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June 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 Your Dairy Feed Rations

Jun 27, 2011

Cross-hedging offers a way to control prices in a complex ration by coupling corn and soybean meal futures and options hedges with cash forward contracts.

 
By Will Babler, First Capitol Risk Management, LLC
 
The high cost and high volatility of feed is one of the main challenges faced by dairy producers when working to manage their profit margins (see figure 1 below).
 Babler chart   Volatile and High priced Feed 6 27 11
While the industry does have considerable vertical integration, most dairies must still buy some or all of certain feeds on the open market. It is no longer enough to treat feed purchasing as its own endeavor, given the risk of getting “legged’”– that is, buying feed high and having milk unsold only to watch the price drop.
 
Simply put, feed and milk hedges most be considered in conjunction in order to effectively manage margins in today’s volatile price environment. Placing these feed hedges requires careful consideration of the ration, price correlations and other physical trading factors.
 
Complex Ration
 
Dairy producers face a unique challenge in hedging their feed cost when compared to cattle, hog or poultry producers. Dairy cows are fed a much more varied diet, which can also change seasonally based upon changes in prices and availability of various feeds.
 
Dairy producers need to take steps to hedge a ration made up of not only corn, meal and forages, but also an ever-changing mix of DDG, corn gluten, canola meal, cottonseed, almond hulls, byproducts, etc. At times, many of these common dairy feeds can be hedged in the cash market, though this comes at the cost of flexibility when considering transactions are typically limited to fixed price forwards, if they are offered at all. Often a compelling alternative is to cross-hedge these commodities in the futures and options market.
 
Cross-Hedging
 
Using a financial instrument as a hedging proxy for a related, but not identical, physical commodity is defined as a cross-hedge. The intention of the cross hedger is to rely on correlations between the underlying commodity and the proxy to offset the cash flows associated with the future purchase or sale of the underlying commodity.
 
Dairy producers can effectively cross-hedge grain, protein and corn silage using the futures and options markets for corn and soybean meal.  A simplistic view of a given commodity, such as canola meal, is that it typically holds portions of its value on an energy basis and on a protein basis. Given that corn is a heavily traded proxy most linked to energy value, and soybean meal is a heavily traded proxy linked to protein value, these two instruments should be considered for the cross-hedge.
 
The next step is to determine the appropriate weightings since they aren’t always intuitive – a 1,000-ton purchase of canola meal doesn’t require a 1,000-ton purchase of soybean meal. There are several means of calculating the appropriate weightings. We recommend that dairy producers work with their risk management advisors to understand these methods and the risks associated with them before diving into fully hedging their ration. Once this is understood, producers can proceed to hedge their net corn and meal exposure for their entire ration.
 
Maintaining Flexibility
 
One of the primary benefits of having the ability to hedge a physical ration with financial tools is flexibility. Here are a few examples of where utilizing financial tools can work to a dairy producer’s advantage when cross-hedging their full ration:
 
  • Availability of Forward Contracts – At certain times, physical suppliers are unable or unwilling to sell fixed-price forward contracts for various commodities. By utilizing financial hedges, the dairy producer can still maintain protection from higher prices and/or lock in feed costs against milk sales in order to manage his or her margins while waiting for cash contracts to become available.
  • Availability of Supply – In some market circumstances, prices may be high and availability of supply may be scarce. In these instances, it is a benefit to lock in a physical contract to ensure supply, but this comes with the baggage of also having locked in the high price. One means to mitigate this risk is to lock in the physical contract and then hedge with short futures, puts or put spreads in order to maintain downside participation.
  • Basis Trading – If the basis for a particular cash commodity is tight, it may be in the interest of the dairy producer to remain patient to lock in the price. This waiting game can be problematic if the flat price is attractive or if the producer has a margin he or she would like to lock in versus milk. By cross-hedging the purchase with long futures, calls or call spreads, the producer can manage the flat price, protect a margin and wait for basis to improve.
  • Optionality – The cash market is usually made up of spot or fixed price transactions. When using financial tools such as options, there is greater flexibility and opportunity to participate in lower prices while still maintaining upside protection.
  • Ration Flexibility – Cross-hedging a ration allows for a certain amount of flexibility in making changes to the physical ration as time progresses. Assuming the relative balance of energy and protein are fairly consistent, a cross-hedge on the net open corn and meal exposure may allow for substitution in the ration for an overall lower cost of feed.
 
Conclusion
 
With domestic and global grain stocks at historic lows, it should be expected that volatility and high prices will persist. In this environment, it is important for dairy producers to increase their focus on effectively managing the cost and price risk of their feed ration. The approach discussed here has correlation, basis and other risks, but in our view, these risks are offset by the benefits of potential price protection and hedging and trading flexibility. We strongly encourage dairy producers to take the time to learn more about these tactics.

 

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.

Study the History of LGM for Dairy to Help Identify Future Opportunity and Value

Jun 17, 2011

You can predict the future, but the market will do what it will do anyway. With LGM for Dairy, you can defend and protect your margin when you have an opportunity.

 
Marv Portrait 4By Marv Carlson, Dairy Gross Margin, LLC
 
My goal this month is to engage you in the LGM for Dairy risk management discussion of comparing the calculated margins with the historical trend from the charts created by Dairy Gross Margin, LLC.
 
What are your goals?
 
Does the margin look like I should take a closer look at securing these opportunities, or is it so low that it can only get better? Do I need to research this further to make an educated decision, or is my gut instinct telling me this is a no-brainer?
 
The Gross Margin is, in essence, the cash flow available to pay your fixed assets, labor, return to management and other operating costs. Maybe you can sleep a lot better if you know that you have a margin floor in place. Maybe the bases are covered for a new parlor or expansion to meet market demand. Maybe it is the much-needed vacation to enjoy with theCarlson chart 6 17 11 family. Know your cost of production. Know the margin needed to meet your goals. looking at this chart may help you take action and minimize any procrastination.
 
You can predict the future, but the market will do what it will do anyway. With LGM for Dairy, you can defend and protect your margin when you have an opportunity. This chart can help you see where the margin currently stands compared to the past. 
 
The following charts are maintained monthCarlson chart 6 17 11bly and published on our website around the scheduled LGM for Dairy sales day, which is the last business Friday of each month, to help you envision the margin trend and make better and informed decisions.
 
Thanks for reading. Look at these charts monthly and start a discussion on risk management with your team.
 
 
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.

Control the Emotions and Impulsive Decisions that Milk Market Volatility Can Produce

Jun 13, 2011

In a roller coaster market, producers often feel they should do something, like jumping in or out of positions. This can lead to all kinds of impulsive decisions--and often poor results. So when do you step in, and when do you ride it out?

 

S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson

Milk prices chugged higher for three straight trading weeks leading up to last Tuesday, June 7.

Roller coasters are sure a lot of fun at the amusement park, but there was very little amusement on June 7, when the milk market fell 75 cents, its daily limit.  If anything, Tuesday’s ride left you feeling quite queasy!  Trade that day was indeed roller coaster-like, with swings both up and down, drawing in even those who think of themselves as disciplined marketers in it for the long haul. Total volume for the July contract totaled over 1,000 contracts, about three times a normal day’s trade for the second month contract. 

As a dairy market advisor who monitors price action in the milk markets every day, it was very apparent to me that emotions ran high and boiled over at times, as both buyers and sellers rushed to establish or exit milk contracts. At times it felt like watching a tennis match, with the ball flying back and forth between the two competitors. 

The timeline below summarizes the volatility and emotion of the session, tracking the July 2011 milk contract:

  • 9:05 a.m. – July Milk opens the day trading session at $20.13/cwt., off 4 cents from the day before.
  • 10:45 a.m. – Heading into the daily cash cheese session, July drops a minimal 4 cents from the open to $20.09. 
  • 10:48 a.m. – Cash cheese session closes with no action seen in either the Block or Barrel market.  This spooks the milk market, and the July contract free-falls to $19.87, 22 cents lower than just three minutes earlier.
  • 11:07 a.m. – Within another 10 minutes, additional traders see the drop and pour into the market. Volume builds, sending July down to $19.51. In just over two hours, July has dropped 62 cents.
  • 11:11 a.m. – Milk buyers have waited long enough, and jump in fast!  Big buy orders throw prices back higher to $19.89, a 38-cent swing back up in 5 minutes. 
  • 11:30 a.m. – The push higher is short-lived, and sellers step back in. This works the July price back down to $19.42, a new low for the day and down 47 in less than a half hour.
  • 12:30 p.m. – Buyers are willing to make one more stand after the sharp set-back and bounce the July price up 18 cents to $19.60.
  • 1:10 p.m. – At the close of the day session, worries prevail and the July prices slide lower to the daily limit at $19.42. 

 

Exhausting!  Can you image trying to decide what to do at any one of these points with only a few minutes to pull the trigger? Fortunately, this much volatility within one day rarely takes place. 

Regardless of how fast it happens, there is always emotion tied to seeing milk prices make sudden swings. Each of these price points could realistically represent one day’s trading session and the emotion would still be there.

Recent conversations with producers we work with demonstrate just how emotional milk market decision-making can be. Producers feel like they should be doing something, whether it is jumping into positions or jumping out. You can feel the level of concern and tension as they search for a feeling of security. This emotion can lead to all kinds of impulsive decisions, which usually do not yield good results.

So when do you step in and when do you ride it out?

The simple fact is that today’s markets change fast, and not always for logical reasons. In fact, the July milk contract is averaging a daily trading range of just over 41 cents in the past two weeks.  Some moves warrant your attention while others may not. Last Tuesday’s move was largely offset by Wednesday’s trade, where milk prices came back sharply higher, including July gaining 45 cents, as cash cheese prices continued to gain. 

The key to knowing whether you should step in lies with advanced planning. Look at key factors like where we are in the milk price cycle (which I’ve written about before), what percent of my milk is protected, and which tools will do the best job if the price goes up, down or sideways. Then, when the price does go up, down or sideways, you have thought about what you will do. You can react faster than if you had done no prior planning.

There are many producers who would rather get a tooth pulled than work on their risk management strategies. Yet working through different strategies and how they will perform in any price direction is key to having the confidence to know when to step in and when to sit tight as the market moves. It will also give the confidence to hold established positions, since you’ll know what your price will be in any scenario. We call this process Market Scenario Planning, and it’s a tool we use every day, to help clients stay focused on the long haul. 

As we work through summertime, chances are that volatile and emotional trading days will happen, especially with milk prices reaching historically strong levels. With that in mind, a little prior planning will go a long way in making disciplined decisions and forming a successful marketing strategy. 

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.

Can Your Hedge Strategy Weather the Volatility Storm?

Jun 06, 2011

Create a risk management plan that will work in any price cycle.

 
Katie Krupa photoBy Katie Krupa, Rice Dairy
 
In recent weeks, Class III futures trading on the Chicago Mercantile Exchange (CME) have been climbing, causing many producers to nervously review and second-guess their current hedge strategy. Writing this on June 3, the June-August average Class III price has moved up more than $2.00 in just the past three weeks.
 
If producers hedged their milk price a month ago, they may be unsatisfied with their hedge strategy since futures prices are significantly higher. Many producers fear this situation, because money will potentially be left on the table. So how can a producer create a hedge strategy that will work in any price cycle?
 
1.                   Remember, hedging is risk management. You are not trading milk futures to “beat the market” or make a quick buck. You are working with a broker, coop or milk plant to hedge your milk price, and reduce your business’s risk from milk price volatility. When you set up your risk management strategy, use your farm’s financials to establish a price that will return an expected profit. Then make your risk management decisions based on financial reasons. Fear and greed should not influence your risk management decisions. Obviously, this is easier said than done. By making decisions based on financials, your risk management strategy should return your expected profit margin, and your business should be profitable regardless of market volatility.
 
2.                   Make decisions as a team. Regardless of whether your management team consists of just you and your spouse, or multiple partners and consultants, you should create your hedge strategy as a team. Now, this doesn’t mean that a management team of eight people need to make every trade decision, but the general risk management goal and philosophy should be agreed upon by the group. Sometimes the smaller the group, the harder the decision is to make. If it is just you and your spouse or relative, be sure that you are all on the same page, and communicate, communicate, communicate. Working as a team will help ensure the decisions are based on financials rather than emotions.
 
3.                   Game-play the hedge strategy. This is very simple but rarely done. When creating your hedge strategy, ask the following questions:
  • What will my milk check look like if the Class III price settles at $9.00?
  • What will my milk check look like if the Class III price settles at $25.00?
If you are uneasy with the answer to either one of these questions, look into different hedge strategies. There are many strategies that can protect the downside while still providing upside potential.
 
4.                   Be flexible. Unfortunately, the milk price can be influenced by a weather pattern, a political event or an act of terror. When these events occur, which won’t be projected in any forecast, you may need to adjust your hedge strategy. It is easy to put on the blinders and say the milk price will not go down to $9.00, or up to $25.00, but it can happen, and it can happen fast. Make sure your hedge strategy will suit your needs if the market changes drastically, or make sure you can change your strategy down the road. Don’t get locked into a hedge strategy that won’t work in a changing market.
 
5.                   Lastly, don’t lose sight of the big picture. Although you may leave some money on the table when the milk price moves up, you are creating a hedge strategy to protect your business should the milk price decline. Regardless of your chosen hedge strategy, there will inevitably be a time when the market moves and you give up some money. The good news is that this typically happens when the milk price is moving higher. Even though you have hedged a portion of your milk, a higher milk price for your un-hedged milk ultimately means more money in your pocket. And, yes, it hurts to miss out on higher prices, but it typically hurts the ego much more than the bank account.
 
Your risk management decisions should be viewed as long-term financial planning to protect your business and the families that depend on your business. Get educated, work with someone who understands your business, and create a strategy that can weather the volatile storm ahead.    
 
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.
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