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Know Your Market

RSS By: Dairy Today: Know Your Market, Dairy Today

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

Knowing When to Contract Your Milk Price

Mar 14, 2011

Dairy producers often hesitate to contract because they're afraid they'll miss out on potentially higher prices. But you can maintain your business in any price cycle if you consistently contract a price that satisfies your farm's needs.

 
Katie Krupa photoBy Katie Krupa, Rice Dairy
 
Regardless of location, herd size or management style, dairy producers across the country struggle when making risk management decisions.
 
It is difficult to find the right broker, choose an appropriate strategy, and then know when to contract. For most producers knowing when to contract is the most challenging decision. Current market volatility and contradicting projections from market analysts have many producers panic stricken, afraid they will make the wrong decision for their business.
 
So how do farm managers make the right risk management decision? The right risk management decision is different for every farm and should primarily be based on the farm’s financials.
 
Before any strategy is determined, or any broker advice is given, the farm should determine an adequate milk price for the operation. Many farms will work with their lender, accountant or even their broker to review the farm’s financials. Once an adequate milk price is determined, current trading prices can be reviewed and a strategy established.   
 
I frequently talk with dairy producers who are hesitant to contract because they are afraid they will miss out on potentially higher prices. For example, if a producer contracts a portion of their Class III milk price at $16.00 per cwt., and the Class III price settles at $17.00, the producer will be paid $16.00, and miss out on the $1.00 of upside potential. Wrongly, many producers will be disappointed in their contracting decision, and shy away from contracting in the future.
 
Let’s back up and examine why the producer contracted milk at $16.00. In this example, the dairy producer determined the farm’s break-even price was $15.00. Therefore, he or she decided to contract at the price of $16.00 to ensure the farm a profit of $1.00 per cwt. The farm made a thoughtful, calculated decision that it would lock in the $1.00 profit, rather than leave itself unprotected against the volatile milk market.
 
In this example, the milk price moved higher than the producer’s contracted price, but that will not always be the case. Dairy farmers understand how volatile the milk price can be, and there will be months when the milk price moves higher than their contracted price, and months when the milk price drops below their contracted price.
 
To have a successful risk management strategy, you should consistently contract a price that satisfies your farm’s needs. We all know the milk price will go up and down, so having a consistent strategy is critical to managing price volatility. If you are consistently protecting a profit, or at least covering your break-even price, you will be able to maintain your farm business in any price cycle. As the old saying goes, no one ever went broke making money.
 
A broker should be able to help guide your decisions and provide market insight to make sure your strategy is appropriate for the current trading environment. The dairy market can change quickly, so your risk management strategy should be flexible, and be able to adjust as the market shifts.
 
To get a better understanding of how your risk management strategy will play out in different markets, run through several scenarios. If the Class III price settles at $10, what is your milk check price? If the Class III price settles at $24, what is your milk check price? A strategy that is appealing if the Class III price declines may not be appealing if the Class III price increases.
 
In addition to milk price risk management, a complete risk management plan should also include input costs. Input costs and risk management strategies to protect inputs vary greatly across the country. Regardless if you grow or purchase most of your own feed, you are subject to input price volatility. All producers should review their cost structure and determine where they are most vulnerable to price fluctuations and manage that risk.
 
Input price management is also very diverse and can include contracting on the exchange, contracting with local mills, utilizing the USDA’s Livestock Gross Management program, or a combination of strategies.
 
There are many different strategies you can employ to protect your milk price and your input costs. Your strategy should depend on your farm financials, debt level and even your personality. Working with a broker who takes the time to ask the appropriate questions, and understands your business’s financials will help you create the best risk management strategy for your unique business. 
 
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.
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