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June 2012 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.

Dairy Producers as Commodity Processors?

Jun 24, 2012

With dairies' feed expenses reaching 70% of milk's cost structure, learn how other industries have long dealt with these input dynamics.

By Will Babler, Principal, Atten Babler Commodities, LLC

Milk Cost Structure

The value or price of milk can be considered to be equal to the sum of fixed costs, labor, feed costs and other non-commodity variable costs. In good years for dairy producers, a profit margin can also be included in the sum. In the past feed costs usually ranged from 25% to 50% of the price of milk. During that time, the cost of producing milk was dominated by fixed costs and, to a lesser extent, non-commodity variable costs and profits.

Babler graph 6 22 12

Source: USDA, Atten Babler Commodities


In recent years, the dominant portion of the cost structure has shifted dramatically away from fixed costs toward feed costs, which are now more than 70% of the price of milk. This shift has occurred as increases in feed costs have not been equally met with a corresponding increase in milk price. This change suggests that many dairy producers, particularly those without vertical integration on feed, now have economics similar to other traditional commodity processors.

Commodity Processor Examples

With over 70% of milk price made up of commodity feed costs, the dairy industry is entering the territory of other commodity processors. Consider the following examples from the ethanol and petroleum industries. These simplified calculations use primary commodities and representative conversion ratios and ignore cash market basis. In each case, the input commodities represent around 80% of the final product value.

Input Commodity Value Divided by Output Commodity Value

(Calculated using the average of nearby futures June 2011 through June 2012)
• Ethanol Producer: (Corn + Natural Gas) / (Ethanol + DDGS) = 83%
• Crude Oil Refiner: Crude Oil / (Heating Oil + Gasoline) = 80%

Considering the recent trend of dairy production moving toward processing economics, it is worth examining the risks faced by processors and the hedging practices they utilize.
Commodity Processor Risks

Commodity processors are heavily exposed to market risks, since commodity prices dictate such a large portion of total costs and all of the final product value. Often processors operate in narrow margin environment where price volatility can quickly eat into profits. If inputs and output pricing become un-correlated, this risk can be amplified.

Commodity Processor Hedging Strategies

Processors utilize two primary hedging strategies in tandem to mitigate their commodity price risk. For the purpose of this article, we will define these strategies as merchandising and crush hedging.

Merchandising is simply managing the physical inflows and outflows of commodities, such that inventory is maintained at a floating price. Consider the example of a dairy that buys all of its corn needs at one point during the year. This creates an inventory position which, since it is a long fixed-price position, protects against higher prices. At the same time, this inventory position also presents a significant opportunity cost if prices fall. A merchandiser mitigates this risk by holding a short hedge position, either short futures or long puts, to financially offset the declining value of inventory in a falling market.

Once the processor has ensured that it has mitigated the risk of inventory values being exposed to market price swings, it next looks to manage its crush margins. The crush margin is the spread between the output commodities and input commodities. As price volatility unfolds for each individual input and output commodity, the crush margin, or profit margin, can vary significantly. When crush margins move to favorable levels, the processor will utilize futures or options to lock in both input and output prices to secure the favorable profit margin.

Lessons for the Dairy Industry

One important characteristic of traditional commodity processing industries is a relatively high level of correlation between input and output prices. While feed costs as a proportion of milk price have become very high, the correlation between feed and milk has been very unstable and is not as high as in most processing industries. While this presents a measure of additional risk for dairies, many aspects of the processor hedging approach should still be considered.

In the current environment, dairies would be well served by cautiously managing inventory risk on feed. They should also be disciplined in simultaneously covering feed each time milk is sold at a fixed priced or hedged with a strategy that includes a short call. Producers should also seek to opportunistically lock in favorable crush margins if and when volatility presents a profitable opportunity.

Given the nuances of the dairy market, it is recommended that producers consider the general themes laid out here for commodity processors and modify the approach by utilizing option hedging tools in order to increase flexibility. While there is no guarantee that the current trend toward a processing environment will persist, it certainly points to a need for an increased focus on risk management and the value of learning from other industries that have dealt with these dynamics for many years.

Will Babler is a principal at Atten Babler Commodities LLC. Contact him at (815) 777-1129 or Learn more about Atten Babler Risk Management.

Risk Disclosure
Risk in purchasing options is the option premium paid plus commissions and fees. Selling futures and/or options leaves you vulnerable to unlimited risk. Transaction cost used throughout this report includes both commissions and fees. Atten Babler Commodities LLC uses sources that they believe to be reliable, but they cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. Unless otherwise stated the information contained herein is meant for educational purposes only and is not a solicitation to buy futures or options.


The Return of $17.00 Milk: Here Today, Gone Tomorrow?

Jun 15, 2012

Consider the underlying fundamentals behind the recent run-up, as well as marketing strategies to reward the rally.

Rocky GinggBy Rocky Gingg, Stewart-Peterson

Class III milk futures have recently surpassed the $17.00 price level, a psychological boost for many, leaving sub-$16.00 milk in the rearview mirror. Many have raised the question of whether the lows are in for the year, or if the market is setting up for a double-dip.

It has been nearly five months since we have last seen $17.00 milk, and the only month to settle above the key price level this year was January at $17.05. Let’s take a look at the underlying fundamentals behind the recent run-up, as well as marketing strategies to reward the rally while maximizing opportunity and minimizing risk.

Gingg chart 1   6 15 12
CHART NOTE: As of June 13, 2012, the purple line in this chart represents the Class III Milk settlement prices so far this year January-May, and the black line represents current futures prices for June through December.




Supply-Side Fundamentals

All eyes have been watching the USDA Milk Production Report, released Monday, June 18. Year to date, dairy producers have added 51,000 head to the U.S. herd, the strongest pace since 2008. The average has been 12,750 head added each month this year. Milk production is up 3.9%, which is the third fastest rate of growth for January-April since 4.7% in 2006 and 4.8% in 2000. Given the recent price action in milk prices, there is much anticipation for a slower growth rate for herd growth and milk production in May.
Demand Fundamentals Remain Supportive
The demand side of the equation has remained strong throughout the year, showing few signs of weakness. Total cheese commercial disappearance has been on a supportive pace this year, with January through March posting record-breaking monthly numbers. The latest dairy export figures for the month of April showed a 12.1% year-over-year gain for total dairy exports. April marked the third largest monthly export total ever at 158,370.10 metric tons. Year-to-date exports have equated to 13% of total milk solids.
International Prices
Prices rose sharply in the latest bi-weekly Global Dairy Trade auction. The overall index rose 13.5% compared to the previous auction, which is the highest percentage gain since September of 2010. Cheddar prices were up 9.4%, which equates to a 15-cent gain from an average price of $1.30 per pound to $1.45 per pound. Oceania cheddar prices were steady in the latest report at an average price of $1.63 per pound. With CME cheddar climbing to the $1.60 level, the CME/Oceania spread is at the narrowest level it has been since November of 2011. International prices will be closely watched from two perspectives: rising international prices give more room for U.S. prices to move higher, but if U.S. prices move to a premium, exports are at risk of a pull back. 
Gingg chart 2   6 15 12
You can watch Dairy Today’s video version of the market week in review by clicking here.
What to Do? Comparing Marketing Strategies
Stewart-Peterson advises its clients to build a solid weighted average price over time, much like building a career batting average. To do that, it’s important to know the impact of various strategies on that weighted average price. The table below helps evaluate various strategies at this time.

The sample strategies on the left of the table represent what producers might use to hedge milk at this time. As you can see, each strategy has pros and cons indicated by the color scaling.
• The first strategy, hedging 50% with futures at 16.50, provides the most downside coverage below $17.00, but has the least upside flexibility above $17.00.

• The second strategy, hedging 50% with a 15.00 put at 25 cents, is essentially the inverse, providing the most upside flexibility above $18.00 but the least amount of downside protection below $17.00.

• The third strategy, hedging 50% with 16.25/18.00 fence at 25 cents, is the middle of the road strategy. It provides better downside protection than strategy #2 and better upside flexibility than strategy #1.

Calculating these strategy choices in advance helps address the indecision that can come with the lower to middle-of-the-range prices that we are seeing right now.

Producers should analyze strategies with their risk tolerance in mind, because each operation’s financial situation is different.  Keep your management team informed of the possibilities. That way, the entire management team is prepared for whatever price scenario unfolds.

Stewart-Peterson Inc. Market Scenario PlanningSM Table
Gingg chart 3   6 15 12

Rocky Gingg is a Market360® Advisor for Stewart-Peterson Inc. He can be reached by calling 800.334.9779 or at

Market Scenario Planning 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 2012 Stewart-Peterson Inc. All rights reserved.

Health of the Industry in a Chart

Jun 08, 2012

One way of looking at Livestock Gross Margin for Dairy (LGM-Dairy)—a margin calculation that uses milk prices minus average feed volume/costs.

By Ron Mortensen, Dairy Gross Margin, LLC
ron mortensen photo 11 05   CopyThe chart below is a great way to view the health of industry. It is basically a chart of milk over feed costs. It is one way we look at Livestock Gross Margin for Dairy (LGM-Dairy)—a margin calculation that uses milk prices minus average feed volume/costs.
The blue lines go back to 1998 and depict the historical view of milk versus feed. There are three time periods when margins were very good (green circles). And there are four periods when margins were very poor (red circles). Dairymen always remember the peaks and the valleys and, when asked, they always have a story about each of these times. 
The pink line on the right side of the chart is the futures value of milk, corn and soybean meal combined to yield a margin for the next several months in 2012.  From the dairy producer’s view, the pink line of the chart looks like it is average.
But digging deeper, this may not be so. Over the last 10 years, non-feed costs have risen. The two red areas in 2006 and 2009 had a bigger negative impact because the industry had higher overall costs. Also, the 2011 green profit area was very short lived and many producers did not recover their losses from 2009.
So average may not be enough.
mortensen   mayfinal2012avcornchartEDAIRYTODAY

Chart available on
If you are using an option strategy or a LGM-Dairy policy which is represented by the pink line, you could lock in minimum margins. These strategies will stop your margins from getting any worse. The options or the LGM policy will kick in and give you additional revenue below this line, if you use a zero-deductible policy.

If the milk prices do move higher (or feed costs move lower), you would get the higher margins or higher revenue.
What conclusion does this lead to?  Manage costs, manage margins and manage risk. Every week, others who write in Dairy Today eUpdate suggest ways to manage your margin and risk. Go back and review their comments.  It will be worth your time.
Feed – Insights

By the time you get this article, the markets will have experienced a “first.” Corn and soybean meal futures (as well as the other CBOT grain/soy contracts) will have traded through a USDA crop report. Market action, volume surges and the sheer thought of getting numbers and having to trade it without much thought is unnerving. Perhaps the USDA will go back to the schedule in 1994 when crop reports were at 2 p.m.  Then the markets would be closed and everyone in the world would have three hours to review the data.
World markets are becoming even more important as China uses more feed for its livestock industry. This has made the next corn crop in China more important. Weather so far has been acceptable in the far north. It is the North China Plain, just south of Beijing, that is now a problem. Temperatures have been soaring, with little rainfall. This area grows about 30% of the China’s corn crop so it will be important as the summer progresses. 
Ron Mortensen is a founder of Dairy Gross Margin, LLC, which was formed in 2006 to sell Livestock Gross Margin Insurance to dairy producers. Mortensen’s firm is now licensed in 23 states. He is also president of Advantage Agricultural Strategies, Ltd., which he founded in 1985, to provide individual risk management advice for farmers and agribusiness using futures, options and cash trading strategies. Contact him at 515-570-5265 or

Is Now the Time to Hedge?

Jun 04, 2012

3 steps to help you decide.

Katie Krupa photoBy Katie Krupa, Rice Dairy
Since milk prices have been improving in recent weeks, many producers have been asking if now is the right time to hedge. Unfortunately, there is no quick and universal answer to this question. There are several things to consider when looking at current hedging opportunities to know if it is a good time for you to hedge.
Below are some steps to walk through to help know if now is a good time to hedge.
Is your equity position strong enough to weather price volatility?
Many producers have asked me, “If I can ride out the highs and lows, do I need to hedge my prices?” If you can truly manage your business through high and low cycles on a cash flow and equity basis and on a personal basis (managing the business and personal stress of price volatility), you may not need to hedge your prices. It is important to note that your risk management strategy is to use your available cash and equity to manage the potential price volatility. Just because you are not hedging your prices, doesn’t mean you are not actively making and following a risk management plan. But don’t fool yourself into thinking that your lack of action on creating and following a risk management plan is just using your cash and equity to weather the volatility.
Is the price high enough to exceed your cost of production?
If you cannot manage the volatility on your own, you will want to explore other risk management strategies. When looking at other available strategies, you will want to understand how the contract/hedge price relates to your farm price and ultimately how it relates to your cost structure. If the current prices are high enough to give you a positive return, now may be a good time for you to hedge. Everyone’s cost structure and comfort level are different, which is why I say now may be a good time.
If the price does not exceed your cost of production, does it offer protection at a sustainable level?
Sometimes the market does not provide a hedge price that enables you to protect a profit. When this situation occurs, I typically recommend looking at a strategy that protects a price rather than locking in a price. Most simply, this can be done by purchasing a put option. For a premium cost, this strategy offers price protection if the market should decline significantly but still allows you to benefit if the market increases. When examining this strategy, because prices are below profitable levels, we most often look at a survivable price rather than a profitable price.
For example, a producer may say, “Although I really need a $16.00 Class III price to return a slight profit, a $15.00 Class III price will allow me to cash flow.” Or, more drastically, they may say, “A $14.00 Class III price will result in a loss from month to month, but my lender will work with me during any potential low price cycle.” Although it certainly isn’t true all the time, I often see lenders more eager to extend operating lines of credit if there is some form of protection on the downside. If you purchase a $14.00 Class III put option and the milk declines to $10.00, although you are below profitable levels, you are still $4.00 above the market price.
These three steps are a just a couple questions you can ask yourself when starting to create and implement a risk management strategy. No two producers or businesses are the same, so there is no one answer that works for everyone. Having some guidelines and understanding your farm financials are critical first steps to implement your risk management strategy. As always, I suggest working with a professional to help guide you through the process and keep you and your business moving in the right direction.

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 There is risk of loss trading commodity futures and options.  Past results are not indicative of future results.
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