Opportunity May Knock Soon to Protect Second-Half Milk
Apr 17, 2011
While there has been much discussion about milk price volatility and milk pricing policy, there are some relatively simple things you can do to take control of your pricing and protect what you've worked so hard to earn.
By Steven Schalla, Stewart-Peterson
After a dramatic setback from February highs to the March lows, Class III futures are starting to rebound.
Cheese futures contracts are leading the way, with several contract months quickly bouncing 14 to 18 cents off their respective lows. In fact, third quarter cheese futures are now averaging over $1.80/pound. Butter and non-fat dry milk prices have also firmed despite a stall in international prices. On the other hand, Oceania cheese prices continue to run strong, and the decline in U.S. prices has reportedly encouraged better export opportunities.
It will be interesting to see how much the spring flush will impact national milk production, starting with USDA’s Monthly Milk Production Report on April 19. Several of our clients admit that after seeing their March milk check with a base Class III price of $19.48 or Class IV price of $19.41, they’ve kept more marginal-producing cows at home, despite cull prices at historic levels.
Understandably, producers want to capture every penny of this market.
By and large, the short-term trend for milk prices continues to be higher and could provide the opportunity to protect a minimum price for the second half of the year. Yes, enjoy the higher prices, and also be thinking about what you can do to make them last for yourself.
Historically, the back half of the year has been the stronger time frame for prices: Over the past 10 years, July-December Class III prices have finished stronger more often than not, and overall averaged 98 cents better when compared to January-June of the same year. One could conclude that doing nothing now would be OK. Enjoy the high prices now. Expect them in the second half of the year too.
Markets never do exactly what we expect, and you must consider the risks of doing nothing. It is noteworthy that only once (in 2007) did the second half of the year finish stronger when the first half of the year average was over $16.00. If April, May, and June 2011 expired today, the first half average for 2011 would be $16.89. And so, from a historical standpoint, we need to be thinking defensively, or at least cautiously, and protect this price while we can.
The wild card continues to be the grain markets and input prices. It is no secret that profit margins are going to be squeezed if corn, bean meal and fuel stay at these levels. This could allow milk prices to stay at higher levels as milk buyers become more concerned about dairy profitability and available milk supply. This support would be short-lived, however, because of course the processors can only sustain demand at high price levels for so long.
A simple protection strategy
Protection strategies for your milk price do not have to be elaborate. Based on the fundamentals cited above, we continue to be fans of using put options to establish a floor or minimum price for the second half of the year. This position will give the flexibility to be protected if the longer-term trend turns sour for milk, or grain markets move sharply lower, while having the opportunity to capture a higher market price. The only risk with a put option, and it is a fixed risk, is an upfront premium cost that is determined based on the minimum price you’d like to guarantee.
Some milk plant programs will buy put options on your behalf, and settle any gains or premium costs off that month’s final milk check.
In the coming weeks, further time value will tick off these option prices, making the premium costs more attractive. When analyzing the cost of such protection, keep in mind that a desire for higher floor prices will command a higher actual premium cost, although as a percentage it is about the same cost.
FOR EXAMPLE: When milk is at $12.50/cwt., a 25-cent cost for a put option is 2% of the milk price. So, when milk is at $18.00, spending the same 2% would be a cost of 36 cents.
This simple put option strategy can go along way in providing predictability in your milk in an uncertain marketplace. While there has been much discussion about milk price volatility and milk pricing policy, there are some relatively simple things you can do to take control of your pricing and protect what you’ve worked so hard to earn.
Steven Schalla is a Market Advisor for Stewart-Peterson, Inc. He can be reached at 800.334.9779 or firstname.lastname@example.org.
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