Know Your Market
The New Attitude Toward Risk Management: It’s Not Gambling But a Sound Business Practice
Mar 15, 2010
By Jon Spainhour, Rice Dairy
Few dairy producers will look back at the last 14 months with anything other than disdain and confusion.
Coming out of 2007 and the beginning of 2008, being a milk producer was a pretty good occupation to be in. Prices were very strong, and in some months were establishing all-time new highs. Feed costs were certainly rising too, but in general, making milk was a very profitable business to be in. In fact, over the last 30 years, due to relatively low production costs and a generally stable output price, there were only good years and really good years. The job of a dairyman was not to worry about prices as much as it was to worry about making as much milk as possible, as efficiently as possible.
Concepts like risk management and margin management were easy to ignore, and many people did. For most, the idea of hedging was viewed as a form of gambling. The few that did choose to step into the fold did so without properly understanding the hedging tools they were using. As a result, the participation from the production side of the dairy industry in the risk management arena was minimal, and even today only a small portion of the annual U.S. milk crop is actively being hedged.
Things changed in the middle of 2008 for most dairy producers when the world economy got caught in a downward spiral that caused commodity prices, which were trading at record highs, to suddenly collapse. Milk was not immune. While trading above $20/cwt in June 2008, milk was trading as low as $9.31/cwt. within only eight months.
While the price of grains fell too, their decrease was not enough to offset the decrease in milk prices. With the average breakeven for most producers still hovering around $14/cwt, and the average Class III price for the last 14 months being $11.78/cwt., times have been tough. There has been a significant amount of loss bestowed upon the equity and production potential of the dairy community. Several dairy producers are on the verge of bankruptcy and sadly, there will be some that won’t survive.
As a result, many producers and lenders are looking back at the last few years and wondering what they could have done differently, and what they can do in the future to avoid such catastrophic conditions. While there are many structural changes that can be pointed at, one of the more obvious changes that many people wish they could have made would have been to use risk management tools like futures and options. Looking back, it is painful for many to realize they could have sold their production for 2009 at around $20.00/cwt during the middle of 2008. What a difference that would have made! Sadly, producer participation at those levels was very minimal.
While there is no sense crying over spilt milk, it is certainly alright to recognize what could have been done then and how that can be used in the future. With that in mind, many producers are starting to switch their attitudes about risk management, from it being a form of gambling to it being a sound business practice. They are beginning to learn how risk management tools like futures and options work and how they can use them to better run their business. That is an attitude I applaud and one that I hope to help foster through my contribution to this column.
My hope is to educate producers, lenders, and anyone else who has risk pertaining to dairy prices, about the basic mechanics of futures and options through this column. On a monthly basis, my point will rarely be centered around my market opinion, but more focused on explaining in a very straightforward way about risk management tools and the different strategies you can employ to better your bottom line. I hope you will join me and learn from our efforts.
Jon Spainhour is a broker/trader with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot, and forward markets. You can reach Spainhour at firstname.lastname@example.org. Visit www.ricedairy.com.
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