Preparation Pays Off
Jul 12, 2012
A lesson in preparing dairy producers for what might happen later this year.
By Mark Ludtke, Stewart-Peterson
An icy-cold story of preparation and survival might be refreshing amidst this summer’s heat. In his best-selling book, Great by Choice, Jim Collins tells the story of Roald Amundsen, the first explorer to reach the South Pole and survive the trip.
The secret of Amundsen’s success in 1911 was preparation. He had eaten raw dolphin meat just to see if he could do it in case he became shipwrecked. He had spent time with Eskimos, learning how to avoid excessive sweating that could turn his clothes to ice.
“You don’t wait until you’re in an unexpected storm to discover you need more strength and endurance,” Collins writes about Amundsen’s philosophy. “You prepare with intensity all the time, so that when conditions turn against you, you can draw from a deep reservoir of strength.”
Amundsen’s trek into uncertain conditions parallels dairy producers’ journey into uncertain milk and feed markets. Internet news sources have been abuzz with news of the latest USDA crop report, weather and crop conditions, and speculation about what impact each day’s developments will have on milk and feed prices. I could add my opinions and the opinions of our advisory team to the piles of commentary. However, I thought it might be more instructive to step back and look at patterns, and the kind of preparation that pays off.
First, let’s look at developments in feed prices—corn in particular. All the fundamentals for corn this year, including USDA’s Planting Intentions Report and progress reports, have pointed to a big crop and affordable feed for 2012. Despite this conventional wisdom, our strategizing back in February had clients buying call options for July and August corn for feed, and in April we recommended calls for September – December corn feed needs (See Electronic December 2012 Corn Futures Chart).
Now, at the time we had recommended buying these calls, some questioned why. “All the fundamentals point to a big crop,” they reasoned. “My gut tells me save the money on calls. . . .”
True. And if you’ve read this column through the years, you know that it is our philosophy not to make recommendations based on market outlook alone. There is just too much risk in that approach.
Early in 2012, no one knew how high or how low feed prices would go for the year. Tight ending stocks meant good weather and good crops were needed to keep prices low. Unless you were able to predict the weather with extreme accuracy, there was just no way to know.
So, facing uncertainty and risk, we looked at all the possible scenarios, and we assumed that any one of them could happen. We created strategies for each scenario and we showed our clients the math. Together, we looked for the sweet spot of protection—one that offered the best protection for the most reasonable cost, for the most logical scenarios, with an exit strategy in case one of the unexpected scenarios happened.
Why was the scenario planning process so important for feed this year? Because the potential swings for feed prices were so great. When we analyzed the average percentage rallies and declines of the last six crop years, we could see that $8.00/bushel corn and $3.50/bushel corn could not be ruled out, and neither could $400/ton soybean meal or $260/ton soybean meal. For dairy producers buying all their corn and protein needs, the difference in the size of their 2012 feed bill was huge.
So, after doing the math, our clients could choose the price protection strategies that best fit their risk tolerance. Many of them chose calls for fourth-quarter corn, as described above. They are now in a position to have a weighted average price for corn of under $6, even if the prices soar all the way up to $12. And, had the rain fallen and prices fallen along with it in anticipation of a bumper crop, there was also a strategy in place to exit those calls. Before the heat was on, the producers had analyzed the numbers, prepared for various price scenarios, and chosen the price scenario that best fit their risk tolerance.
My point here is NOT to say any particular recommendation was the right one. It is to illustrate the strategic process. Why? Because a similar situation is shaping up for milk, and producers need to do a little more math now to prepare themselves for possible scenarios ahead.
Milk price scenarios
The big picture prediction for 2012 milk was that prices were going to eventually fall apart. Milk production had been strong right up to the recent record heat wave. Many producers had contracted milk in some form, fearing prices would crash. If producers who have contracted milk have not prepared strategies for exiting those positions, they could find themselves locked into lower prices as feed prices climb.
For example, if you are holding positions for August-December milk, it will be important for you to choose a trigger price at which you will exit your futures positions, and replace it with a put option that will offer protection while allowing you to take advantage of higher prices.
Or, if you have a fence position in place, buy back your sold call options. If your milk is sold via forward contract, consider a call option strategy. Do it soon, before the next wave of news hits and it’s too late.
Yes, analyzing all these price scenarios and developing strategies for every potential price direction takes work. But in the face of uncertainty, there is no substitute for preparation.
Prepare now for what might happen later this year.
Mark Ludtke consults with dairy producers nationwide concerning their choices for risk and opportunity management. He can be reached by calling 855.334.0700 or at firstname.lastname@example.org.
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