.

Declining price activity could result in a producer’s downside milk price hedge coverage being capped out or limited, while increasing prices could result in margin calls and a producer’s upside participation being limited.

The three-way collar strategy embraces the minimum price philosophy appropriate for milk hedging. Over time, the milk price distribution has shown the value of not fixing or capping out price opportunity with a given strategy. It is preferred to employ a strategy that will allow the producer to benefit from higher milk price opportunities if they unfold during the term of the hedge. Producers are finding it more applicable to use straight purchased puts or fence strategies (i.e., buy a put and sell an out-of-the-money call) for their milk price risk management actions in lieu of sold futures and fixed price cash contracts. For these producers, the three-way collar is a natural additional strategy alternative to be considered since it leaves room for upside price participation up to the level of the sold call.

The three-way collar has some pronounced differences when compared to using a long put or fence strategy. These differences can be observed by reviewing recent option premium quote examples for these three alternate marketing tactics.

For example, let us assume a dairy producer wishes to establish a Class III Milk price floor for expected production for the period of time from Oct ‘12 thru March ‘13. The average Class III Milk futures price for this period is $19.25. The producer wishes to compare his option strategy choices:

• Buy a straight $18.00 put for $.40/cwt. premium

     - Result: Hedged $1.25 below the market (less the premium and transaction cost), no price cap or downside hedge protection limit, no margin call obligation.

• Buy $18.50 put / Sell $21.00 call “Fence” strategy for $.23 cwt. premium
     - Result: Hedged $.75 below the market (less the premium and transaction cost), capped out at prices above $21.00, no downside hedge protection limit, margin call obligation on the sold $21.00 call.

• Buy a Three-Way Collar - Sell $16.50 put/Buy $18.50 put/Sell $21.00 call for a net premium of $.11/cwt. 
     - Result: Hedged $.75 below the market (less the premium and transaction cost), capped out at prices above $21.00, downside hedge protection limit at the $16.50 put. The long $18.50 puts will cover the margin call potential of the short $16.50 puts. Thus, the only margin call potential is on the sold $21.00 call.

Those using the three-way collar have found it useful when there is a longer period of time involved in the position. Selling a time premium of two options is advantageous in mitigating a portion of the time-related premium cost of the desired purchased put.

The three-way collar strategy is preferred when Class III milk futures are in the upper portion of their historical range, as is the current $19.25 futures average for Oct ‘12 thru March ‘13 relative to the historical high Class III announcement of $21.76.

Time also may allow the holder of the three-way collar to buy back one or both of the sold options during the term of the hedge as futures prices move. The offset of the sold call options thus removes the cap and margin call obligations while the offset of the sold put would remove the limitations on the downside hedge participation.

The ability to manage the risk and limitations of the position should be considered a positive feature of the strategy. The margin obligation is the same as the fence strategy and requires the producer to have a dedicated line of credit to fund the position to term regardless of the amount of margin called for. Liquidating the three-way collar for margin-call reasons may incur substantial premium loss due to sold option premium volatility.

When looking at the above strategy choices, individual producers should make their selection based on profitability, price level, premium cost, the price limitations and the margin obligations. Those producers that have an understanding of various hedge strategies will be best positioned to make a strategy selection that fits their hedge objectives risk tolerance and financing capacity.

Risk in purchasing options is the option premium paid plus commissions and fees. Selling futures and/or options leaves you vulnerable to unlimited risk. Transaction cost used throughout this report includes both commissions and fees. Atten Babler Commodities LLC uses sources that it believes to be reliable, but it cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. Unless otherwise stated, the information contained herein is meant for educational purposes only and is not a solicitation to buy futures or options. The author of this piece currently hedges for his own account and has financial interest in the following derivative products mentioned within: Class III milk.

Carl Babler is a principal with Atten Babler Commodities of Galena, Ill. Contact him at or 877-259-6087.

Actively Manage Your Market Positions into 2013

Sep 07, 2012

History has shown that when feed prices are highest and the feed outlook is most uncertain, we also see some of the best selling opportunities in the milk market.

Stewart Peterson   Mark LudtkeBy Mark Ludtke, Stewart-Peterson

The last few weeks have been offering opportunities to price milk for 2013. Did you take advantage of the opportunity and make some incremental sales? As I visit with producers from around the country, after we’re done lamenting about the 2012 crop and feed prices, this is the question I ask.

Here is a common response I get from those who are not hedging milk: “I’m not seeing the margin I want, so I’m not going to make a sale yet.”

Indeed, in a high-feed-price environment, as you look out beyond the nearby months, there may be no attractive margin to be had. My fear is that the dairy industry has placed such an emphasis on protecting margins that we are failing to recognize the opportunities that each market offers, independent of one another.

Allow me to make the case for making some incremental milk sales now, and then managing those positions in an active, ongoing way into 2013.

On Sept. 4, March 2013 Class III milk closed at $19.20 per cwt., and March corn futures closed at $7.95 per bu. Even at these prices, many producers are reluctant to hedge milk because they believe that corn will push higher and subsequently push milk prices higher. The problem is that, even if corn prices do head higher and do result in higher milk prices, there is no guarantee that the milk price will increase enough to improve margin, or even maintain what-if-any margin a producer may see today. And so, at what price level do you jump in and get started?

What we do know for sure is that milk at $19.20 is relatively high historically, and we should see this as an opportunity to price some of our production. History has shown that when feed prices are the highest and the feed outlook is most uncertain, we also see some of the best selling opportunities in the milk market.

Once we establish a position, we can then, with the variety of hedging tools available, actively manage that milk position and either continue to protect it or take advantage of even higher prices if they occur. It’s not a “price it and forget it” proposition. It’s like most other things on the dairy – intensively managed.

It’s like this: You put corn silage into the bunker once a year. You test it and calculate your ration and plan for other supplemental feed purchases. But you don’t test it once and forget it. You continue to monitor it, test it, and make sure you are using that corn silage to the best of its ability. That’s because the nutritional profile of that silage is constantly changing, and you can’t feed it for the rest of the year the same way you did on the day you put it in the bunker.

So it is with managing your market positions. You have to start somewhere, and almost never is it a “price-it-and-forget-it” proposition. The market is offering bright spots with opportunities to price milk.

If I walk away from it, I will never have any opportunity to widen my margin. If I actively manage it, I can look for opportunities on both the milk and the feed side, and make decisions that can effectively widen my margin over time.

If you are attending the upcoming World Dairy Expo in Madison, Wis., I look forward to discussing your 2013 marketing choices and opportunities. Please look us up in the Exhibit Hall and come have one of the famous Badger Dairy Club grilled cheese sandwiches on us.

Mark Ludtke consults with dairy producers nationwide concerning their choices for risk and opportunity management. He can be reached by calling 855.334.0700 or at

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 2012 Stewart-Peterson Inc. All rights reserved.

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