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April 2011 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.

What’s Happening with LGM for Dairy?

Apr 25, 2011

Although the insurance program has ended for the 2011 crop year, continue to learn and develop strategies for your dairy to use when it becomes available again later this year.

Marv Portrait 4By Marv Carlson, Dairy Gross Margin, LLC
Just slightly more than two hours from the afternoon availability of Livestock Gross Margin (LGM) for Dairy Insurance on March 25, 2011, USDA’s Risk Management Agency ran out of the budgeted subsidy set at $15 million for the 2011 crop year. 
So, consequently, LGM for Dairy insurance sales have ended for the 2011 crop year. Word from reliable sources is that LGM-Dairy sales probably will not be available again until Oct. 28, 2011.
We will keep you informed throughout the year as to changes with LGM for Dairy. During this time, we will provide you with snippets on LGM for Dairy so you can continue to learn and develop strategies for your dairy operation for when it is again available.
You may be over-budget on your monthly dairy feed budget, too! Managing the risk of rising feed prices is a major component of Livestock Gross Margin insurance. 
Understanding feeding value equivalents still has merit in a margin management planning process. Most energy and protein feed sources’ pricing structures are compared to or based off the CBOT corn and soybean meal prices. When you have least-cost rations developed in the Midwest, I am confident there is a comparison to corn and soybean meal values somewhere in the software’s architectural framework.
The risk protection structure of LGM for Dairy is simply milk minus feed. Corn is used as the energy component, and soybean meal as the protein base for all feedstuffs in the ration. I said simply, right? Well, that part is actually simple. The harder part is collecting your feed data in tons to compare to your milk production. Each feedstuff is converted to its corn and soybean meal tonnage, and then divided down to feed per cwt. of milk.  
Since there is quite a large acceptable range for feed inclusion in each month’s target marketings, the hardest part is the determination process of how much feed to include.
Each farm operation feed-cost risk structure is different. They may value the feed produced on the farm at cost of production. They may have pre-priced a portion of their feed needs they must purchase, and additional feed risk protection with LGM for Dairy is not needed. Some farms have a larger land base and don’t need to purchase additional forages. 
When you look into the crystal ball, you may not see an immediate need for feed risk protection. As you can see, there are many different situations. With LGM insurance only sold on the last business Friday of each month, strategies for feed inclusion amounts may change from month to month, depending upon market conditions or risk protection tools put into place.
I will work you through using the LGM for Dairy feed calculator. The goal is to know your feed usage “Baseline or Benchmark” for total feed needs on your operation.
Obviously the feed for the lactating cows needs to be included. How about the dry cows? That feed cost is paid back from milk sales, so add it in, too. The next question is: “Do you buy replacement heifers or raise them on the farm?” Feed for this phase of production gets paid back from milk sales, too.
To get started, collect tonnage for feeds fed during the given period of time you want to match with milk production data. Then go to our web site http://www.dairygrossmargin.com and look under premium estimator. You have two options, the online web-based calculator and the downloadable spreadsheet.
Both of these options have been developed and are maintained by Professor Brian W. Gould of the Department of Agriculture and Applied Economics, University of Wisconsin-Madison, and his team.
I recommend using the Excel spreadsheet, since you can save your work and fix any data entry errors you may have made. As you review the spreadsheet, you will notice three worksheets. The first two are for feed data input, “Concentrates and Grains” and “Forages.” The third is “Total Feed Equivalents” for summary and comparison. Be sure to enter the milk production in cwt. on worksheet “Total Feed Equivalents.”
This is a list of how to proceed from this point:
  • Enter Feed in Tons for feeds listed on the Concentrates and Grains worksheet.
  • Enter Feed in Tons for feeds listed on the Forages worksheet.           
  • Look at “Total Feed Equivalents” worksheet.
  • Review “Is Feed within Allowable Limits?”
  • Check and review your feed inputs.
This spreadsheet is pretty slick to use and really a great place to start for using understanding your feed usage when considering LGM for Dairy or using corn and soybean meal contracts or options to offset risk for feedstuffs that are not exchange traded.
Marv Carlson is with Dairy Gross Margin, LLC, in Sioux Rapids, Iowa. Contact him at marv@dairygrossmargin.com or (712) 240-8395. Visit the firm’s website for more information: www.dairygrossmargin.com.

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.

 

Copy of S Schulla Bio PictureBy 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 sschalla@stewart-peterson.com.

 

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. 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. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2011 Stewart-Peterson Inc. All rights reserved.

Manage the Margin Rather Than Just the Milk Price

Apr 11, 2011

By analyzing your dairy’s financials, and creating a risk management strategy that protects your profit margin, you can reduce your farm’s exposure to price volatility.

Katie Krupa photoBy Katie Krupa, Rice Dairy

When creating a risk management strategy, dairy farmers should look at the complete milk price equation. Milk price risk management should include both the price the milk is sold for and the cost to produce the milk.

In order to consistently make a profit, many farms manage the margin between the milk price and the input costs. Current volatility in both the milk price and the input costs results in producers needing to manage more than just the milk price if they want to protect their profitability.

Currently on the exchange, the corn price is approaching $8.00 per bu., oil is trading over $110 per barrel, and the milk price is trading around $17.00 per cwt. (close to $18.00 for summer months).
The milk price and the input costs have been extremely volatile, and producers are becoming more anxious for the future profitability of their business. While a $17.00 Class III price looked extremely appealing at the beginning of the year, producers are now nervous that current milk prices and rising input costs will return negative margins.

It appears price volatility is here to stay, so many producers are taking matters into their own hands and taking the risk off the table for both milk income and expenses. Risk management plans are becoming more complete, encompassing both the milk price and the input costs.

Many producers don’t know how to manage the margin between the milk price and the input costs, but luckily the resources available to them are constantly expanding. Brokers, consultants, lenders and other industry professionals are creating and utilizing tools for dairy producers that enable them to analyze and then protect their profit margin.

Understanding the margin between milk price and cost of production is helpful to producers for many reasons. Firstly, if you don’t know what your cost structure is, you aren’t able to improve it. Many producers will be able to cut their costs once they know where the money is going. Secondly, knowing your income and current milk production can help producers realize their cows’ full potential. Understanding the value of an extra pound of milk per day per cow will help drive management decisions in the right direction for the farm. Even without a risk management plan, a complete margin analysis can help producers improve their profitability.

Once the analysis is complete, producers can review their risk management options and make a decision that is best suited for their farm business. Many producers are discouraged by the numerous risk management strategies available to them, and unfortunately this scares them away. Although the options seem overwhelming at first, knowing the farm’s current financials will help the decision-making process. By identifying the input costs and milk price, the producer and their decision making team will be able to identify which risk management strategies will best serve their farm. 
 
Producers now have various tools available to them to control price volatility in both the milk price and the input costs. New programs offered by the government and a growing number of programs offered by cooperatives help supplement the already vast contracting options available on the exchange. It is important to review and understand your risk management options and examine how they line up with your farm’s unique needs.

Many producers I work with find that analyzing their financials helps them better identify the appropriate risk management strategy, implement that strategy, and ultimately be happy with that decision. Implementing the strategy is very difficult for many producers. Fear that they are making the wrong decision is overwhelming. To combat this fear, analyze the numbers and make your risk management decisions based on farm financials. Take the emotions out of the decision-making process.

By basing your decisions on farm financials, you will be satisfied with your decision because it will be good for your farm business and ultimately good for you personally.

By analyzing your farm’s financials, and creating a risk management strategy that protects your farm’s profit margin, you can reduce your farm’s exposure to price volatility. Regardless of how the milk and input prices move, if your risk management strategy has protected the margin, your profitability will be protected. Creating, implementing, and being satisfied with your risk management strategy will be easier once you understand the farm’s financials, and protect the margin, rather than just the milk price. 
  
Katie Krupa is the Director of Producer Services with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at klk@ricedairy.com. Visit www.ricedairy.com.

The Right Tool at the Right Time

Apr 04, 2011

While we can’t know with certainty what the market will do, we can resist our hardwired tendencies and put the odds in our favor while hedging. Here’s how to select the best available tool for a given market circumstance.

 
By Will Babler, First Capitol Risk Management, LLC
 
CME floor trading PSOur last “Know Your Market” article discussed hedging philosophy and risk management program objectives and expectations. The key takeaways from that article were:
·         Philosophy - Dairy producers and other market participants can’t consistently out-guess the market over the long-term.
·         Objectives - A good risk management program should focus on minimizing risk and capturing opportunity.
·         Expectations - A consistently executed risk management plan isn’t intended to beat the market but rather smooth out earnings, support long term business planning and avoid emotional and financial stress.
 
Against this background, the next natural question from dairy producers is typically, “What tools are available to implement my plan, and when and how should I use them?”
 
A Hedger’s Toolbox
 
Dairy producers have firsthand experience in finding new and creative ways to fix things on their farms. An improvised ‘fix’ may get the job done in the short term, but to do things correctly often requires the right tools. The same principal applies when reaching into the hedger’s toolbox.
 
Fortunately for dairy producers, numerous cash market and futures and options tools are available to effectively mitigate risk and capture opportunity. Often the best place to start is in the cash market, where producers can typically utilize an array of cash forward contracts to lock in feed prices or lock in milk prices. The futures and options markets for corn, soybean meal and milk are also available to provide additional flexibility in protecting prices and margins.
 
Understanding the financing requirements for cash and futures tools is critical, but for this article we will first focus on when and why to utilize fixed price instruments (cash forward contracts, futures) and when and why to use minimum price or maximum price instruments (puts, calls). Moving forward, we will assume the mechanics of these instruments are understood, and first focus on how emotional biases impact hedging decisions by commodity market participants.
 
Emotional Bias
 
The cyclical nature of commodity markets brings with it the whole range of human emotions and biases – fear, greed, complacency, overconfidence, anger, elation, etc. These emotional responses to volatile markets often lead to sub-optimal, if not disastrous, market-related management decisions. In an effort to avoid these pitfalls, let’s take a look at the all-too-common thought processes of some commodity producers and their infamous last words during different market cycles:
 
·         Low prices / Low margins – “The market has changed. Things are going to be tough for a long time. There is nothing I can do to improve things. I can’t take any more losses. I’m not going to do anything because I don’t think it can get any worse, --or-- I’m going to lock-in these poor margins because I can’t take any more pain and I don’t know what else to do.”
 
·         Average prices / Average margins – “I wish the market was a little higher. I just read a report that things are going to improve. I’ll worry about hedging at some other time. “Right now, I’m doing fine and, besides, I have a big project I’m working on. I don’t need to consider hedging right now since I don’t think I have much risk. I wouldn’t be a producer if I didn’t think prices and margins were going to go higher.”
 
·         High prices / High margins – “The market has changed. We have entered a new era, and demand is going to stay here forever. I don’t think supply is going to catch up any time soon. I don’t see anything that is going to knock this market off of its peak. I don’t need to hedge because things are only going to get better from here.”
 
Most of us can relate to these emotional responses to market cycles. Yet mean reversion drives booms and busts, and unfortunately this behavior usually results in doing exactly the wrong thing at exactly the wrong time. While we reiterate that we can’t know with certainty what the market is going to do, the following section looks at ways we can resist our hardwired tendencies and seek to put the odds in our favor while hedging.
 
Making the ‘Right’ Decisions
 
We’ve provided some examples of how extreme risk aversion, complacency and greed lead to poor risk management results. Here are some thoughts on attempting to work with the commodity market cycles to attempt to put the odds back in your favor. These concepts are also shown graphically in Figure 1.
 
·         Low prices / Low margins – Recognize both that the market could go lower, but that over time the odds are that it will rebound. This points to taking minimum price and minimum margin positions to stop the bleeding but leaving plenty of room for upside. The positions selected should be for a shorter duration and for a lower premium. This approach avoids taking further losses and avoids extreme risk aversion that can prevent a producer from participating in the eventual upswing in prices and margins.
 
·         Average prices / Average margins – Recognize that the market could move sharply in either direction. This indicates taking a blended position using both options and fixed price hedges, scaling in along the way. The hedges should be considered for a medium duration and should seek to minimize premium cost. Positions such as min/max options that provide a window of protection are often the best tool for keeping costs down, avoiding huge losses and keeping upside open for participation in improved margins. Maintaining consistent hedge coverage protects against the complacency associated with middle-of-the-road margins.
 
·         High prices / High margins – Recognize that what goes up also comes down. The axiom that high prices are the best cure for high prices couldn’t be truer. When prices and margins reach extremely favorable levels, it doesn’t take long for producers to ramp up production and end users to reduce demand or seek out alternatives. This typically results in a sharp correction in prices and margins. Similarly, low prices and low margins reduce capacity and supply, thereby eventually creating a shortfall of production and appreciation in prices. Appreciating the cyclical nature of commodity markets keeps us from getting too greedy and allows us to lock in favorable margins over a longer duration using fixed price tools.
 
Conclusion – Providing Structure
 
Selecting the right tool at the right time is no easy task and comes with no guarantees. It certainly involves a deep understanding of the mechanics of each tool as well as a producer’s risk tolerance and financial capacity. Still, the conceptual issues discussed here should always be the starting point.
 
Another important aspect of applying the right tool at the right time is to do so consistently. We have found that this is best done by planning ahead and documenting objectives, limits and organizational control points in a written hedging policy.
 
In our next article, we will review the key contents of an effective risk management policy.
 
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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