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July 2010 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.

Hedge Lines for Futures Financing: A Smart Move for Banks, Dairies

Jul 29, 2010

By Jon Spainhour, Rice Dairy

During the last few months, we have discussed the different hedging alternatives that dairy producers can use to help protect their bottom lines from adverse moves in their variable input and output prices. 

 

Producers can “sell” fixed priced contracts called futures to contract their milk price. They can also purchase insurance contracts called puts to establish minimum prices for the milk check. Their input prices for corn and soymeal can also be contracted by “buying” fixed price futures contracts. Calls are insurance contracts that be purchased to ensure a maximum cost price for these inputs.

 

After spending some time studying these concepts, many dairy producers conclude that these risk management tools are a fairly easy concept to understand and that they can have great value toward the ongoing profitability of their operations. 

 

The next step for them is to find a broker whom they feel comfortable with, and then open an account with them. It’s good to work with that broker to establish execution strategies based on breakeven analysis and risk tolerance levels.  Every dairy operation will be different, so it is important to spend a good deal of time on these two points. 

 

At this point, one of the last concepts to tackle is the amount of capital that a dairy can deploy toward its risk management strategy. Every futures account is required to carry a minimum deposit balance based on the amount of contracts hedged. This minimum balance is called the “margin” amount. 

 

Each Class III contract that a producer sells requires a minimum deposit of $1,300.  This minimum must be maintained even if the market moves higher. For example, a producer who sells one September Class III contract at $15.00/cwt. is required to deposit $1,300 in his account.  If the futures market moves lower, his futures account will reflect the gains on the contract and will have excess money in it. 

 

However, if the futures market moves to $15.50, his account will reflect a $1,000 loss. To remain contracted, he will need to deposit an additional $1,000 to bring his account back to current status. 

 

While everyone wants to call the top of the market every time and never have to worry about margin calls, that’s not likely to be a reality. Producers who use futures and options as part of their risk management strategy should be fully prepared to add money to their account and be able to do so in a very prompt fashion. 

 

For some, having a sizeable amount of cash to finance their futures position is not a problem. For others, having to send cash off the farm to Chicago at a moment’s notice is something they simply can’t afford, even if they see they true value in hedging.

Over the course of the last two years, I can’t tell you how many producers have told us they want to hedge but simply can’t afford the risk of having to make a sizeable margin call. In many of those cases, the market proceeded to move lower, proving to be a missed opportunity, resulting in a lower net milk check than what could have been established with futures. 

 

It is my opinion that the majority of the dairy producers we work with are in that very same state of affairs right now. They would like to hedge at these current futures levels, as they can ensure some of the better profitability in over three years, but they don’t have the cash to support that decision. 

 

It is also my opinion that this shouldn’t be the case. Midwest grain producers wrestled with this issue long ago and convinced their banks to issue them a funding stream called “hedge line of credit” to facilitate these types of transactions.

 

These hedge lines are used solely for the purposes of financing a futures and options position and can’t be used for other purposes like paying the labor bill. They alleviate the capital requirements for producers and allow them to focus solely on managing their risk from a profitability and risk-tolerance point of view. 

 

Since risk management in the dairy industry is a fairly new strategy, these lines of credit exist in dairy but are not prevalent. I believe this shouldn’t be the case. Banks should be willing to write these hedge lines for dairy producers as well as grain producers.  By doing so, they are not only helping their dairymen protect their bottom line, but they are also helping to protect the bank’s bottom line as well. 

 

A dairy producer’s risk is ultimately the bank’s risk as well, and both parties should be pushing to make hedge lines of credit an easily accessible tool that can help alleviate that risk.   

 

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 jcs@ricedairy.com.Visit www.ricedairy.com.

 

 

Risk Management Is Also About Opportunity Management

Jul 19, 2010

By Steven Schalla, Stewart-Peterson

 

We know from history that commodity markets are generally cyclical. For example, the milk market has seen cycles of 30-40 months from low point to low point, with different influences in each cycle. In general, markets are always seeking a supply and demand balance, and therefore, they are cyclical.

 

Because the markets spend a fair amount of time in the area of low prices (with the past 18 months inordinately low and prolonged), you as a producer of a commodity deserve to get the best possible price you can when prices trend upward.

 

It’s not realistic that you’ll always be able to sell your milk for the top price the market offers. No one can consistently predict the top. My point is this: As prices strengthen, don’t be so focused on RISK management that you forget about OPPORTUNITY management.

 

Over the past two weeks, we’ve seen a fairly aggressive rally in third-quarter milk prices, supported by hot and humid weather throughout the country (expected supply decreases) and higher cheese prices (demand increases). As a result, several of our third-quarter months are climbing to the $15 price level. That’s been a pretty elusive number, and many dairy producers are undoubtedly thinking, “I better get going and sell.”

 

The emotion of the situation can be compounded by pressures from other influencers, such as bankers, spouse, and business partners, all of whom are anxious to lock in a price for positive cash flow.

 

If the financial situation of your operation requires you to sell as soon as prices rally to assure cash flow and stop bleeding, that’s fine. There are certainly dairies that require this kind of risk protection. Yet even in this situation, it’s always good to explore how you can add a little bit of flexibility into your milk marketing.

 

If your financial situation and risk tolerance allows for a little more creative thinking, you could look at a variety of pricing strategies and see what impact each strategy has on your overall price. Remember, in a comprehensive marketing approach, each decision works toward building the best possible weighted average price over time.

 

Let’s look at a couple of strategies and see what impact our decisions have on our overall price received if any number of different market scenarios unfold:

The first strategy is a simple forward contract position, selling milk at $15. It is a fixed position, guaranteeing the $15 price even if prices fall, but giving you no opportunity to participate in potentially higher prices.

 

The second strategy combines a forward contract with call options. The purpose of call options is to protect against the really big price jump by allowing us to participate in a price rally, even though we already have milk sold at a “good” price of $15 through the forward contract. You really start to see the benefit of this tool if the market hits $16 or beyond.

 

The third strategy does not use a forward contract; rather, it uses a put option at a cost of 25 cents to give us a minimum price of $14.25 and no ceiling as prices climb.

 

After reviewing the effect of each strategy in various price scenarios, we then need to decide which strategy is best for our situation. If you are a highly leveraged dairy with cash flow stress right now, you may need the forward contract. If you are an operation with a fairly strong equity position and can withstand the risk of a $14.25 floor price, then you may want to use put options to give yourself the best upside opportunity.

 

It comes down to reviewing the scenarios, knowing your financial goals, understanding what you (and other influencers around you) can stomach, and deciding which strategy will perform the best for you.

 

Which price scenario will unfold this fall? No one can say for sure. Technical analysis would tell us that prices should be strengthening through the fall, and patience and planning could mean opportunity. That’s the reason I’m addressing this topic now, so you can realize opportunity if the market rallies. (Heaven knows, you’ve borne some of the worst prices in the cycle.)

 

No one knows exactly what the market will do, but you can be ready for whatever scenario the market dishes out.


 

Market Scenario Planningsm Summary

Strategy

Weighted Average Price Impact in Each Price Scenario

$12.00

$13.00

$14.00

$15.00

$16.00

$17.00

Forward Contract September milk at $15.00

15.00

15.00

15.00

15.00

15.00

15.00

Forward Contract September milk at $15 and buy Call Options ($15.75 call option at cost of 25 cents)

14.75

14.75

14.75

14.75

15.00

16.00

Purchase Put Options covering September milk ($14.50  put option at cost of 25 cents)

14.25

14.25

14.25

14.75

15.75

16.75

 

Steven Schalla is a Market Advisor for Stewart-Peterson Inc. He can be reached at 800.334.9779 or sschalla@stewart-peterson.com.


Market Scenario PlanningSM is a service mark of Stewart-Peterson Inc.

 

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 2010 Stewart-Peterson Inc. All rights reserved.

Popular Tactic: Offset Premiums While Establishing a Milk Price

Jul 02, 2010

By Jon Spainhour, Rice Dairy

 

Over the course of the past few months, we have discussed two types of risk management tools that dairy producers can use to help manage their output and input prices on their farm.  

 

At first we discussed fixed priced contracts, called futures, which allow for dairy producers to establish a set selling price for their milk or a set buying price for their corn or soymeal. In either case, the ultimate price that the producer will sell his milk at or buy his inputs at will be determined by where he contracted them, regardless of where the spot price is at the contract expiration. 

 

We also discussed contracts, called options, which act more like insurance than fixed price contracts. Producers can buy puts on specific price levels, called the strike price, which will establish insurance against their milk check going below that level. Puts are commonly referred to as floors. They can also buy calls, which is insurance against prices moving up, against their expected soymeal and corn input prices.  Calls are commonly referred to as ceilings.

 

The beauty of options contracts is that they establish minimum prices of milk while still allowing the producer to benefit from upwards price movements. They also establish maximum prices for their input costs while still allowing them to benefit from downwards price movements.  In both cases, the producer must pay a premium for their insurance.

 

So far, we have discussed the issue of options strictly from the perspective of buying insurance.  However, in order for you to buy insurance, someone else has to sell it to you. 

 

The person that sells a dairy producer a put/floor is essentially betting that the spot price will not go below the strike level. He is compensated for that risk by the premium that he collects. If the market goes below the strike level, he assumes all the risk below the strike level minus the premium that he collected. If the market settles higher than the strike level, he gets to keep the entire premium that he collected. 

 

Dairy producers often times find the premiums that they have to pay for puts as being too expensive. One tactic they can employ is to sell calls/ceilings and use the premium that they collect to offset the cost of the puts/floors.

 

In this case, they are establishing a floor, which is the lowest price they will receive for their milk and paying for it by selling a ceiling, which is the highest price that they will receive for their milk.

 

This type of structure has several different names that you may have heard of at some point: windows, fences or risk reversals. Regardless of what name you use, it is a fairly straightforward structure that establishes a minimum and a maximum milk price.

 

For example, a dairy producer who wants to set a floor for his September milk production can buy $14.00/cwt. puts for $0.20/cwt. This means that the minimum price that he will receive for his production will be $14.00/cwt. He can offset the cost of the $0.20/cwt. premium by selling $16.00/cwt. calls and collecting $0.20/cwt. Under this structure, the maximum price that he will receive is $16.00/cwt. This means that for a net cost of zero, the producer has set a floor at $14.00/cwt. and a ceiling at $16.00/cwt.

 

The exact same type of strategy can be employed on the input side of the equation, only the producer can offset the cost of purchasing corn and soymeal calls by selling puts and collecting a premium. 

 

I hope this was helpful, since I know that this can seem like a complicated subject matter.  However, when broken down into simple components, I think it paints a more clear picture of a time-tested risk management structure that many dairy producers have been using for years to help manage their profitability. 

 

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 jcs@ricedairy.com.Visit www.ricedairy.com.

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