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Know Your Market

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The Fixed-Price Contract Can Foretell Your Milk Price

Apr 12, 2010

By Jon Spainhour, Rice Dairy

 

Many dairy producers have begun to change their attitude toward risk management tools like futures and options.

While they once viewed these tools as a form of gambling, producers are changing their minds. Many now see them as a sound business practice that will help them survive the ever-increasing volatility in the price of dairy products. 

 

One such tool is the fixed-priced contract, more commonly referred to as a “futures” contract. This is nothing more than an agreement to buy or sell something at a specific price, at a specific time, in the future. 

 

In the dairy complex at the Chicago Mercantile Exchange, we predominately trade Class III milk. The contract size is 200,000 pounds. There is a contract on every month for 24 months in the future.

This means that as dairy producer, I can agree to contract my milk today at a specific price, for as little as one month in the future and as many as 24 months in the future, in 200,000-pound increments. The price that I choose to contract that milk at is a price that is decided on the open market. 

 

Let’s assume, for example, that a dairy producer creates an average of 1 million pounds of milk every month, or an equivalent of five Class III contracts (1 million pounds/ 200,000 pounds). He would like hedge his expected production today, for only the July 2010 time period. The futures contracts for July are trading at $14.25/cwt.

He agrees to sell his five contracts worth of milk at those levels. This means that during the middle of April, he knows that the price that he will receive for his 1 million pounds of milk in July will be $14.25/cwt., regardless of what happens to the spot price of milk between now and July.

 

Let’s use two scenarios. In the first, the price of milk is below $14.25/cwt. We’ll assume that the Class III price for July was $12.00/cwt. For the second scenario, the price is below $14.25/cwt. at the end of July.

 

First scenario: While the mailbox check that he will receive will only be $12.00, his futures account will have contracts in it that he sold at $14.25. This means that his futures account will have $2.25/cwt. worth of profit of in it for each of his five contracts that can apply toward his low milk check. Between his $12.00 mailbox check and his $2.25/cwt. futures profit, his net milk check is $14.25/cwt.

 

Second scenario: The flip side of this discussion is the case where the mailbox check comes in higher than the Class III contracts that were sold at $14.25/cwt.

If the price of milk in July were to come in at $17.00/cwt, the dairyman would receive a mailbox check of $17.00/cwt. Because he agreed to sell his milk at $14.25 on the futures market, however, he will have $2.75/cwt. worth of losses in his futures account. When he applies those losses to his milk check, his net price is $14.25/cwt.

 

In either case, his net price for his milk production in July was $14.25/cwt. This means that in the middle of April, this dairyman knew the price he was going to receive for his milk in July would be $14.25, regardless of what happened to the spot price of milk. 

 

That is the nature of a fixed-price, or futures, contract.

 

Look for “Know Your Market” in the May 11 issue of Dairy Today eUpdate, when I will discuss contracts that act more like insurance, guaranteeing a minimum milk price while leaving the potential for much higher prices. Those contracts are called “options,” and I hope you will join me for that discussion. 

 

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.

 

 

This column is part of the Dairy Today eUpdate newsletter, which is delivered free to your inbox every Tuesday morning. Dairy Today eUpdate provides the latest in dairy markets, policy, management and production, and news. Click here to sign up.

 

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