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Know Your Market

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

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

If You're Hedging the Margin, Don’t Try To Guess the Market

Mar 11, 2013

No one knows what the market will do, so it’s important to hedge at a price that is good for your business.

Katie Krupa photoBy Katie Krupa, Rice Dairy

Continuing market volatility in both milk and feed has many producers looking to hedge their feed along with their milk. While most of you in the Midwest think hedging feed is a natural part of managing your business, producers throughout the rest of the country are mostly unfamiliar with the concept. While many folks will do local contracts or even hedge basis, hedging feed on the exchange is new – and, for many, hedging milk on the exchange is also new.

With continued market volatility, it is extremely important for your risk management strategy to incorporate milk and feed -- and possibility other commodities, but I’ll save that for another article.
When looking at managing a margin between milk and feed, a great first step is to figure out what your risk is and how to hedge for volatility. For milk, you may get a good hedge by simply hedging Class III. This usually works great for producers in the upper Midwest.

But milk utilizations in your area may be more diverse, and using a combination of Class III and Class IV contracts may give you a better level of protection in your marketing area. Or, for producers out West, a hedge using cheese or powder contracts may work better. The market is constantly evolving, so it is good to work with someone who understands your milk market so they can help you prepare for volatile markets in your specific area.

For feed, you may have a good portion of your feed needs in storage until harvest, so the bulk of your shirt-term risk may be your protein needs, but longer term, your risk increases. Or, the opposite end of the spectrum is you are a purchase operation, so beyond what you have already purchased for the next several weeks or months, you are 100% at risk.

Many people will ask, "If I am hedging milk and feed, should I do both on the same day, or try to time the market and get a better price on different days?"

My answer is that you should hedge a margin that is good relative to your business. If the available margin that you are looking at hedging will return a profit for your business, then you have to opportunity to hedge a profit. That opportunity does not always exist. If you only hedge one side of the equation (milk or feed) and the prices change, your profitable margin can quickly erode and you may only have the opportunity to protect a breakeven or worse.

Most likely, the best day to hedge milk may not be the best day to hedge feed, but do you know when those days are? Does anyone? Unfortunately, these markets don’t always give you, the dairymen, a great opportunity. But sometimes you get a good opportunity, and you can protect your profits for the upcoming 6 months, or even 12 months. If that opportunity exists, are you comfortable passing it up, or trying to pick a better day and ultimately becoming a speculator rather than a hedger?

Take a look at the graph. It shows the Class III milk price for March 2013, the March 2013 corn price and a corresponding milk-feed margin based on futures prices trading on the CME. While it is easy to look back and say you should have hedged feed last spring at the low, and milk last fall at the high, no one knows if the future will provide better or worse opportunities.

Krupa chart snag it
I can imagine that many producers hedging milk in the summer (thinking it can’t move higher) would have waited to hedge feed because the "experts" said corn would decline in the summer (we all know that didn’t happen). Then you would have ended up with a low milk price, and a high corn price because of an unforeseen drought. Your milk-feed margin would have been inverted.

Unfortunately, you can probably think of many other examples where there milk and feed prices did not do as the analysts projected, and the milk-feed margin declined, and profits eroded.

The reason for risk management is that we don’t know what the future will bring. So, while it is easy to see the historical graph and pick out the best times to hedge milk and hedge feed, we can’t see the future as we sit here today.

If you hedge today, the margin could move higher or lower. That is why it is important to hedge the margin at a price that is good for your business. I’ll let you set the definition of "good," could be profit, could be breakeven and, in a bad market, could even be below breakeven. If you hedge only milk or only feed, and wait for a better opportunity, you are exposing yourself to the risk that the price will move the opposite direction, and your opportunity to hedge a profit may completely disappear. No one knows what the market will do. That includes me, economists, cooperative leaders, lenders or other brokers. Be sure your risk management strategy is complete and not exposing you to more risk but setting up an incomplete hedge.

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. You can reach Katie at klk@ricedairy.com.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.
 

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