A closer look at the farm bill’s MPP, set to launch Sept. 1, and its effect on market liquidity.
By Dave Kurzawski, INTL FC Stone
While the price of U.S. cheese teeters around the $2/lb. level and market participants scan the horizon for some sort of disruption or directional shift in prices, it might just be quiet enough to discuss another evasive topic: the dairy subtitle of the new farm bill.
President Barack Obama signed the Agricultural Act of 2014 in February. A behemoth document that was beaten, battered and caught in the political cross-hairs for two years, the bill emerges with progressive changes for U.S. dairy producers. The dairy section of the bill promises to deliver, among other things, a more sensitive safety net for U.S. dairy farms based on an ‘income over feed’ margin – not milk price alone.
Much has been written about the new Margin Protection Program (MPP), how it operates, and what lose ends will need to be tied up before its launch, slated for Sept. 1. Few, however, have yet discussed the possible consequences of the new dairy farm policy. Among the immediate concerns is the potential influence the MPP could have on derivative market liquidity.
Producers are a very large component of sell-side liquidity at the Chicago Mercantile Exchange’s (CME) dairy markets. By focusing on a "margin threshold" to trigger indemnities to producers, the MPP does a good job of mimicking existing risk management tools used by producers -- such as futures, options and forward contracts to lock in a profit margin. Because of this, the concern is that the new program will cannibalize sell-side liquidity at the CME making it tougher for buyers to hedge. In essence, the more interest there is in the farm bill’s new margin program, the less liquidity there could be in the CME dairy markets.
Currently, several university studies raise this concern, saying that, in general, such a program (if certain levels of participation are realized, etc.) will remove some portion of sell-side liquidity in the existing exchange-traded products and forward contracting programs. Given the structure of the program, producers may, in fact, increase use of MPP during times when the futures market forward curves are already predicting low margins or certainly low milk prices. But the world of commodity risk management decisions has many subtle levels.
Initial discussions with dairy producers tell me they like the flexibility of the MPP but that they will treat it as a safety net for that milk not actively hedged. Those producers who already manage price risk have commented that if they use the new program, it will be in collaboration with current derivative management tools – not in lieu of these tools. The current sentiment is then not very consistent with a significant departure from using present derivatives for hedging purposes. Row-crop producers, who use futures and options as well as crop insurance year in and year out, are a good indication that this mindset could hold up in the dairy markets as well.
Although CME dairy contracts continue to grow yearly, many producers I’ve spoken with who do not actively manage their profit margin today have claimed that there is not enough current information on the MPP to make a call on their future involvement. Final rules and a general lack of understanding today could be the program’s Achilles heel. Still, expect a good showing of MPP participation from producers who do not currently manage price risk because of the, at least perceived, low barriers to entry. That won’t necessarily threaten liquidity of forward contracting programs or liquidity at the exchange.
Sentiment surrounding the MPP is positive, but the current temperature of dairy producers when asked if they will use the program exclusively is lukewarm. While the MPP provides an important safety-net, it seems as though producers won’t enjoy the same type of coverage, flexibility and profit-capture of existing risk management tools. The dairy industry is happy to see a more progressive public policy approach, but with current information available it appears the program is unlikely to result in a material decline in sell-side liquidity for exchange-traded products.
David Kurzawski 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 Kurzawski at 312-456-3611.