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Class III Futures Are For More than Just Class III Milk

Dec 09, 2011

As producers complete farm budgets for 2012, proactive marketing strategies can not only defend but help achieve goals. There are Class III hedging opportunities for all producers, regardless of location and utilization.

S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson
‘Tis the season! The holidays are a wonderful time of the year full of family, friends, Christmas cookies, and New Year’s resolutions. There’s also something that’s likely on your to-do list that is not as warm and exciting as the holiday trimmings: completing the farm budget for the coming year.
Many of our clients have been sharing their cost of production results as an important component of their risk management planning. Moreover, our team has made a point to ask our clients what goals the operation has for 2012, both financially and otherwise. This is where designing marketing strategies becomes fun—when you’re not just looking to defend a breakeven price, but designing and implement a strategy to achieve the goals that allow the operation to thrive.
In our eyes, this is the most moving reason to pursue a strategic marketing approach: to control your own destiny in 2012. The concerns about milk prices in 2012 have been well discussed in the news, and the bottom line is that even the best forecaster doesn’t know for sure what will happen. 
However, we can review today’s futures prices and determine what these values mean for your situation. We can even go a step further and analyze how changes in these prices would impact reaching your goals. These are important steps if you want to control your destiny. These steps put you in the driver’s seat, rather than always guessing what might happen and trying to react.
How to get it done
Now that I’ve given you the philosophy, let’s discuss how to do the analysis.
To achieve an understanding of how milk futures prices impact your situation, it is necessary to assess how your cash or “mailbox” milk price compares to the announced Class III value. This is the starting point in formulating a marketing strategy. 
Here’s a question we get all the time: “What if I don’t produce a majority of Class III milk, is it appropriate to use Class III futures?” 
The actual Class utilization for your milk is not important in this calculation. We are simply after the average difference between your milk price and Class III price, commonly referred to as the “basis.” So, it doesn’t matter whether you produce Class III milk or Class I milk. The correlation still works. Here’s an example: 
The All-Milk Price represents a weighted average of “mailbox” prices dairy processors paid in a given month for all grade A and grade B milk. These monthly prices from the past 10 years are graphed on the chart below, along with the Class III announced prices over the same time frame. 
Schalla   USDA All Milk Price and Class III Price 12 11 
With a simple eye-ball test, it is easy to see how closely these prices are related, and with some basic statistics, we can confirm this observation. If you are a wonky analyst like me, it is easy to calculate a correlation coefficient and illustrate, when you know the change of one variable (like Class III milk price), how accurately you can project what the change will be in a second variable (such as the All-Milk Price).
The relationship or correlation between the two variables is scored on a scale of -1.00 to +1.00. A score of greater than +0.50 or less than -0.50 in most applications is considered a strong correlation (with zero meaning no relationship can be concluded).  
In our example with milk price, the correlation coefficient analysis between Class III prices and All-Milk Prices returns a score of +0.9676, confirming that there is a direct and very strong correlation between the two prices. If the Class III price is changing, it should be possible to project the related change in the All-Milk Price. While very strong, the correlation is not perfect and, in occasional circumstances, the changes between the two prices will not be exact. However, for a consistent, long-term milk marketer, this should not be a material issue.
This analysis illustrates why it is not necessary to produce Class III milk to use Class III futures. We’ve done this same study for individual farms across the country, and results demonstrate the strong correlation every time. Then, we just need to understand the typical “basis,” or difference between your mailbox price and the Class III price. 
Referring back to the chart above, we can calculate the basis of the All-Milk Price by subtracting the Class III price for each respective month. Over the past ten years, the All-Milk price has averaged $1.31/cwt. over the Class III price, or in other words, the All-Milk Price has a positive average basis of $1.31/cwt. This is the critical first piece of information needed when working to understand how Class III hedging strategies relate to your milk price and reaching your operations goals.  
The Class IV Futures
It’s also noteworthy that Class IV Milk futures are available along with Class III futures. It makes logical sense that hedging Class IV production with Class IV futures would be superior to using Class III futures. The very low volume of trade in the Class IV market, however, can present additional challenges. 
To put this in perspective as we work through our 2012 marketing strategies, the table below lists the Class III and Class IV futures contract and their respective Open Interest in early December. Open Interest is the total number of contracts outstanding, or being held, by all market participants. As you can see, the Class III total open interest is over 14 times that of the Class IV futures.    
Schalla   Milk Futures Open Interest 12 11               
Low volume does not make it impossible to use the Class IV market. It does mean that users will have to use extra patience when working to get their orders done, or be willing to give in on price more to get orders done, and repeat the process in the need or desire to exit the position prior to expiration. 
Using the same correlation coefficient analysis demonstrated above, Class III and Class IV prices score +0.8596, illustrating the direct and very strong relationship between the two prices. While not a perfect correlation, we place a high value on the ability to efficiently enter and exit hedging positions in a volatile and fast changing marketplace. Thus, in almost all cases, we recommend producers, particularly producers new to using these tools, utilize the Class III futures to achieve the optimal results. 
In short, there are Class III hedging opportunities for all producers regardless of location and Class utilization.
·                     The first step is to find your average basis relative to the Class III price.
·                     Armed with this number, design your strategies and test the scenarios of different prices changes that could take place during the coming year. This is a process and requires a time commitment, but the satisfaction of meeting your goals makes it well worth the investment.
·                     Of course, if you’re not comfortable with tackling this process yourself, or simply do not have the time, find a trusted advisor who will learn the details of your goals not only for the next year, but for the long run, to form a successful relationship.
Happy Holidays from the entire Stewart-Peterson family. May the potential of 2012 be fruitful, bearing happiness and success!
Steven Schalla is a Market Advisor for Stewart-Peterson, Inc. He can be reached at 800.334.9779 or
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 2011 Stewart-Peterson Inc. All rights reserved.
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