Don’t let a "woulda, coulda, shoulda" mentality set in if you’ve missed a pricing opportunity. Here’s advice on avoiding that trap.

By Chip Whalen, CIH

Forward dairy profit margins have been in retreat over the past several weeks as milk prices have come down from loftier levels back in April. Meanwhile, feed costs have largely held steady or even increased in some cases as with soybean meal.

In the bigger picture, forward margins still exist at relatively high levels from a historical perspective, although some producers may nonetheless be discouraged that current margin projections are not as strong as they once were. This can be problematic on a number of levels. A "woulda, coulda, shoulda" mentality may set in where one feels badly to have missed an opportunity. This is not only unproductive because there is nothing a producer can do about it in hindsight, but even worse it can begin to cloud future decision-making.

Many readers of this space probably identify with Katie Krupa’s recent post in discussing the emotions that come into play when making marketing decisions. To experience the feeling of having lost an opportunity stirs up emotion which can be very hazardous when facing important financial decisions for your business.

As an example, maybe you would look at the prior margin opportunity as the benchmark to now shoot for and opt to do nothing until that opportunity presents itself again. Should margins continue deteriorating and possibly go negative, you might panic and make a rash decision to stop the bleeding and contract at unfavorable levels. While some of you reading this might think they would never find themselves in that position, I can tell you that I have experienced this firsthand and it is more common than you might think.

How does one avoid this trap? Emotions can run very strong and are quite subjective – personal experiences that vary from individual to individual. One way to keep emotions in check and limit their impact on your marketing is to bring objectivity into the decision-making process. In reading through Katie’s post that I previously referenced, she mentioned making decisions based upon the financials of your business and the concept of establishing goals.

I think this is a key point that deserves more attention. We believe it is critical for a dairy to establish goals and objectives in helping to refine their decision making process, and this all starts with a clearly defined plan. What is an acceptable return for my operation? How much risk am I willing to accept in trying to achieve this return? How much capital do I have access to that can assist me with margin management strategies to protect forward profitability?

These are some of the questions that come up in drafting what we refer to as a margin management policy that clearly spells out what the goals and objectives are, and how we intend to achieve them. This does not have to be a complicated document, but serves as a roadmap for determining where we want to go and how we plan on getting there.

Just as you might plan a summer driving trip and consider all the possible roads or routes that can bring you to your destination, you might similarly lay out all of the different marketing tools at your disposal to protect both your forward feed expenses and milk revenue. This might include an array of cash market contracting alternatives such as forwards, hedge-to-arrives, basis contracts, min/max combinations, etc. It might also include derivative alternatives including exchange-traded futures and options.

What are the features of these various contracts? What are their costs and limitations? When might I choose to use one alternative over another? This is where some of those initial questions come back into play, such as how much risk I am willing to accept or how much access to capital I have to allocate to the process. A more refined approach to marketing starts to present itself when certain alternatives can be eliminated, which may not fit with my tolerance for risk or level of capitalization. What about my goals and objectives? Perhaps I can define forward profit margin levels that represent returns for my operation which are attractive based upon the investment that I have in the business. What if I could set targets that trigger alerts telling me when this level of projected profitability has been achieved in a forward time period?

I might consider in advance what types of strategies or positions I would elect to use in the market to protect my forward profitability should an opportunity present itself, such that I was ready to take action once that event occurred. What I am describing is the process of crafting this margin management policy so that the decision making becomes objective and clearly defined.

Katie also mentioned the idea of including an outside advisor in helping with these decisions. In addition to someone like herself or myself who might assist in navigating through the various contracting alternatives at your disposal, another key partner in this process is your lender. Despite what some people might think, your lender is a very important stakeholder in your business, and wants to see that your dairy is successful and profitable. Including them in the discussion of your goals and objectives and how you might use various contracting alternatives might lead to opportunities of incorporating certain tools you would not have otherwise considered.

While a margin management plan cannot promise that you will "hit the highs" on milk or "catch the lows" on feed, it can bring a lot more structure and objectivity to the decision making process. It can even become quite granular and sophisticated, spelling out what types of strategies to use on each piece of the margin, depending on what levels of historical profitability are on the table for instance, or under what circumstances those strategies may be adjusted over time.

Regardless of how simple or complex the plan is though, one major benefit of having it in place is to remove the natural emotion that comes into play when faced with making key financial decisions for your business. You put a lot of care and attention into how you care for your dairy herd and the quality of milk you produce. Similar attention should be paid to how you are securing forward profitability to continue dairying successfully into the future.

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.

How would the program’s results have fit into your operation?

By Ron Mortensen, Dairy Gross Margin, LLC

These "Know Your Market" commentaries are usually a chance to look forward and to plan for future marketing and risk management strategies. The thought is to continue to look forward at how to make your dairy business financially sound by using several different risk management techniques. Risk management/marketing can be emotional, stressful and time consuming, yet it is a needed task.

Perhaps by looking back occasionally, a producer can become more comfortable with different marketing techniques. Therefore, this is a review of what has happened to LGM-Dairy for December, January, February and March. The analysis is for the October 2012 sales period. Because milk prices moved significantly lower in the December-March period, these policies show good payoffs for that timeframe. Also note MILC did kick in and shows payments for three of the four months.

If you purchased LGM-Dairy in October 2012 for December, January, February and March, the following table indicates the indemnity payouts. If you purchased coverage for more than these four months, the total payout will change. Remember, the indemnity payments are averaged over all of the months you purchase.

Why is this review important? It shows, most importantly, that an LGM-Dairy policy functioned as it should. It provided cash flow when margins contracted. Perhaps a policy was purchased simply because milk was near $20.00/cwt. Maybe it was purchased due to the unknowns about feed costs at that time. Or maybe it was purchased as a systematic step in a marketing plan. How would these results have fit into your operation?

Below you will find a summary of the indemnity payments for average feed inclusion. Your specific results may vary a little based on how much corn and meal you put on your policy. The data and calculations were in part derived from U of Wisconsin LMG Dairy website. You can evaluate your policy by going to http://future.aae.wisc.edu/lgm_analyzer/.

LGM-Dairy Average Corn and Soybean Meal
Purchased Oct. 26, 2012 for the December to March period
1560 cwt. milk, 20.5 tons corn, 6 tons soybean meal
$14.21 average gross margin guarantee
Premium $0 deductible $.60/cwt.
Premium $1.00 deductible $.16/cwt.

December
Expected milk prices $20.34, actual prices $18.66, down $1.68/cwt.
Expected corn prices $7.45, actual prices $7.19, down $.26/bu.
Expected soybean meal prices $482.23, actual prices $458.33, down $23.90/ton

January
Expected milk prices $19.53, actual prices $18.11, down $1.42/cwt.
Expected corn prices $7.46, actual prices $7.26, down $.20/bu.
Expected soybean meal prices $482.23, actual prices $458.33, down $66.47/ton

February
Expected milk prices $19.26, actual prices $17.25, down $2.01/cwt.
Expected corn prices $7.46, actual prices $7.32, down $.14/bu.
Expected soybean meal prices $469.32, actual prices $421.86, down $47.46/ton

March
Expected milk prices 18.98, actual prices 17.00, down $1.98/cwt
Expected corn prices 7.47, actual prices 7.39, down $.08/bu
Expected soybean meal prices 462.27, actual prices 433.83, down $28.44/ton

The following charts are a summary of possible policies purchased during the Oct. 26, 2012 sales period:

Ron Mortensen is principal of Dairy Gross Margin, LLC, an agency that specializes in LGM-Dairy products and owner of Advantage Agricultural Strategies, Ltd., a commodity trading advisor. Contact him at ron@dairygrossmargin.com or visit www.dairygrossmargin.com.

Tips to help make risk management decisions and implement a plan that will work for your dairy.

By Katie Krupa, Rice Dairy

When it comes to making risk management decisions, many producers struggle with the decision-making process. Risk management can often be emotional, the information can be overwhelming and, simply put, producers don’t want to miss out on potential higher prices. The volatility has many producers asking themselves if risk management is right for them, but they still struggle with the process.

Below are a couple of tips and tactics to help make risk management decisions and implement a plan that will work for your business.

Emotion

I often find the emotional aspect of risk management is the hardest hurdle to overcome. Because the dairy is a huge part of their life, many producers are emotional when they have to make important financial decisions for their dairy. Is this the right decision for the business? Will this help financially? Will this help reduce stress, or increase stress? Will the other mangers of the business be happy? These are just some of the questions producers wrestle when reviewing their risk management opportunities.

Firstly, these emotions are normal and healthy. You care about your business and you want to make sure you are doing the right thing for your future. Secondly, don’t struggle with this alone. Bring in an outside advisor/consultant to help guide you through the process and keep you on track to making a good financial decision. Be sure to discuss your goals and strategies with the full management team rather than make the decision alone. And lastly, make your decisions based on the financials for your business; try to eliminate emotions such as fear and greed from the process.

Don’t want to miss opportunity

No one wants to miss out on any income potential, but we have to weigh the risks and the rewards. Dairy farming is naturally a high-risk business not for the faint of heart, so removing some of the risk may seem unnatural. But with the increased price volatility, many producers are finding that risk management is a vital survival tool for their business. While I certainly don’t know what the future will bring, I can almost guarantee that if you utilize risk management tools on a consistent basis, you will miss out on some of the market’s upside potential.

The good news is that, with the many diverse risk management tools available to producers, your missed upside opportunity may be minimal, and you are still protecting against the downside if prices should decline. The risk you are protecting should outweigh the reward you are potentially giving up. But figuring that out can often be emotional, so don’t struggle with that decision alone.

Not comfortable enough with all the available strategies and market insight

In recent years, the number of risk management strategies available to producers has grown significantly. While this is ultimately a good thing, it can be overwhelming to producers who do not have a substantial amount of time to dedicate to risk management. I am seeing more and more producers outsourcing their risk management needs to an experienced broker, consultant or advisor.

At first, I was very surprised by the producer’s desire to hand over the responsibilities, but after working with several dairies, I have found that the producer is more satisfied knowing that the risk management plan was created and executed based on financials of the business rather than emotion. Your broker/consultant/advisor should be making the risk management decisions based on your farm financials, upcoming needs (such as expansion), and even taking into consideration your personality. Having a third party execute the strategy removes the emotion of the farm and allows the decision to be based on numbers rather than feelings.

No one ever wants to hear "I told you so," especially when you are telling it to yourself. If you are currently sitting on the fence not sure if risk management is right for you, get off the fence and get some guidance from a professional. Getting the process started will help you make decisions down the road, and will calm that uneasy feeling you may currently have.

Katie Krupa is a broker 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.

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

By Carl Babler, Atten Babler Commodities LLC

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.

Figure 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.

Figure 2 (right) – Class III vs. Class IV Pricing
Source: FutureSource

Moving 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.

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

By 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.

So, 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.