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

How Far into the Future Should You Hedge Your Milk Price?

Apr 09, 2012

It all depends on one other major component of your dairy operation.

Katie Krupa photoBy Katie Krupa, Rice Dairy
I am frequently asked, “How far into the future should I hedge my milk price?” Although there is no simple answer for everyone, my answer is typically longer than they think.
Historically, most people would hedge their milk price for three to nine months, but I would be willing to hedge for a longer time period with one caveat: Hedge your feed prices along with your milk price.
Recently there has been a strong focus on the milk-feed margin, and it has been for good reason. Since the recent low in February 2009 to the most recent high in August 2011, the variation in the milk and major feed prices has been drastic. Regardless of which formula you analyze for the milk-feed margin, you will notice a significant difference between 2009 and 2011.
The one thing that has remained relatively steady for each month is that there was, at some point in time, an opportunity to hedge a decent margin for each month. Keeping in mind that farm financials are drastically different, I use the historical average margin as a benchmark (which is currently around $9.70 for the past five years). Using the average is effective on a broad scale because we are taking into account the change in milk price and the change in feed price, which is typically the biggest variable for input costs.

 
Class III Milk
Corn
Soybean Meal
February 2009
$9.31
$3.87
$293.28
August 2001
$21.67
$6.88
$349.60
Percent Change
133 %
78%
19%

 
 
 
 
Class III milk futures trade on the Chicago Mercantile Exchange for roughly 24 months before the contract settles, and typically corn and soybean meal futures trade even longer. Therefore, we can look at where that margin has traded for 24 months before the contract settles. It is important to note that although a contract may trade for 24 months, the first several months the contract is available the interest may be so small that it is not feasible to get a trade done at the price listed.
In the graph, I have the historical trade margin for February 2009 – that is, milk minus a specific amount of corn and specific amount of soybean meal. Again, every milk-feed margin contract is different, but the underlying concept and subsequent price variation is similar. As the graph shows, the opportunity to hedge a margin above $8.00/cwt. existed until December 2008, and most of those months the margin traded above $9.00/cwt.
I show the graph for February 2009 because that was the worst month in recent history for the milk price and the milk-feed margin. There are many other months like February 2009, where the opportunity to hedge a higher price existed, and there are months where the margin increased consistently until settlement, meaning that any hedges placed would have resulted in a loss of upside opportunity.
 Krupa   Feb09 MarginTradeData 4 9 12
My point in showing you this graph is to challenge your ideas on when to hedge your milk price. Your decision on how far out to hedge should not be based on the milk price being at $15, $20, or even $25/cwt., but it should be based on the milk-feed margin being at a profitable level for your farm. And when you are hedging your milk, be sure to hedge your feed risk as well. You would not be hedging if you leave one side of the milk-feed equation unhedged.
Depending on the producer and his or her ability to hedge feed, I am comfortable hedging milk 12-18 months (longer if there is a market for those months furthest out) into the future as long as their feed risk is protected. If you consistently hedge a profitable milk-feed margin, undoubtedly there will be times when you miss out on some higher prices, but you will be protected when the margin declines, and you will be returning a consistent profit.
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. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at klk@ricedairy.com. Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.
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