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

Hedge Lines for Futures Financing: A Smart Move for Banks, Dairies

Jul 29, 2010

By Jon Spainhour, Rice Dairy

During the last few months, we have discussed the different hedging alternatives that dairy producers can use to help protect their bottom lines from adverse moves in their variable input and output prices. 

 

Producers can “sell” fixed priced contracts called futures to contract their milk price. They can also purchase insurance contracts called puts to establish minimum prices for the milk check. Their input prices for corn and soymeal can also be contracted by “buying” fixed price futures contracts. Calls are insurance contracts that be purchased to ensure a maximum cost price for these inputs.

 

After spending some time studying these concepts, many dairy producers conclude that these risk management tools are a fairly easy concept to understand and that they can have great value toward the ongoing profitability of their operations. 

 

The next step for them is to find a broker whom they feel comfortable with, and then open an account with them. It’s good to work with that broker to establish execution strategies based on breakeven analysis and risk tolerance levels.  Every dairy operation will be different, so it is important to spend a good deal of time on these two points. 

 

At this point, one of the last concepts to tackle is the amount of capital that a dairy can deploy toward its risk management strategy. Every futures account is required to carry a minimum deposit balance based on the amount of contracts hedged. This minimum balance is called the “margin” amount. 

 

Each Class III contract that a producer sells requires a minimum deposit of $1,300.  This minimum must be maintained even if the market moves higher. For example, a producer who sells one September Class III contract at $15.00/cwt. is required to deposit $1,300 in his account.  If the futures market moves lower, his futures account will reflect the gains on the contract and will have excess money in it. 

 

However, if the futures market moves to $15.50, his account will reflect a $1,000 loss. To remain contracted, he will need to deposit an additional $1,000 to bring his account back to current status. 

 

While everyone wants to call the top of the market every time and never have to worry about margin calls, that’s not likely to be a reality. Producers who use futures and options as part of their risk management strategy should be fully prepared to add money to their account and be able to do so in a very prompt fashion. 

 

For some, having a sizeable amount of cash to finance their futures position is not a problem. For others, having to send cash off the farm to Chicago at a moment’s notice is something they simply can’t afford, even if they see they true value in hedging.

Over the course of the last two years, I can’t tell you how many producers have told us they want to hedge but simply can’t afford the risk of having to make a sizeable margin call. In many of those cases, the market proceeded to move lower, proving to be a missed opportunity, resulting in a lower net milk check than what could have been established with futures. 

 

It is my opinion that the majority of the dairy producers we work with are in that very same state of affairs right now. They would like to hedge at these current futures levels, as they can ensure some of the better profitability in over three years, but they don’t have the cash to support that decision. 

 

It is also my opinion that this shouldn’t be the case. Midwest grain producers wrestled with this issue long ago and convinced their banks to issue them a funding stream called “hedge line of credit” to facilitate these types of transactions.

 

These hedge lines are used solely for the purposes of financing a futures and options position and can’t be used for other purposes like paying the labor bill. They alleviate the capital requirements for producers and allow them to focus solely on managing their risk from a profitability and risk-tolerance point of view. 

 

Since risk management in the dairy industry is a fairly new strategy, these lines of credit exist in dairy but are not prevalent. I believe this shouldn’t be the case. Banks should be willing to write these hedge lines for dairy producers as well as grain producers.  By doing so, they are not only helping their dairymen protect their bottom line, but they are also helping to protect the bank’s bottom line as well. 

 

A dairy producer’s risk is ultimately the bank’s risk as well, and both parties should be pushing to make hedge lines of credit an easily accessible tool that can help alleviate that risk.   

 

Jon Spainhour is a broker/trader 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 Spainhour at jcs@ricedairy.com.Visit www.ricedairy.com.

 

 

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