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May 2013 Archive for Know Your Market

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

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

Dairy Futures and Options: Consider Class IV

May 24, 2013

There are three notable trends in the Class IV market that dairy producers should take into account.

Carl BablerBy Carl Babler, Atten Babler Commodities LLC
 
Since the launch of dairy futures by the Chicago Mercantile Exchange (CME) in 1996, the majority of attention, trading volume and risk management strategies have revolved around Class III milk contracts.
 
Approximately 60% of U.S. Federal Order milk production is used to produce cheese, thus the expected emphasis on Class III Milk. Early on, the CME provided risk management education directed toward producers and processors of Class III Milk. Dairy producers nationwide began a journey along a continuing futures- and options-based risk-management learning curve that featured Class III contracts. Even California Order producers found the Class III contract as a useful means to manage price risk on the cheese portion of their milk check.
 
The Class III futures contracts have been the primary hedge tool that allows processors to offer producers contracting programs. In addition, Class III options have provided both producers and processors various strategies to place boundaries on price risk. Class III futures, Class III puts, Class III calls -- everything Class III has led the way of dairy futures and options products.

Class IV milk, the milk used in the production of butter and nonfat dry milk, is also listed on the CME with active futures and options contracts. This is a lesser known market to most producers, but it is one that should be better understood by those in certain regions of the country, especially in California. Current Class IV prices, the volatile profit margin environment and increased interest from producers, processors and end-users have recently spurred increased activity in Class IV trading.

Class IV Liquidity
 

Class IV contract liquidity has recently improved as shown in Figure 1 below. This provides California producers the ability to capture opportunities offered by the volatile butter and powder market, markets that increasingly reflect the growing export interest in these commodities. California producers now are able to manage components beyond cheese value in their milk price. Producers can combine Class III and Class IV futures contracts to minimize basis risk and protect all of the components of their California overbase price.

The improved liquidity in the Class IV options market in particular has provided producers the opportunity to establish minimum price (long put options) and min/max (fence – long puts/short calls) positions for a known net option premium. Class IV contracts are also providing effective hedge instruments for producer in other regions of the country were milk checks are significantly driven by butter and powder value. Note the increase in trade volume of Class IV futures since the start of 2011 as shown in Figure 1 below.


Babler graph 1   5 24 13Figure 1 (right) – Class IV Futures Liquidity
Source: FuturesSource

Class IV Trends

There are three notable trends in the Class IV market that producers should now be considering:

1. Class IV volume and open interest, while not at their historical peak, are trending higher. Higher volume and open interest in the past have been associated with high Class IV milk prices. This relationship between high prices and higher trading activity is a benefit to producers that wish to protect favorable prices and margins and need the liquidity to do so.

2. During most past periods, the Class IV market has traded at a discount to Class III as shown in Figure 2 below. Currently, the spread has reversed, with Class IV trading at a premium to Class III across the next year. This historical abnormality should be considered as an opportunity for producers to protect the relative value of their Class IV exposure.

3. Class IV option trading has recently picked up pace and now offers a viable opportunity for producers to increase their hedging flexibility. Option volume recently hit a multi-year high as shown in Figure 3 below. Producers who are currently engaged in the Class IV option market have been able to make use of a wide variety of strategies, including outright long puts, put spreads, min/max positions and three-way spreads.

Babler graph 2   5 24 14
Figure 2 (right) – Class III vs. Class IV Pricing
Source: FutureSource


Babler graph 3   5 24 13Moving Forward

Producers are advised to explore the availability, liquidity and opportunities to use Class IV futures and options contracts to better manage their specific risks. Doing so can reduce the basis risk between milk check prices and the ultimate settlement values in their hedging account when the appropriate ratios of Class III and Class IV are taken into account. Understanding the implications of complementing Class III positions with Class IV futures and options products should be explored with an experienced dairy commodity risk manager.

Figure 3 (above) – Class IV Futures & Options Volume
Source: CME

Risk in purchasing options is the option premium paid plus transaction. Selling futures and/or options leaves you vulnerable to unlimited risk. Atten Babler Commodities LLC uses sources that they believe to be reliable, but they cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. The author of this piece currently hedges for his own account and has financial interest in the derivative products mentioned within: Class III milk.

Carl Babler is a principal with Atten Babler Commodities of Galena, Ill. Contact him atcbabler@attenbabler.com or 877-259-6087.

Dairy Price Rebound Ahead after GDT Cool-Down?

May 20, 2013

Though the spring price rally has stalled, summer is poised to bring weather-driven markets, lower milk production and resurging demand.

Derek Nelson FC Stone copyBy Derek V. Nelson, INTL FC Stone

The results of the GlobalDairyTrade (GDT) auctions over the past several months have been a key factor reflected in the rise of dairy prices both here in the U.S. and on an international basis, most noticeably during the rally witnessed in the months of March and April when Class III prices gained over $2 per cwt.

The rise of the GDT prices reflected continually disintegrating conditions in New Zealand as scorching heat and the most wide-spread drought experienced in 30 years devastated pastures and curtailed the milk production of the dairy product exporting juggernaut.

For the months of March and April, the GDT Trade Weighted Index (TWI) Price Index rattled off double-digit gains for three consecutive events before tapering off. Domestic dairy futures soared. Class III prices eclipsed the $20 per cwt. level, butter futures pushed into the upper $1.80s and NFDM into the mid-$1.70s. Then, during the mid-April event, rains finally returned and alleviated immediate concerns relating to dairy product availability out of New Zealand. Tempers cooled, bringing to a rather abrupt end the explosive rally in prices of the dairy commodities.

Through the month of May, the past two GDT auctions results have portrayed a shifting away from the bullish sentiment that feverish gripped the dairy marketplace. Gone are the calls for $2.00 + cheese and $25 per cwt. Class III milk, having been replaced by a pessimism, has producers looking to protect their downside price risk while dairy end-users sit on their hands waiting for the bottom to develop in the markets before locking in their needs for the remainder of the year.

FC Stone graph 5 20 13So, where will the markets go from here, and what are the factors that will be driving price action in the near term?

Despite the slumping GDT auction prices, there remains a tightness of dairy products around the globe. The heavy rains in New Zealand have done little to salvage the tail end of their production season and, without up-to-date cull numbers out of the region, we cannot be too certain that their production rates will return to the levels seen during the 2011/12 season. European production has been hampered by a lingering winter and a less than ideal spring. Domestically we have had our own weather issues to contend with as a late-emerging spring in the North and a rapid escalation of temperatures out West have created an uneven and staggered spring flush across the nation.

Feed prices have benefited of late due to the sharp decline in grain prices, but concerns related to forage supplies in the Midwest and the Western states have led to rationing and/or alterations to feed mixtures, which have a negative impact on production levels. While the heavy rains over the past month have gone a long way to reduce drought conditions in much of the Corn Belt, the rain mixed with cool temperatures across the nation has whittled consumer demand as the grilling season has yet to materialize in many parts of the country.

Currently, domestic dairy commodity prices reflected upon the Chicago Mercantile Exchange have found a modicum of support, though continued weakness in the near term running through early June should be expected before summer’s heat starts to tamp down on milk production levels. The dairy markets -- like the grain and feed markets -- have become weather-driven at this time of year. As temperatures rise across the nation as we enter the long-awaited summer months, demand should increase, cutting into the burgeoning product supplies that have accumulated over the past several months, leading to a rebound in dairy prices across the board.

Derek Nelson is a Risk Management Consultant with the Chicago office of INTL FCStone. INTL FCStone offers comprehensive risk-management and margin hedging programs and services to dairy producers, processors, traders and end-users. You can reach Derek at 312-456-3623 or derek.nelson@intlfcstone.com

Corn at $4 or $10: Plan Ahead for Both

May 13, 2013

This spring's planting delay has created more 2013 uncertainty. Be aware of the possibilities to manage both your feed and your milk prices.

Patrick PattonBy Patrick Patton, Stewart-Peterson Inc.

If April showers (and snow) bring more uncertainty about 2013 crops, what does uncertainty bring? For dairy producers, it can be ongoing uneasiness or a set of strategies that cover your feed needs no matter what the markets do.

We’re still preparing our clients for a potentially wide price range for 2013 corn and soybeans. Corn could be $4 or $10 in 2013, and soybeans could be $269/ton or $476/ton in 2013.

"Oh, that’s helpful," you might say. You might like a little bit narrower price range to use in your planning. First, I’ll provide perspective on the wide ranges, then I’ll provide some suggestions for avoiding the stress of a potentially wide swing.

A simple historical analysis helps us understand what could happen to feed prices this year. If we look at price rallies and declines on a percentage basis from year to year, we see the following:

• Since 2006, the average percentage rally in December corn from the first trading day in January to its contract high is 36.8%.

• The average percentage decline in December corn price from the first trading day in January to its contract low has been -19.3%.

The table below displays the average, maximum and minimum percentage rallies that the December corn and December soybean meal prices have seen from their respective closing prices on the first trading day in January.

S P chart   5 13 13

Applying this analysis to 2013,we start with the December 2013 corn futures contract, which was $5.92 on the first day of trading in January. Using the average percentage rally of 36.8% to the contract high would suggest a risk of corn rallying to $8.10/bushel before 2013 is over. The maximum percentage rally seen of 66.4% would say a price of $9.86/bushel is not impossible.

On the downside, the average price decline of -15.1% to the contract low would say that $4.78 December corn is possible, and the maximum percentage decline of -39.6% to the contract low would say that $3.58/bushel December corn is possible.

This analysis shows that an extreme price swing cannot be ruled out. Now let’s factor in what is currently playing out in the market:

While there are many factors that move prices, the major driver right now is weather. Everyone is nervous because of delayed planting and the potential for higher feed prices if we have another year of poor crops. Planting being the first hurdle, we were only 12% planted as of May 5 when our five-year average is nearly 50% planted by this time. This has happened nine times since Stewart-Peterson opened its doors in 1985. Of those nine occurrences, yields ended up below the 10-year trend line seven times. This would suggest lower yields, lower ending stocks, and higher prices as 2013 plays out.

On the other hand, in 2009, planting pace remained behind normal throughout the planting season, and then near-perfect growing conditions resulted in record yields.

What if that happens again this year? Could it? Well, using a very conservative yield estimate of 146 bu. an acre, and also conservatively estimating that farmers plant 1.5 million acres fewer of corn this year as a result of late plantings, you can still build a case for increased ending stocks for the 2013 crop. Even if we factor significant demand rebounds, ending stocks would increase to more than 1.2 billion bushels. If a 153.5-bu. yield were achieved, ending stocks under the same assumptions would balloon out to 1.9 billion bushels. That translates to falling feed prices.

So, as you can see, there is a good case for 2013 corn to be in the $4 range or the $9-$10 range. That’s a wide swing for a dairy operation to manage. With prices on the lower end of that range right now, it’s wise to lock in a feed price to protect against short-term price increases due to planting scares. If we do not have a good crop, you will be glad to have coverage.

If we do have a good crop, there should be opportunity to bring down your average price for feed. Locking in feed prices does not have to be (and should not be) a one-time thing. With the help of an experienced advisor, you can actively manage your price and use strategies to incrementally bring down your average price for the year.

In fact, there is real risk if you do not actively manage the value of your feed inventory. Again, looking back to 2009’s delayed planting, it ended up that we had higher than trend-line yields, and falling grain prices helped drive down milk prices. Many producers had high-priced feed in inventory as milk prices fell, with no price protections in place.

Be aware of the connection between feed prices and milk prices. If we do have strong yields and ending stocks increase, we will see falling grain prices and, as a result, lower milk prices. Consider using the current milk market, which has been largely supported by short-term feed scares and international dairy prices, to lock in a favorable milk price and protect yourself from a potential milk price crash.

So, while we cannot predict what grain prices will do, we can encourage you to be aware of the possibilities, and plan ahead. Uncertain markets require a recognition of what is possible and then active management of both your feed and your milk prices.

Patrick Patton is Director of Client Services for Stewart-Peterson Inc., a commodity marketing consulting firm based in West Bend, Wis. You may reach Patrick at 800-334-9779, or email him at ppatton@stewart-peterson.com.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, promoting the use of marketing tools, including futures and options. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Copyright 2013 Stewart-Peterson Inc. All rights reserved.

Then and Now: Put Margins in Historical Perspective

May 03, 2013

Negative profitability during the first quarter of a year is not all that unusual. But it is possible to protect what is on the table today.

chip whalen thumbBy Chip Whalen, CIH

As readers of our column and those familiar with our approach to risk management are aware, we spend quite a bit of time focusing on and analyzing opportunities in deferred time periods to protect profit margins.

A lot can happen from the time a projection is being made to when a margin will actually be realized in any given marketing period. Some things like weather events cannot be anticipated in advance and have an enormous impact on profitability. Other things may repeat seasonally year in and year out and influence the profitability profile from one time period to the next. As an example, the first quarter of the calendar year tends to be a tough one for dairy producers.

While seasonal patterns do not always play out and any particular year can be unique with its own fundamental dynamics in play, the point is that the first quarter is not always kind to dairy producers. The first quarter of 2013 was no exception. Up until quite recently, milk checks were not covering the cost of bringing that milk to market.

The fact of the matter is that negative profitability during Q1 is not all that unusual. The charts below help illustrate this. The first is a seasonal graph of first quarter milk margin indexed on a scale of 0 to 100. What this basically shows is the time of year when first quarter margin tends to be strong and other times of the year when it tends to be weak. I have circled two areas of focus on the graph.

Whalen chart 5 3 13 a again

The green circle highlights the time of the year when the first quarter’s projected profitability tends to be strong. We are in a period currently during the April-July timeframe when first-quarter margins tend to be at their highest level of the year. If you glance a bit further to the right, you will notice a red area circled that highlights the time of year when the first quarter margin tends to be the weakest. It normally occurs during the actual marketing period of the first quarter itself. In other words, if you are on the open market, you tend to realize the worst possible profit margins for that calendar quarter of the year by accepting spot feed costs and milk prices during that period.

The second chart displays the past 10 years of first quarter profit margin, including the current projection for 2014. This "stacked" view of the Q1 margin allows you to track where each of the past 10 years’ Q1 margins ended up versus what was being projected prior to the actual marketing period if you follow the individual lines back in time. Another thing this graph allows you to do is compare past years so you can see how strong or weak certain years were relative to others.

Whalen chart 5 3 13bTwo things stand out to me about this graph. The first is where Q1 margins typically end up. With the exception of 2005 and 2007, most first quarters are lucky to breakeven and there is a noticeable tendency for the margin to deteriorate from January into March. In fact, none of the Q1 margins within the past five years have finished in positive territory, and 2009 obviously sticks out like a sore thumb.

The second thing that strikes me about the graph is where the profit margin is currently being projected for the first quarter of next year. I drew an arrow to the current projection to show where it is on the graph. At just under $2.00 per cwt. for this particular model operation, the profit margin is currently at the 90th percentile of the previous 10 years, and exists at a very strong level from a historical perspective. It is pretty clear to see that for this particular dairy, anything between $2.00-$3.00 per cwt. would be an outstanding profit margin for Q1, and something north of $3.00 percwt. would be extremely rare within the context of history.

While I have no idea where the profit margin for the first quarter of 2014 will ultimately end up 10 months from now or what things will affect that profitability as we move through the balance of this year into next, I do know that it is possible to protect what is on the table today. Moreover, there are a variety of ways this profitability can be protected. Perhaps it would be desirable to preserve the opportunity for a potential $3.00 per cwt. margin in Q1? Maybe you would like to protect against the possibility of a catastrophe repeating itself like in 2009? Some may even be happy locking in the current projection and just walking away.

What is the best strategy? It really depends on you. Everyone will have a different outlook, tolerance for risk, comfort for contracting and access to capital that will allow them to consider different alternatives. Regardless of what strategy someone may ultimately choose, I hope you can see how projecting profit margins and putting them into an objective context by looking at history can greatly help with the decision-making process. Being a more informed decision maker is really the first step to becoming a margin manager and taking charge of your dairy’s profitability.

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com.

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