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May 2011 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.

Hedging Tools to Manage Dairy Margin and Milk Basis Risks Are Available

May 27, 2011

Understanding hedging tools and variables – from the Midwest to California – can help influence your basis risk, or the difference between cash and futures prices.

 
By Will Babler, First Capitol Risk Management, LLC
 
A sound dairy margin management strategy should first focus on managing the most significant and most volatile margin driver – milk price. Simply put, no other variable influences bottom-line results as much as milk price. Fortunately, futures and options tools are available to manage this risk.
 
Normally it is enough to just consider these tools as adequate hedging instruments without diving into the details of how cash milk prices and the milk check in your mailbox relate to the futures settlement price. However, when taking the next step toward managing margins, we need to consider the influence of basis risk, or the difference between cash and futures prices. Unless basis is understood, it is difficult to match hedging expectations with hedging results.
 
Federal Order Milk Basis Risk
 
A simplification of a typical Midwest producer’s milk check shows that the Class III milk price is the primary driver while the following also play an important role:
·         PPD – producer price differential
·         Components – fats, solids, protein
·         SCC – somatic cell count
·         Premiums – quality, volume, location or other premiums
·         Deductions – hauling and other costs
 
Most of these factors, except for PPD, are relatively stable or seasonally variable aspects of a producer’s operation. It is important to understand the historical impact of these factors on past basis results as well as future basis expectations.
 
The PPD is variable based on market prices and utilization, which adjusts the pay price based on the value of other dairy products aside from cheese. Since these factors vary with market volatility, the PPD can have a significant influence on the realized basis and mailbox prices. In a narrow margin environment, it is important to take into account all the factors listed above, understand past basis history, and have a tool to project forward basis. Without taking these steps, a margin hedging program is unlikely to meet its expectations. See Figure 1 for an example of the basis variation introduced by just the PPD.
 
Figure 1
 Babler   PPD chart   5 27 11
California Basis Risk
 
The California basis risk scenario includes many of the issues above. An additional complication is that this market is not Class III-dominated. The California order is driven by the equivalents of both Class III (cheese) and Class IV (butter and powder). Depending on price spreads, either the Class III or the Class IV equivalents make up slightly more than half of the pricing influence. With this in mind, California producers should be utilizing both Class III and Class IV hedging tools to manage their price risk.
 
Historically, the superior liquidity of the Class III futures market has led most California producers to focus on hedging with this tool. This approach has its place but, within a margin management context, the basis risk of hedging with only Class III could exceed the margins available in the market.
 
This points a California dairy producer toward taking into considerations the factors in the prior section and also seeking to manage the entire spectrum of his or her milk price risk by hedging in both the Class III and Class IV markets. Recent improvements in market liquidity for Class IV futures and options have made this approach much more practical. See Figure 2, which shows the reduction in basis risk by using a simplified hedge approach of 50% Class III futures and 50% Class IV futures. This approach has considerably less basis risk compared to hedging only with Class III.
 
  Figure 2
Babler   Calif overbase basis comparison 5 27 11
Conclusion
 
Managing margins and price risk is an exercise in balancing risk and reward. Milk basis risk should be included in this balancing act. By properly understanding and quantifying this risk, a producer can improve the performance of his or her margin hedging program and, hopefully, have hedge results that meet initial hedge expectations. This is particularly important in a narrow margin environment where there is less room for error and all assumptions are important.
 
Will Babler is a principal partner at First Capitol Risk Management, LLC. Contact him at 815-777-1129 or at wbabler@firstcapitolrm.com. Visit the company’s website at www.firstcapitolrm.com.

LGM for Dairy: How to Assess the “Percentile Ranking” of This Month’s “Margin Estimate”

May 23, 2011

A decision-making tool can help you visualize how the current month’s Livestock Gross Margin for Dairy ranks in relation to previous margin time frames.

 
Marv Portrait 4By Marv Carlson, Dairy Gross Margin, LLC
 
Our percentile rank for the month’s Livestock Gross Margin for Dairy is based on historical comparisons to actual margins or margins that could have been calculated in times before LGM for Dairy was available.
 
Dairy Gross Margin, LLC has developed a decision-making tool to help dairy producers visualize how the current month’s Livestock Gross Margin for Dairy ranks in relation to previous margin time frames. Several producers have asked how the CME Class III milk price going into the current sales month compares to recent times, so we have added this feature to the percentile rank decision-making tool for further analysis.
 
When you look at the chart below and on our webpage, you will notice the “average feed” and “low feed” percentile comparisons in addition to “milk.” The 10-year and five-year percentile comparison gives the longer term and more recent snapshots by month that LGM is available during the current sales period. Where you see “#NA,” that means there is no LGM insurance offered that month.
 
For instance, take the January average feed margin estimate of $11.98. The 10-year average percentile was 80.60%. This means that 80.60% of the time over the past 10 years the margin estimate would have been calculated lower, and 19.40% of the time it was calculated better. I would say this margin estimate achieved a “B minus“ grade. The five-year percentile ranking for the same $11.98 estimate was 77.30%, or a “C plus” grade.
 
We have set up average feed and low feed inclusions for our margin estimate comparisons. The low feed calculation was designed for producers who grow most of their own feed or have other risk tools placed into action. The average feed calculation is based on a near total amount of feed needed for the average ration a producer may be feeding.
 
The Risk Management Agency’s (RMA) purpose for the variable feed inclusion allows you to factor in variables to match you operation such as:
·         whether you’re growing your own heifers;
·         dry cow feed needs;
·         amount of feed needs that must be purchased in relationship to feed grown on the farm;
·         milk production level goals you may have.
 
We recommend you calculate your corn and soybean meal equivalent based upon your total feed usage. From there, look at the cost percentage vs. total cost to determine margin coverage needed for the “at risk” component of your feed needs.
 
The percentile ranking of your own margin estimate will vary from those we present each month, since the LGM for Dairy margin estimate is calculated by subtracting your feed inclusion values for corn and soymeal from the value of 100 lb. of milk (milk minus feed equals margin).
 
Percentile Rank Comparison Chart from the April 29, 2011 LGM for Dairy Sales Date:
 LGM for Dairy Carlson   Percentile Rank chart 5 24 11
 
Check our website: www.dairygrossmargin.com under “Dairy History” to view the Percentile Ranking Decision-Making chart for Margin and Milk comparisons. Even though LGM for Dairy will not be available until this fall, we are maintaining our decision-making tools and updates to help you “manage the margin” for better profitability.
 
Marv Carlson is with Dairy Gross Margin, LLC, in Sioux Rapids, Iowa. Contact him at marv@dairygrossmargin.com or (712) 240-8395. Visit the firm’s website for more information: www.dairygrossmargin.com.

 

Are Bullish Milk Fundamentals Enough to Hold Prices?

May 14, 2011

In today’s global economy, everything from China’s currency valuation policy to the price of crude oil impacts the dairy sector and your milk price. How much can milk prices withstand bearish pressure from “outside markets”?   

Copy of S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson
 
Over the past several months, there has been a lot of good fundamental news for milk prices. While cow numbers have increased by 176,000 head since March 2010, these gains have been largely limited by historically high cull prices that have led to huge dairy cow slaughter figures.
 
In addition, Cold Storage figures for cheese continue to run below year-to-year average growth of about 5%, with the last two months reported at 4% and 3% increases respectively. Butter stocks are ever so slowly recovering, but still remain 25% off from a year ago. Much of this can be explained by the phenomenal exports seen for cheese and butterfat this year as Oceania struggled through another lackluster production season. 
 
And most important, national milk production has been in line with average growth rates at 2.2% year-to- date and, if anything, have left processors looking for additional supply. 
 
All of these factors have contributed to the strong prices currently seen on the Chicago Board of Trade. Class III prices have challenged $18.00/cwt. in some months next fall, while Class IV values have exceeded $20.00. With the fundamental picture described above, many producers are expecting strong prices to continue through the end of the year. 
 
So, what are we telling our clients right now? In working with each of my clients, my goal is to prepare them for any type of price trend and milk price. While there are many positive fundamentals for milk, we’re also planning for a less rosy picture. Here’s a scenario I’m visiting with my clients about, in an effort to be ready for anything:
 
Possible “outside market” impact
 
In the past several weeks there have been developments in the “outside markets” that could put some real pressure on the milk complex. Does milk have enough strength and bullish reasons to stand on its own? In globally connected markets, how much can milk prices withstand bearish pressure from “outside markets?” 
 
Before diving into this analysis, let’s first define what is meant by “outside markets.” Naturally, there are additional financial markets that will have a direct or indirect effect on the dairy industry and thus milk prices. A simple example is grain market price changes affecting feed costs and farm profitability. 
 
Another traditional example is the U.S. dollar and its impact on exports. More recently, other markets also have become more influential, such as the U.S. and international stock markets being used as a benchmark of consumption trends and spending ability of consumers. In today’s global economy, everything from China’s currency valuation policy to the price of crude oil impacts the dairy sector and your milk price. 
 
Since last summer, the trend for commodities has been higher. The Continuous Commodity Index, which is an index of all commodity prices, rose 54.6% from June 2010 to the week of April 16, 2011. While each commodity sector has had bullish news, the sinking U.S. dollar has been an underlying supportive factor. In addition, inflation fears have led to commodities being a trendy market for investors. 
 
However, since the week of April 16, there has been a quick and dramatic shift in these trends. The U.S. dollar posted a key reversal to start the month of May, and the Continuous Commodity Index broke dramatically lower. As demand for many commodities shows signs of rationing at these historic price levels, energy and grain prices have reversed as supply concerns ease. 
 
As it relates to your dairy, this shift in commodity trends is a doubled edged sword. With higher milk prices, profitability would increase quickly, and so could national milk production as producers take advantage of the opportunity. The simple domino effect of this scenario goes like this: Fragile consumer spending (here and abroad) hinders demand, commodities shift to a lower trend, and milk gets dragged downward despite good fundamentals. 
 
This is one of several trends that could materialize in the coming months. As milk-price risk and opportunity managers, our goal should be to prepare for whatever the market may do. In today’s world, prices react to just about anything, so why not be ready for anything? 
 
Maybe the more challenging question is, “How can I be ready for anything?”
 
  • First, consider your current strengths and weaknesses as a risk manager and marketer. Key constraints could be knowledge, time or discipline. Ask yourself, “What is preventing me from managing risk and marketing well?” Then resolve to remove the barriers and get it done.
  • Second, consider marketing strategies as they affect 100% of your milk production. Marketing, say, only a third of your milk isn’t going to protect you enough, or secure meaningful opportunity. There are ways to layer strategies with incremental portions of your milk.  
  • Third, run an analysis on the impact of each potential strategy. This can quickly show which positions will help your situation the most, and which will do very little. 
  • Finally, and probably the most important advice for today’s marketer, is, “Don’t be distracted.” Our experience continues to show that successful marketers are far less concerned about why the market is moving, and instead focus on what their next step will be. This shift in focus in easier said than done, because we all want to understand “why.” The results, however, are rewarding.
  
Steven Schalla is a Market Advisor for Stewart-Peterson, Inc. He can be reached at 800.334.9779 or sschalla@stewart-peterson.com.
 
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 2011 Stewart-Peterson Inc. All rights reserved.

Life Without LGM

May 09, 2011

Although USDA’s Livestock Gross Margin for Dairy Insurance program is on hiatus until later this year, other alternatives can protect the margin between your milk price and feed costs.

 
Katie Krupa photoBy Katie Krupa, Rice Dairy
 
The USDA’s Livestock Gross Margin for Dairy (LGM-Dairy) Insurance program has been available for nearly three years, but its producer popularity was nearly non-existent until recent months. Unfortunately, the popularity for this one-stop margin insurance program was so great that it exhausted the government’s allocation of $15 million of underwriting capacity.
 
Currently, the sale of LGM-Dairy is halted, and will not resume until October unless Congress authorizes additional funding prior to then. Assuming no additional funding is authorized, December 2011 will be the first month dairy producers can protect through LGM-Dairy. (If bought in October, coverage could start for December).
 
With so many producers now interested in LGM-Dairy, it’s a good time to point out some alternatives to the USDA’s margin insurance program.
 
First, let’s review the concept behind LGM. Rather than just protecting the milk price, LGM protects the margin (difference) between the milk price and the feed costs. The margin is determined by a model and, at its simplest, the producer can cover the feed needs for a set amount of milk. While LGM is simple, it isn’t always the most accurate for producers since their feed ration is not evaluated but rather a fixed model. The biggest perk to LGM was that it could be purchased for as little as one cwt. of milk per month, which made it very usable especially by smaller producers.
 
Most dairies have shied away from using the exchange to trade both their feed and milk due to:
·         contract size
·         lack of education on exchange trading
·         margin account requirements
·         varied feed ingredients in the ration
 
LGM simplified and standardized the process by converting a typical ration into corn and soybean meal equivalents. The good news is that producers can do this ration conversion themselves (or with the help of a broker/consultant). I work with producers on a daily basis to convert their ration, which is often very diverse, into corn and soybean meal equivalents. This conversion enables them to trade their feed costs on the exchange. By trading feed and milk, we can protect the margin between the milk price and the feed costs.
 
Taking this process one step further, we can trade milk and feed through various hedge strategies on the exchange. That means we have the opportunity to either lock in a margin, or protect a margin. For example, we can fix the milk price and fix the feed costs, or we can protect the milk price from dropping and protect the feed costs from increasing. With the second scenario we are protecting the margin, but if the milk price should rise and/or the feed prices decline, the producer will benefit from these price changes. But if the milk price drops, and feed prices rise, the producer will be protected. 
   
Unfortunately, there are some hold-ups when trading on the exchange. The biggest one is contract size. From a 10,000-foot level, trading both milk and feed on the exchange is best suited for a dairy with at least 300 cows. Due to contract size for corn and soybean meal, a producer with less than 300 cows will typically be over-contracting his or her feed needs if trading through the exchange. Additionally, producers are required to fund a margin account when they place the trades. In short, money is due upfront on the exchange, as opposed to LGM-Dairy, where it is due at the end of the insurance period.
 
So are there any options for the herds with less than 300 cows? Maybe. Several of the co-ops are now offering margin, or feed contracts that can be used with milk contracts to protect the margin between milk and feed. I would check with your co-op or milk plant to see if any options are available.
 
The bad news is that price volatility is here to stay, and currently LGM-Dairy is unavailable. The good news is that hedge programs are evolving to combat price volatility and allow producers to protect their milk to feed price margin. Trading on the exchange offers a wide variety of hedge strategies for both milk and feed prices, and can be user-friendly when working with a knowledgeable broker.                
 
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. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at klk@ricedairy.com.Visit www.ricedairy.com.

Creating a Risk Management Plan

May 02, 2011

Here are seven key questions to ask yourself in developing your hedging strategy.

By Will Babler, First Capitol Risk Management, LLC
In my previous article, we discussed selecting the right hedging tool at the right time. Another important aspect of applying the right tool at the right time is to do so consistently. We have found that this is best done by planning ahead and documenting objectives, limits and organizational control points in a written hedging policy. When it comes to hedging, as in other aspects of managing a dairy, failing to plan is planning to fail.
Here are some key questions that should be answered in a good risk management policy.
1.       What is the purpose of the plan?
The purpose of a risk management plan, or policy, is to drive intentional decision-making. When a game plan has been written down on paper and approved by a management team or board of directors, it empowers the decision-makers in the organization. The purpose section of any plan should include an acknowledgement of commodity risk and the explicit statement that commodity transactions will be taken for the purpose of managing risk and not speculating.
 
2.       What is my hedging strategy?
In our view, a hedging strategy should encompass two ideas: 1) to minimize risk; and 2) to capture opportunity. Making this clear statement in a risk management policy sets the framework for how decisions will be made relative to selecting hedge positions.
 
3.       What are my position limits?
There is a huge universe of potential tools that can be used to manage commodity risk. Depending on experience and risk tolerance, a hedger should limit this universe of tools to the ones that will be most useful for their particular situation. This section should determine which markets are allowed (i.e. corn, milk, soybean meal, etc.) and what types of position can be taken (futures, options, option spreads, marginable positions, etc.). In addition to qualitative limits on markets and position types, this section of the policy could also set specific quantity limitations on how many open contracts can be held for any particular category of position.
 
4.       What budget am I willing to spend on hedging?
Closely tied to position limits in any hedging plan is the hedging budget. Setting a budget for option premiums has several benefits. Budgets provide the ability to plan for cash flows as well as restrict the possible choices of hedging tools so that the range of decision points is reduced. This drives timely decision-making. Budgets should account for a hedger’s risk tolerance and financial capacity as well as values that historically would be practical to execute in the market.
 
5.       What profit targets do I want to hit?
This is the million-dollar question: Essentially how much risk do I want to take and at what level am I comfortable taking a profit? This section of a risk management plan is unique to every dairy based upon its risk tolerance, financial capacity and operational performance. Managing commodity risk and margins is effectively managing the profitability of your business. Setting profit targets can be based on looking at historical performance, equity return expectations or financing and debt coverage requirements. A good policy will lay out specifics as to what profit-margin levels are worth scaling into and for what volume of total production.
 
6.       What financing requirements does my plan create? 
There may be significant financing requirements associated with hedging, depending on the tools allowed in the position-limits section of a hedging plan. Provisions should be made for periodically stress-testing open positions for possible variation margin requirements as well as for stress-testing potential new hedges prior to their execution.
 
7.       Who is responsible for the plan?
Finally, the plan should lay out clearly who in each organization is responsible for the various tasks that the plan will require. This section would identify who is authorized to make decisions, initiate trades and transfer funds. Other details such as reporting, disclosure and accounting should also be addressed in this section of the plan.
 
Conclusion
Over time, we have seen that the most successful hedgers are those who act consistently and decisively. Having a written risk management policy is one way to drive that behavior and potentially replicate their success. Markets aren’t interested in waiting for any individual to make a decision about what they should do.
 
With increased volatility in prices and margins, it is increasingly important to act decisively. Taking decisive action is much easier when the emotion has been removed through planning where everyone in the organization is in agreement as to hedging objectives. We strongly advise seeking out experienced advisors and putting pencil to paper to create a written plan before embarking on any hedging endeavor.
 
Will Babler is a principal partner at First Capitol Risk Management, LLC. Contact him at 815-777-1129 or at wbabler@firstcapitolrm.com. Visit the company’s website at www.firstcapitolrm.com.
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