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August 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.

What’s in Store for 2012 Prices? A More Experienced Milk Market

Aug 29, 2011

After the last high-price cycle, many dairy producers learned to expect the very worst. Now the milk market has taken the lessons of the previous cycle and is trying to avoid the same costly mistakes. 

S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson

One of my favorite quotes is from Mark Twain: “A man who carries a cat by the tail learns something he can learn in no other way.”
 
Experience can be the best teacher and, since 1996, dairy producers and milk users have been learning quickly about using an open futures market to manage risk and opportunity for their milk. And there have been many lessons over the past 15 years. 
 
The lessons that stick with us the most are often the most painful, such as carrying a cat by the tail! In our dairy world, you don’t have to look any farther than the price depression of 2009. Even today, more than two years after the low point of June 2009, the most common reason producers give when asked why they want to start marketing is to “avoid a year like 2009.” 
 
As milk prices have reached historic highs (like they did in 2008), the talk of the impending next depression is rampant. The lesson many dairy producers learned was to expect the very worst. But the latest rally of milk prices has included some key differences from 2008, demonstrating that the milk market has learned from experience.
 
The most important difference between these respective high points in the milk price cycle is the prices offered in the forward curve. The “forward curve” is simply how the future prices map out compared to the front month contract. These are the prices the producers and milk users are analyzing when considering major decisions such as expansion or exiting the business. 
 
As a milk producer, the forward curve can suggest three basic things about expectations of the future: 
·                     the market needs more production,
·                     the market needs the same amount, or
·                     the market needs less production. 
 
During times of peak demand (or absence of supply), the market will build a premium into the close-up prices to indicate that it needs your production now. This summer, July and August Class III prices have topped $21.00 as year-to-year milk production growth has slowed from 3.3% last September to a mere 0.7% in July. At the same time, both domestic and export demand has been solid through the first half of the year. The result is the market paying up for available supplies to meet this demand and encouraging a boost in near-term production.  
 
However, after the third quarter months in 2011 the futures drop off dramatically. While 2012 prices have appreciated about $1.00 per cwt. this summer, these prices are only averaging about $17.00, or a dramatic $4.00 per cwt. less than the front months. Here, the market is signaling that it expects available supplies to increase (or demand to decrease) this fall and winter, resulting in a lower price. Rapid growth in cow numbers this year in the Northwest and Southwest regions helped lead to this expectation. 
 
This discount in prices next year is a stark contrast from 2008. In February of that year, the forward curve carried a 12-month futures price average that broke over $17.00 and maintained above that level until mid-August. Moreover, during five weeks in May and June 2008, the next 12 months averaged over $20.00. The market signal was clear: The expectation was that the market needed a lot more milk for a prolonged period of time, and producers appropriately responded as such. Of course, as the supply pipeline filled, the global financial crisis stalled demand (particularly exports), compounding price declines. An invaluable lesson was learned by all about the power of the forward curve.
 
When we talk to producers, we’re glad to hear that many are detecting this critical difference. With high input costs, there is a considerably different signal when forward prices show $20.00 versus $17.00. While $17.00 for 2012 milk is often described as feasible, this more conservative price seems to be resulting in more conservative expansion goals on an aggregate level. The actual extent of production growth (or potentially lack thereof) will be seen this fall as milk-per-cow productivity improves in cooler weather.
 
This analysis is not to say that a sharply lower price scenario for 2012 is not possible, but, rather, that the milk market has taken the lessons of the previous cycle and is trying to avoid the same costly mistakes. In the case of U.S. dairymen, this starts with cow numbers and milk production. 
 
Of course, there are numerous other factors that will also impact prices looking into next year. International supply and demand will be vital as New Zealand targets a robust production increase of 5% growth, and many global economies struggle with high debt levels and imbalanced budgets, leading consumers to tighten their own spending habits. Feed cost will also stay top of mind as expectations of a short crop drive prices higher. December corn has broken into new contract highs, and bean meal futures continue to test major resistance at $375 per ton.   
 
These moving parts lead to a number of potential scenarios for 2012 prices, providing both opportunity and risk in the coming months. While it may not be necessary to implement specific positions today, discussing different strategies and how they will impact your price in either an up or down price trend will be very beneficial.  Especially with the busy harvest season just around the corner, this preparation will be rewarded when you are able to easily implement the positions when the timing is right. 
 
While we can’t say with certainty what will happen in 2012, we can say with certainty that proactive strategizing now will lead to more confidence in decision-making and stability in your price for the coming year.
 
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.

Do You Have a Market Plan in Place?

Aug 22, 2011

High-cost feed purchases and uncertain milk prices add to the risk of 2012. A few moments of planning now will help with the cash flow and overall profitability of your operation.

 
Marv Portrait 4By Marv Carlson, Dairy Gross Margin LLC
 
In dairy country, the silage choppers will be chopping and the silos will be filled. The hay, if you are in the Midwest, is close to the last cutting. If you are not in the Midwest, many of you may have additional costs because you are buying forage. These additional purchases add to the risk for 2012. Most all of this feed is purchased or has been grown and stored, waiting for the price to go up.
 
Now the risk is all on the price of milk. Will it move higher? Will it move lower?
 
It might be time to think about your business plan. A few moments of planning now, without having a panic attack, will help with the cash flow and overall profitability of your operation. It just makes sense to ensure you generate positive returns for the feed you have purchased or have in storage. The plan should include a break-even calculation.  
 
The next step is to estimate the feed stocks you will have on hand. Estimate the dollars you have invested in the hay and/or pile of silage, knowing it needs to be converted to cash. Look at what milk prices are in the future. How much milk do you have to cover with Livestock Gross Margin-Dairy, cash sales, futures or options?
 
We have always suggested using LGM-Dairy as part of the marketing and business plan. By using LGM-Dairy on 33% of your projected milk, you will have coverage for a portion of your fixed expenses and your feed.
 
In October, when we can buy LGM-Dairy, look at the lowest amount of feed possible. You can find a link to the LGM for Dairy Analyzer, designed by Dr. Brian Gould, at our website. It will give you the potential margins you can lock in for 6 to 10 months. LGM-Dairy would establish a floor on your revenue.
 
Here is an example from the LGM Analyzer: 

  • Insurance contract month of August 2011 looking forward to the months of December 2011 through July 2012.
  • Deductible level of $1/cwt. at the lowest amount of feed input allowed.

 
Carlson chart 8 22 11 a

The second choice is to use an options strategy by buying milk puts and soybean meal calls. We do not need to suggest buying corn calls if you have silage and/or wet corn. These option purchases will establish a floor on your revenue.
 
The third choice is to use forward contracts or futures if milk prices are above your break-even. This would establish an absolute price. If you use futures, you are subject to margin calls. If for some reason the market moves higher, you will have accomplished your goal, but you may have missed an opportunity by selling at a lower price. 

Fall is a good time to start the planning for 2012. If you have any questions, please feel free to call me at (712) 240-8395 or contact me by e-mail at marv@dairygrossmargin.com.

 Carlson chart   8 22 11
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.
 

Executing a Dairy Margin Management Plan

Aug 15, 2011

Successful dairy margin managers should focus on these points to help drive consistency in executing their margin management program.

By Will Babler, First Capitol Risk Management, LLC
In prior articles in this Dairy Margin Management series, we have reviewed strategic issues such as hedging philosophy, selecting the right hedging tool and developing a commodity risk management plan. We have also discussed tactical issues such as understanding milk basis risk and hedging complex feed rations. Maximizing the potential benefit of these various topics requires discipline and consistency in execution.
With volatile markets and a distracting operating environment, it is one thing to have a plan. It is an entirely different thing to follow through with it. Successful dairy margin managers should focus on the following points to help drive consistency in the execution of their margin management program:
·         Written Policy – Having a written document that outlines the agreed upon hedging tools, budgets and targets allows for decisiveness and time savings. It also prevents second guessing since all stakeholders in the operation have come together and made a final decision on the policy. This written game plan allows for a consistent approach in execution since expectations and constraints aren’t a shifting target.
 
·         Regular Schedule – Dairy managers have no shortage of pressing issues vying for their attention. Unfortunately, markets don’t have a pause button. Fast markets can result in drastic changes in profitability. Setting aside regularly scheduled times for review of the risk management program keeps opportunities and risks from slipping through the cracks. These scheduled times can be used for either internal review or discussions with outside advisors. Many managers set aside a short amount of time each day or each week for a quick review of positions, prices and margins. A more in-depth review is often scheduled biweekly or monthly.
 
·         Actionable Information – To consistently execute a hedging program requires turning a huge quantity of market and operational data into good information. It is important that a dairy margin manager have their vital numbers in front of them before making any hedging decisions. Actionable reports should include details of milk and feed prices and price trends, option hedging costs, coverage and exposure and forward profit opportunities. Having a means to assemble this information in a consistent format allows for time savings as well as the ability to view opportunities and risks through the same lens as time passes.
 
·         Stick with the Plan – When forward profit margins are in historically high percentiles, it should be easy to take steps to lock in this opportunity. Yet the typical dairy producer may have trouble pulling the trigger. These are times to reflect back on the policy, which should direct a less emotionally conflicted course of action – scaling into hedge positions that lock in margins as they reach historically favorable levels. In a perfect world, a hedger would spend his or her time only making decisions on how to go about locking in these types of opportunities. In reality, hedgers must also focus on playing defense. When margins become less than ideal, the tendency is for producers to pull back and decide they no longer want to hedge. This ignores the fact that margins could erode further. Consistently managing risk requires maintaining hedge coverage in good times and bad. This approach requires discipline that is rewarded over the long term by smoothing out the peaks and valleys in margins.
 
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.

Milk Futures Will Remain on Edge, Along with Nerves

Aug 08, 2011

With cash markets and milk futures surging, the best way to navigate extreme prices is to stay consistent, remembering and sticking to your market goals.

 
S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson
 
In the midst of a whirlwind of events impacting dairy prices, cash markets and milk futures have surged over recent weeks, returning to levels not seen since the spring of 2008. Spot cheese values have plateaued just over $2 per lb., and milk futures have matched the 2007 and 2008 highs at $21.50 per cwt.
 
This time around, however, many producers have told me that $21.00 milk doesn’t feel very historic or all that special. With current feed costs, and knowing that current profits are still rebuilding the balance sheet for many, this perspective is warranted.
 
On the other hand, it is still an exciting time for milk and dairy prices, given how elusive these levels have been. Last Friday, the July Class III price was announced at $21.39. This is about $6.00 per cwt. more than the Class III average over the past five years of $15.17. In fact, of the past 60 months, only five have seen an announced Class III price over $20.00. An additional nine months have been over $18.00, amounting to a mere 23.3% of the time the Class III prices has been over $18.00. (See chart below.)
Schalla   Milk Price Table b
 
This five-year perspective dates back to mid-2006 and the start of commodity price increases as a whole, including the grain and energy markets. Even considering these outside markets’ influence on dairy, historically speaking it is definitely a special time for milk prices.
 
It’s taken a combination of events to achieve these price levels for both dairy products and milk futures. Throughout the first half of the year, exports have been exceptional. Total cheese exports through May have increased 56% compared to a year ago, while total butterfat gained 74% from last year. In addition, milk supply has been slow to grow despite higher prices. Actually, supply growth has slowed significantly over the past 10 months from a peak of 3.34% in September 2010 to 1.07% in June 2011.  
 
While the story has been supportive so far, milk futures will continue to watch these indicators. For example, Oceania cheese prices have recently set back to below $2.00/pound and processor comments suggest that exports have begun to slow. So, traders may start to scale back their expectations of cheese exports, putting pressure on milk futures. Another example is milk production trends. It is a well-known fact that production growth should be minimal for July and likely August too. However, what will happen in September and beyond?
 
Emotions in check
 
As we work with dairy producers through different possible price scenarios, conversations get particularly interesting and emotional because of the extreme prices. Individual perspectives range across the spectrum -- from blindly bullish and complacent to blindly bearish and worried sick. Of course, neither is healthy. 
 
In our experience (and we’ve seen many milk price cycles), the best way to navigate extreme prices is to stay consistent, remembering and sticking to your market goals. Like athletes who sticks to their regular routine before the big game, avoid major changes now that will throw you further off balance. That means stay consistent with:
 
  • how you conduct your market analysis;
  • the type of positions or contracts you’ll utilize;
  • your risk level—do not suddenly become much more or less aggressive with you hedges without good reason;
  • your preparation—always do your homework and prepare for the unexpected price move before it happens.  
 
If you’ve been frustrated with marketing results as the market has rallied higher, you won’t make it better by jumping in and out of the market based on your emotions. Keep your head about you. If you calculate your weighted average price for the year so far, you may find that you’re not really giving up as much as you thought you were in exchange for some important protection.
Remaining consistent, incrementally capturing more and more of this upward trend, will keep you best prepared for when prices swing the other way. 
 
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.

Case in Point: Historical Example of Dairy Price Hedging with Put Options

Aug 01, 2011

Here’s a real example of a trade strategy utilizing put options that returned an average $0.20 per cwt. to the dairy producer over 40 consecutive months.

 
Katie Krupa photo By Katie Krupa, Rice Dairy
 
Dairy farmers are frequently skeptical about using futures or options to protect their milk price. The concern is that the person on the other side of the trade knows more about the market, so the dairyman’s trade will always result in a loss of money to the dairyman.
 
In order to debunk this myth, below is a real example of a trade strategy utilizing put options and returned an average $0.20 per cwt. to the dairy producer over 40 consecutive months.
 
For this example, the dairy producer is going to purchase a put option to protect his or her milk price. Put options require buyers (dairymen) to pay a premium upfront. In return, they are protecting their milk price from declining below their chosen level of protection. If the milk price should increase, the producer will receive the higher milk price, less the premium that was already paid.
Krupa   chart 1   7 29 11
 
For this example, I wanted to set up an easy-to-follow strategy, so I simply purchased a put option for a cost around 20-35 cents per cwt.
 
I purchased put options for four consecutive upcoming months, waited four months and then I purchased the next four consecutive months. The first purchase was made on 1/15/2008. I purchased a $15.00 put option for the months of March-June 2008, for an average cost of $0.22 per cwt. Then, on 5/15/2008, I purchased a $17.50 put option for July-October 2008 for $0.21 per cwt.
 
I continued this strategy through 2011, and the prices are outlined in the table.
 
This strategy is simply based on time (contracting every four months) and takes no trade recommendations into account. I am providing this example to show that even trading done on a schedule, rather than market insight, can help producers protect their milk price. The outcome of the above outlined strategy is price protection when milk prices are low, but limited losses (just the paid premium) when the milk price moves higher.
 
Results
 
2008 – In 2008, the milk price began to decline during the summer months. The puts options that were purchased for the spring and summer months expired worthless. (The premium was paid, but the milk price was higher than the level of price protection). Later in the year, the milk price declined below the purchased $17.50 put, so there was a return from the purchased put option. In total, the average difference from USDA’s announced Class III price was -$0.03 per cwt. (There was a $0.03 per cwt. loss). That is, $744 on an annual basis for one milk contract of 200,000 lb. per month – roughly the milk produced from 100 cows.
 Krupa   chart 2   7 29 11
2009 – This was the worst year the dairy industry had experienced in recent history, but the put options that were purchased helped protect the milk price from completely bottoming out. In January 2009, the USDA Class III price was $10.78. A $15.00 put was purchased on 9/15/2008 for 35 cents, so the net gain for January was $3.87 per cwt. In February, the USDA Class III price was $9.31, but the $15.00 put that was purchased for 40 cents provided a net return of $5.29 per cwt. In total for the year, the put option returned an average of $0.77 per cwt., which is $18,380 for the year for one contract (200,000 lb. per month).
 
2010 – This was a much better year than 2009, but still prices were relatively low during the first half of year, and the purchased puts did return some value. In total, the average difference from USDA’s announced Class III price was $0.07 per cwt., or $1,700 for the year.
 
2011 YTD – Prices have been improving in 2011, which means the put premium was paid, but the puts are expiring worthless, which is a good thing because milk prices are moving higher. Year to date, the average difference is -$0.19 per cwt., or -$2,331 for the six months that have settled this year.
 
2008-2011 Summary – The average price difference from the Class III price is $0.20 per cwt., which is nearly $18,000 for one 200,000 lb. contract (100 cows).
 
This historical example using put options illustrates how dairymen can protect their milk price but still benefit when prices change direction and move significantly higher. There are numerous other hedge strategies that can be employed. This is just one example. As always, I recommend producers talk with industry professionals, become educated and make decisions that are best for their unique farm business.
 
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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