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Lower Production Costs Bring Dairies New Opportunities, Risks

Sep 27, 2013

With costs down by $2-$3 per cwt., dairy producers should take steps to fully understand how to best protect themselves.

By Will Babler, Atten Babler Commodities LLC

Many dairy producers have struggled to understand the magnitude of the change in cost of production that is on the horizon. As September comes to a close, we have not fully escaped the multi-year draw in grain stocks or the lingering impact of the 2012 drought, but changes are just around the corner. Case in point is Figure 1 (below) that shows the projected drop in cost of production between the final quarter of the 2012/2013 old crop and the first quarter of 2014 when we will be fully utilizing new crop. The median benchmarking data drawn from our customer base indicates as much as a $2.00/cwt. to $3.00/cwt. drop in cost of production.

Babler chart 9 30 13

Despite the good news, some producers’ expectations seem anchored by the extremes of the most recent year or most recent January-June financial statement. They can’t see past the recent market situation to fairly evaluate the forward opportunity. These producers put themselves at risk of not making the right risk management decisions if they don’t re-adjust their expectations and frame of reference for what is a normal or realistic price, cost of production or profit margin.

Profitability Controversy

Figure 1 calculates the break-even cost of production by considering feed costs, non-feed variable costs, fixed costs and financing costs. It also adjusts for milk premiums and other revenue such as cull cow sales, co-op dividends, etc. Profitability and cost of production can vary wildly region to region and producer to producer and are often sources of controversy whenever industry cost of production numbers are put forward. A given producer may disagree with the numbers presented here, but that brings us to our main point – averages or generic assumptions aren’t good enough in a volatile environment and each producer should have an accurate cost of production model for their operation. This couldn’t be more true as we make a transition out of a historically tight feed supply and demand situation.

Moving forward

The change in cost of production is a welcome sign for dairy producers and steps should be taken to fully understand the new opportunities and risks that are now at hand. Producers should consider their ability to answer the following questions:
• What is my current cost of production and profit margin?
• What is my expected cost of production and profit margin for each month going forward?
• How does my cost of production and profit margin change with each daily change in the forward markets?
• At what price levels for milk and feed can I protect a break-even margin?

Producers who have clear answers for the above questions are more likely to see that the situation has changed and are prepared to act decisively. For example, a Midwest producer may think he or she needs near $18.00 to breakeven in 2014 and, in turn, passes up an opportunity to utilize a hedge strategy that may protect profitability in a $16.50 market for Q1 of 2013. Those who struggle with these questions need to move quickly to get their arms around their numbers to avoid misconceptions anchored in past price levels and cost of production metrics.

Risk in purchasing options is the option premium paid plus transaction. Selling futures and/or options leaves you vulnerable to unlimited risk. Atten Babler Commodities LLC uses sources that they believe to be reliable, but they cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. 

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