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Dairy Margin Management: A Focus on Profit Rather than Price

Feb 07, 2011

Producers who embrace a structured margin management approach will be well prepared for the heightened volatility, increased competition and uncertainty on the horizon.

 
By Will Babler, First Capitol Risk Management
 
In today’s market, dairy producers face unprecedented volatility and risk. Commodity price volatility for milk, dairy products and feed are on a rollercoaster with no end in sight. This can prove overwhelming for the producer who, aside from financial management responsibility, is already fully occupied with operational tasks.
 
Still, the management of commodity price risk is perhaps the most important determinant in the financial success of a dairy. Few other factors in the operation are as volatile or as big a lever on earnings as feed and milk prices.
 
Some dairy producers have responded to this challenge by taking time to learn about risk management tools and their application. Over time, these producers often proceed along a spectrum of experience and confidence that entails hedging milk, feed or both, using some combination of cash forward contracts, futures or options. At the end of this learning curve is a structured hedging approach that we believe will be necessary for producers to succeed and compete going forward. We refer to this approach as a structured Dairy Margin Management program.
 
Dairy Margin Management Definition
 
Dairy Margin Management is the process of cutting through the noise and the fog in the marketplace to purposefully and directly limit commodity price risk while also taking advantage of opportunities created by volatility.
 
A producer engaged in structured Dairy Margin Management takes matched hedge positions that simultaneously protect input and output commodity prices. This approach allows for a focus on profit rather than price. It also eliminates the need to be right on the timing, direction and price level of each individual leg of the profit margin spread.
 
The Case for Dairy Margin Management
 
Over the coming months, via a series of articles in this column, we will seek to build the case for implementing a margin-focused commodity hedging strategy. Future articles will cover hedging fundamentals as well as detailed discussions of important dairy-specific margin management issues:
·         Hedging Philosophy – What we do know and don’t know about markets and what to expect from a hedging program;
·         The Right Tool at the Right Time – How to select the best available tool for a given market circumstance;
·         Creating a Risk Management Plan – Key questions that must be answered when devising a risk management policy
·         Revenue Hedging and Milk Basis – Understanding your milk basis and the ability to tie down the biggest variable in profitability – milk revenue;
·         Feed Hedging with Cash and Futures – Controlling prices within a complex ration by coupling corn and meal futures hedges with cash forward contracts;
·         Executing the Margin Management Plan – Consistency required to run the plan on a day-to-day basis;
·         Hidden Value in Hedging – Option premium costs and end-of-year hedge profit and loss statements don’t tell the whole story of hedging costs and benefits.
 
Moving Forward
 
On the horizon, we see great opportunity in commodity markets and dairy production. However, this opportunity also includes the likelihood of heightened volatility, increased competition and uncertainty. We feel strongly that the producers who embrace a structured margin management approach will be well prepared for this environment. We look forward to providing insights which will allow producers to progress upward on the risk management learning curve.
 
Will Babler is a principal partner at First Capitol Risk Management, LLC. Contact him at 815-777-1129 or at wbabler@firstcapitolrm.com. Visit the company’s website at www.firstcapitolrm.com.
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