Taking protective steps now could help you limit losses if a lower price scenario occurs.
By Bob Devenport, Analyst, Stewart-Peterson Inc.
“There is no opportunity in milk right now.” When I begin a conversation about protecting milk prices, I’m often met with that statement these days. So, I thought I’d write my response in this column for the many dairy producers who are waiting for opportunity’s knock.
First of all, let’s talk about the word “opportunity.” It’s a subjective word. Many dairy producers define opportunity as, “the chance to lock in a satisfactory margin.” Again, that definition is subjective. What is “satisfactory” to you may not be what the market is offering. Does that mean there is no opportunity?
If you engage in price risk management only to capitalize on perceived opportunity, then you are not engaging in true price risk management. There’s a sliding scale between the bookends of “risk” and “opportunity.” A dairy operation is always positioned somewhere along that scale. If you are not seeing opportunity, then there is risk present. Your opportunity actually takes the form of protecting against downside risk.
Here’s a current example:
A dairy producer looks at current prices and thinks, “Prices have come down so much from last year at this time… How could they go any lower? I’ve already weathered this big sell-off, so I’ll just wait until I see more opportunity.”
The reality is that there could be much more downside risk in this market right now. True, a dairy producer may not see any “opportune” – meaning “favorable” – prices right now. Still, there is risk of prices going lower. Prices went from $20 last year to $15 now, and that does not mean that prices will not go lower than $15.
By doing nothing, you are assuming more risk. The market does not abide by your definition of a “good” price. It’s not going to go higher just because it fell below your cost of production for a while and you believe it will bounce back up. What if it goes to $12? How long could you weather that price point? And if you could be ahead of the market when things get really hairy, why would you choose not to? Taking protective steps now could help you limit losses if that lower price scenario would occur.
Yeah, it’s not fun. You’re not contracting $20 milk anymore. You’re contracting $15 milk, and it’s not as exciting. You’re going to be glad, though, that you’re at $15 if we see $12. You will see things differently when you have created a $3.00 opportunity.
Now you might ask, “How likely is it that prices will go lower?” No one knows for sure, and it is risky to make all your plans around one scenario. That’s why we constantly scenario plan.
What we do know is that prices move in cycles. The average bear market for Class III milk is 17 months in duration. If we’re following a normal bear cycle, that means we’re just getting started on this downturn. It could be a very drawn out process. Note that bear markets are never a straight trip down through 17 months: Within that larger downward trend, there will be price swings. Price corrections will present opportunities.
After nearly five years of very good prices, none of this feels like familiar territory. Perhaps that is why producers are a bit reluctant to act. We really haven’t seen a major bear market since 2009. We had a setback in 2012, where it looked like we were going to start a bear market, and then the 2012 drought came along and that was enough to turn things. We’re due again for a bear market.
This downward turn may not last a full 17 months. It is important to remember, though, that the average duration is 17 months. It’s not three or four months. So, if you’re thinking that you weathered the low prices and things are going to go up from here, think again. The odds are not in your favor. That’s a compelling reason to protect downside risk.
If you’re really worried about the scenario that prices will go back up, then pick a strategy that allows you to be open to the upside. Buy call options to cover your sales. Or create a fence strategy where you have a floor, and a ceiling, and you still have some room for prices to move up or down.
Here again, keep perspective: If you’re so worried that prices might go up, shouldn’t you be equally worried that prices might go down? Prices going down is probably a worse scenario for your dairy than prices going up.
Price risk management isn’t only about capturing price opportunities; it’s also about covering your downside risk. Doing that may be the opportunity you are seeking.
Bob Devenport is a dairy markets analyst with Stewart-Peterson Inc., a price management firm based in West Bend, Wis. You may reach Bob at 800-334-9779, or email him at firstname.lastname@example.org.
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