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Know Your Market

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

Is Now the Time to Hedge?

Jun 04, 2012

3 steps to help you decide.

Katie Krupa photoBy Katie Krupa, Rice Dairy
 
Since milk prices have been improving in recent weeks, many producers have been asking if now is the right time to hedge. Unfortunately, there is no quick and universal answer to this question. There are several things to consider when looking at current hedging opportunities to know if it is a good time for you to hedge.
 
Below are some steps to walk through to help know if now is a good time to hedge.
 
Is your equity position strong enough to weather price volatility?
Many producers have asked me, “If I can ride out the highs and lows, do I need to hedge my prices?” If you can truly manage your business through high and low cycles on a cash flow and equity basis and on a personal basis (managing the business and personal stress of price volatility), you may not need to hedge your prices. It is important to note that your risk management strategy is to use your available cash and equity to manage the potential price volatility. Just because you are not hedging your prices, doesn’t mean you are not actively making and following a risk management plan. But don’t fool yourself into thinking that your lack of action on creating and following a risk management plan is just using your cash and equity to weather the volatility.
 
Is the price high enough to exceed your cost of production?
If you cannot manage the volatility on your own, you will want to explore other risk management strategies. When looking at other available strategies, you will want to understand how the contract/hedge price relates to your farm price and ultimately how it relates to your cost structure. If the current prices are high enough to give you a positive return, now may be a good time for you to hedge. Everyone’s cost structure and comfort level are different, which is why I say now may be a good time.
 
If the price does not exceed your cost of production, does it offer protection at a sustainable level?
Sometimes the market does not provide a hedge price that enables you to protect a profit. When this situation occurs, I typically recommend looking at a strategy that protects a price rather than locking in a price. Most simply, this can be done by purchasing a put option. For a premium cost, this strategy offers price protection if the market should decline significantly but still allows you to benefit if the market increases. When examining this strategy, because prices are below profitable levels, we most often look at a survivable price rather than a profitable price.
 
For example, a producer may say, “Although I really need a $16.00 Class III price to return a slight profit, a $15.00 Class III price will allow me to cash flow.” Or, more drastically, they may say, “A $14.00 Class III price will result in a loss from month to month, but my lender will work with me during any potential low price cycle.” Although it certainly isn’t true all the time, I often see lenders more eager to extend operating lines of credit if there is some form of protection on the downside. If you purchase a $14.00 Class III put option and the milk declines to $10.00, although you are below profitable levels, you are still $4.00 above the market price.
 
These three steps are a just a couple questions you can ask yourself when starting to create and implement a risk management strategy. No two producers or businesses are the same, so there is no one answer that works for everyone. Having some guidelines and understanding your farm financials are critical first steps to implement your risk management strategy. As always, I suggest working with a professional to help guide you through the process and keep you and your business moving in the right direction.

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.Visitwww.ricedairy.com. There is risk of loss trading commodity futures and options.  Past results are not indicative of future results.
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