There may be reasons that keep you away from using futures and options to manage your risk, but don’t let factors such as basis be one of them.
By Jon Spainhour, Rice Dairy
When Rice Dairy first began developing our relationships with dairy producers, one of the very first issues that we were forced to tackle was the concept that every dairyman essentially received a different price for his or her milk.
It was difficult for a dairyman in California to feel comfortable hedging his milk production with Class III and Class IV futures and options when his actual pay price may quite different than the national average.
In truth, even the dairymen in Wisconsin felt that the variance in their milk check with the national Class III/Class IV average was enough to make them uneasy about using Class III/Class IV futures to manage their price risk. With no exact financial mechanism to match their actual milk check, many chose not use risk management tools at all.
In reality, what these dairymen were identifying is referred to as basis. Basis is essentially the difference in price between two similar objects. This price spread may be caused by the difference in the grade of quality or something just as simple as geographic location. Most dairymen see this play out every day when they buy their corn. They can expect that the price of corn in the Arizona is going to be more than the price of corn in Illinois. In this case, the difference is likely due to the extra distance corn has to be shipped to in order for it to get to Arizona.
In the case of milk, prices can -- and likely will be -- different for almost every single dairyman. These differences are generally caused geographic location.
Those closer to an urban population typically get a higher milk check because their milk goes into higher-end products like fluid milk and they don’t have to haul it as far. Those whose milk may be heading into lower-end products and are far from a population center typically get a smaller milk check. Other pay price factors can come from factors such as fat and protein levels.
While we list the factors that cause one dairy’s milk check to be bigger or smaller than the next, I tend to view these differences to be a very small factor in deciding whether or not a dairyman should use Class III/Class IV futures and options as their risk management tool. What is more important than acknowledging that there is a difference in the milk price between Arizona and Wisconsin is acknowledging the relationship between the two.
Class III and Class IV futures establish their final settlement levels based on the national average milk price. Almost every state except California reports in their federal order minimum pay price. Those numbers are used to establish a national average, which represents all the different price levels that dairymen across the country were paid. While each state’s numbers are different than the national average, the basis is typically static. This means that, while there can be some variance from month to month, the premium that Florida receives over Wisconsin is generally about the same.
As long as we can generally count on this relationship staying strong, I believe it is appropriate for dairymen to use Class III and Class IV futures as their risk management tools.
From time to time, the relationship between your milk check and the national average may get a little out of whack. The premium you typically receive over the national average may erode a little or the discount you typically receive may widen. Again, there are a number of different factors that can cause this to happen, but in general these effects are short lived. Many times, there is a readjustment the very next month which actually goes far enough in the other direction that it works in your benefit, making the whole situation a loss.
Many people will tell us that they don’t know their actual basis to the national averages. They are quick to cite the general premium or discount they receive in their geographic area, but they cannot give you particulars.
I believe finding this basis out is as simple as looking at your milk checks for the last three years and comparing them to the Class III or Class IV settlements for those months. My guess is that while the prices are different, there is a very strong and consistent relationship between your milk checks and national averages. Even California, which has its own minimum pricing mechanisms, has a correlation factor of 97% over the last five years.
In closing, there may be reasons that keep you away from using futures and options to manage your risk, but don’t let factors such as basis be one of them. It matters not that you get $2.00/cwt. less each month than the national average. What is really important is that you consistently get $2.00/cwt. less. If that is the case, then you can feel comfortable moving forward in hedging your milk check with Class and Class IV futures and options.
Jon Spainhour is a broker/trader 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 Spainhour at firstname.lastname@example.org.Visit www.ricedairy.com.