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

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

Competitive Pricing: It’s What Works for You, Not Your Neighbor

Aug 27, 2010

Spainhour PS jpegBy Jon Spainhour, Rice Dairy

 
One of the toughest issues that dairymen struggle with pertaining to risk management is their fear that they will be leaving money on the table that their neighbor didn’t. 
 
Many dairymen that we work with answer the following question with fear and hostility: “If you sell you milk at $16.00/cwt. and your neighbor sells it at $16.30/cwt., are you going to be able to live with yourself?” The typical answer is a resounding “Heck, no!”
 
While this is certainly understandable, as no one likes to feel like someone else got a better deal than they did, whether it’s buying a car or selling their milk, I think that it is an attitude that will soon prove to be damaging to the long-term profitability of dairymen who choose to subscribe to it.
 
It is my belief that as we move through time, more and more dairymen will begin to focus on what really matters most: their net profit margin. Focusing solely on getting the best price for milk will cause them to miss out on profitable hedging possibilities.
 
The very same dairyman who sold his milk at $16.00/cwt. may have a completely different cost structure and breakeven levels than the dairyman who sold his milk at $16.50/cwt. Depending on what his fixed and variable costs are, he may actually be making far more money that the dairyman who sold his milk at $16.50/cwt. 
 
Put another way, the first producer may have a breakeven level of $13.50/cwt. and he sold his milk at $16.00/cwt., representing at $2.50/cwt. profit margin. The second producer may have a breakeven level $14.50/cwt. and sold his milk at $16.50/cwt., representing a profit margin of $2.00/cwt. As you can see, the first producer was better off, although his milk price was lower than the second. 
 
Most producers will tell us that while they would consider this approach to “margin management,” they have two problems:
1) They don’t know what their breakeven is;
2) They don’t know how to hedge their variable costs. 
 
My solution to the first problem is to hire an accountant. They should be able to help you pinpoint both your fixed and variable costs and lay it out on a per-hundredweight basis. It may cost a little money to go through the process, but it is an expense well worth the money.
 
My solution to the second problem is to hire a broker who can help you fix your variable costs like corn and soymeal with futures. Other costs like interest rates, energy prices, hay and alfalfa can be fixed as well. Once you know how to establish these costs on a per-hundredweight basis and know the prices you can lock them in at, you begin looking at hedging your milk price. 
 
One of the easiest things you can do at this point is to establish breakeven levels, either through fixed priced or option contracts, and then buy Class III milk puts against that level. In this case, you can enter a particular period of milk production knowing that at worst case, you will break even on the year. The best case is that you will do quite a bit better than that if the price of milk rallies. 
 
Another approach you take after you establish where you can fix your input prices is to sell fixed priced futures contracts, assuming they are at levels that are higher than your input levels. 
 
In either case, you need to know your breakeven levels, and you need to be able to do that with a reasonable degree of accuracy, not a back of the envelope guesstimate.
 
Then you need to know how to fix those costs through either physical purchases or longer term purchase agreements. Then you need to make sure that you establish your milk price at the same time. Buying your corn and then waiting to sell your milk could be a risky situation. Do them both together, establish a profit margin, and then get back to doing what you do best: making milk more efficiently than anyone else in the world!
 
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 jcs@ricedairy.com.Visit www.ricedairy.com.
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