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February 2013 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.

Market Timing: How Do You Know When to Act?

Feb 24, 2013

Get ready: Spring and summer tend to see the biggest commodity price moves. Here's how to determine when a sizeable price movement may occur.

Kyle Schrad   CopyBy Kyle Schrad, INTL FCStone

Volatility is a buzz word that gets used frequently when discussing commodity markets. Since the 2008 spike in volatility, when the CBOE VIX (a benchmark volatility index) traded up over 60, we’ve been moving lower. Currently we’re back near mid-1990s’ levels, trading just above 10. Could it be that this is just a sign of the lower commodity price times? That answer sure seems to be a strong no!

In the last year alone, we’ve seen corn prices rally from the low $5.00s all the way up to nearly $8.50, while Class III prices moved from $15.23 per cwt. in May all the way up to $21.02 per cwt. in October. The risk of strong price movements certainly doesn’t seem to be fading.

Volatility and market price risk are part of everyday business for dairy producers. Many producers are now using exchange-traded tools to help mitigate that risk. One common complaint from producers is that they’ve either felt burned by the market or they’ve missed out on upside potential. With commodity volatility falling toward historically lower levels, options on futures contracts generally become relatively less expensive and thus a more attractive tool.

I like to try to use a few relatively simple market indicators to help determine the timing of when to apply the aforementioned option tools. One of these factors is historical volatility, which, as discussed above, looks to be advantageous currently. Next, taking a look at historical price percentages can offer some insight to the potential size and direction of a market move.

The current market conditions -- with both corn and milk trading in the upper 30th percentile of their five-year historical prices -- open up the opportunity for both products to move rather sharply lower. In fact, USDA’s chief economist Joe Glauber predicted during a presentation at the Ag Outlook Conference just a few days ago that grains would move sharply lower into next year. The upside price potential of the market still has a strong case to be made given the recent poor economic conditions experienced by dairy producers and the significant drought conditions in the plains and Midwest. We don’t need to mention the ever-changing demand factor and any other number of market influences.

Seasonality is the next influencing factor that I like to look at to help determine when a sizeable move may occur. From a seasonal perspective, we don’t typically see big price movements in either the Class III or corn markets during the early part of the calendar year, as you can see in these charts. (Be sure to note the different starting points on the x-axis to the calendar year in the milk vs. corn charts and the subsequent mostly sideways pattern from December through the spring months).

INT FCStone graph 1   2 22 13Currently both the grain and milk markets seem to be entering a more sideways "choppy" type of trade consistent with our expectation based on this historical analysis. The biggest moves tend to occur in the spring and early summer months when weather is the biggest influence on both corn and milk production. So, we can target this time of the year as a more opportune time to look for large price movements.
Intil FC Stone   graph 2   2 22 13
With producer margins having long been negative to just slightly positive, many economists are projecting very good returns for later in 2013, with most expecting corn prices to drop while milk prices remain steady to slightly higher.

I tend to agree that producer margins at some point will be very strong in 2013. My concern, however, is that a sizeable price movement -- either to the upside or the downside in grains -- is likely to be met with a sizeable price movement in Class III futures as well. The best time to plan for stormy seas ahead is when the water is calm.

Whether you’ve been a long time participant in the futures market or you’re just getting started, taking a step back to evaluate the market for opportunities when they arise can be key. In my opinion, the aforementioned factors look to be aligning for an opportunity to use long options, buying calls on corn/soymeal, and buying puts against Class III, to protect against a sizeable adverse price move while still allowing for participation should milk prices rise or grain markets fall.

Kyle Schrad is a Risk Management Consultant with the Chicago office of INTL FCStone. INTL FCStone offers comprehensive risk-management and margin hedging programs and services to dairy producers, processors, traders and end-users. You can reach Kyle at 800-504-5621 or kyle.schrad@intlfcstone.com.

What It Takes to “Know Your Market”

Feb 15, 2013

Dairy producers have been so innovative and so good at lowering your costs of production. Now you must arm yourselves with knowledge about the opportunities beyond production.

Scott Stewart   Copy

By Scott Stewart, CEO, Stewart-Peterson Inc.

As our team visits with producers across the country during this winter meeting season, it is evident how much dairy producers want to "know their market." And they are confused by it.

At the Pennsylvania Dairy Summit this past week, I had the opportunity to speak with the group about the markets and what is needed to make good decisions in 2013. In the Q&A session, a question was asked about the disconnect between the futures market and the mailbox price dairy producers are paid. Why the disconnect? And how does a producer make decisions if there is a disconnect?

To be sure, the milk pricing system in different parts of the country is a political quagmire. Beyond the politics, the question remains whether the markets are an effective and accurate picture of what your milk (or feed) is worth. The question behind this question is, "Should I be using the markets at all, because they might not be an accurate representation of value?"

The answer is that all markets are a reflection of information and data and the price you can expect in the future, with all the fundamentals factored in. We must keep in mind that the markets are not perfect. I liken it to the relationship you have with your spouse or your children. Nobody is perfect. Your spouse will have a bad day or overreact sometimes. Your son will come home with a B+ instead of an A sometimes. And yet we respect these people for who they are as a whole. They are an important part of our lives and we have a relationship with them for the long haul. The markets are also imperfect, and it doesn’t mean we can’t embrace them.

In Pennsylvania, I made the case that managing risk through the markets is an important part of a dairy producer’s operation for the long haul. That’s because, in the commodity business, prices will always go through boom-and-bust cycles and settle near the average break-even point for all producers. Those who stay above break-even survive; those below will find something else to do. So you have to be better than the average of all producers. You have to continually look for ways to produce better, and capture even a little bit better price.

A producer came up to me after the speech and said, "That’s a tough message." I know it is. Our dairy producers have been so innovative, and so good at lowering their costs of production, that the average is getting tougher and tougher to beat. You have to turn over more stones to find opportunity. My hope for the industry is that we never lose hope that opportunity is out there. We can be determined to arm ourselves with knowledge about the opportunities beyond production, so that we can be empowered to take advantage of those opportunities.

An example of that would be applying a consistent, disciplined approach to the markets in the same way that you take a consistent, disciplined approach to improving a herd average. I remember one producer we spoke with in October was so confident that the milk price would climb that he decided to stop his previously consistent pricing activities. Since October, we have seen second-month milk come down $3.98 off of the high. I’m sure that producer is thinking, "The markets just don’t make sense." And that goes back to my original point, that sometimes the markets do not behave like we think they should.

If you’re looking for a connection between all the news and fundamentals that are available right now and the market price, you may not always find one. That’s because, again, the market has all of those fundamentals, plus expectations about future fundamentals, factored in.

Just think about the corn market. USDA’s average price projection for corn has historically been fairly accurate and it is substantially above where the corn market is today. When corn sold off a dollar after the highs this fall, we still hadn’t come anywhere close to what the USDA’s average price forecast was for the year. So as a fundamentalist and a follower of past history and a believer in the data, you would say that corn prices should be going up, up, up right now. Instead they have gone down. The fact is that high prices rationed demand. After that happened, a producer from the thumb of Michigan said to me, "The markets are efficient, aren’t they?" Yes. And they do make sense. . . . It’s just that the dots do not always connect perfectly and obviously for us as we sift through the news.

Does that mean there is something wrong with the markets? Last month I met with a very large western producer who was absolutely convinced that the markets were out of control. He was very knowledgeable about milk and cheese fundamentals, exports, imports – the whole works. Despite his vast amount of knowledge, he simply could not connect his knowledge to the price action that week. He was completely paralyzed -- not doing anything to protect his prices or look for opportunities.

The reality is that the market already had all of his information factored in, and it’s reacting to the information he doesn’t have yet. Market prices reflect reality and expected reality. And they are not always perfect. At any given moment, they might be a little higher or a little lower than actual value. It is a futile chase to try and figure it out.

Your time is better spent looking for strategic opportunities. If you are taking a consistent and disciplined approach to pricing your commodities, you can protect against risk as well as look for opportunities to be on that higher side of average. That’s proactively turning over stones to look for a competitive advantage. If you are paralyzed and do not engage, you’ve left that stone unturned.

Some do not like my competitive view of the world, and some might even say that the markets are not fair, that if I end up with an above-average price, then someone "loses" on the other side of that trade. I view that as an excuse not to engage, because buyers and sellers are in the marketplace to agree on a price for a product that fulfills a need for them at the time. The markets are a tool for the benefit of our businesses in this uncertain, ever-changing world.

One very young dairy producer in Pennsylvania posed this question: "You paint a picture of a very competitive, uncertain world. What would you tell someone who is just starting out in the dairy business?" My answer was to keep getting better. Leave no stone unturned in your quest to be better than average. For some that is a scary message. Others will embrace the challenge. In which camp do you fall?

As I stressed in Pennsylvania: You don’t have to view yourself as a victim if you set the goal of being a victor. Don’t be paralyzed by the market. Rise above it.

Scott Stewart is CEO of Stewart-Peterson, a commodity marketing consulting firm based in West Bend, Wis. You may reach Scott at 800-334-9779, or email him at scotts@stewart-peterson.com.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, promoting the use of marketing tools, including futures and options. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. 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. Copyright 2013 Stewart-Peterson Inc. All rights reserved.

Managing Both Sides of the Coin: Risk vs. Opportunity

Feb 10, 2013

Guidelines on how to approach marketing decisions for milk and feed.

chip whalen thumbBy Chip Whalen, CIH

Many dairies are no doubt thinking about how to protect their profitability right now. Milk prices have declined from late last year while feed costs have recently increased. It is easy to get lost in all the confusion and not feel confident with how to approach marketing decisions, although there are some guidelines that can be followed, which may help.

First, it is important to know what your forward profit margins are projected to be out in the future. A margin model can be built which essentially organizes both your costs and revenues by production periods into a tool that will provide forward visibility of your profitability. Using the futures market as a price discovery mechanism, this model by extension becomes a margin discovery tool that can help you make better decisions about how to protect your forward profitability. While no one knows for certain what prices will do in the future, it is possible to put prices and profit margins within an objective context that can be evaluated to inform the decision-making process.

As an example, looking at a long-term chart of milk futures will show you that prices do not spend much time above $20/cwt. or below $10/cwt. Similarly, if you were to look at a chart of corn futures, you likewise will observe that prices above $8.00/bu. are quite high from a historical context while prices below $3.00/bu. (at least nowadays) are quite low.

Profit margins can also be examined this way. A profit margin projection can be compared to similar profit margins for that particular production period over some past historical timeframe, and ranked to determine how relatively strong or weak the current margin is.

whalen chart a  2 10 13

Spot margins in the first quarter of 2013 are now being projected at a loss of $0.13/cwt. for a model dairy operation which ranks at the 30th percentile of the past 10 years. This means that 30% of the time within the past 10 years the dairy was losing more money during the first quarter, while 70% of the time the dairy was more profitable. By contrast, a projection of profit margins in the fourth quarter of 2013 is currently $2.53/cwt. for the same model dairy that ranks at the 90th percentile of the past 10 years.

Why are the two profit margins so different? For one, it has to do with revenue projections. Class III Milk futures for February and March are in the low $17.00/cwt. range while those for October, November and December are about $1.00/cwt. higher. Feed cost projections also factor into the difference. While nearby corn and soybean meal prices are trading over $7.00/bu. and $400/ton, respectively, new-crop corn and soybean meal futures are priced at discounts of $1.40/bu. and $70/ton to spot levels.

Whether or not Class III Milk will still be over $18.00/cwt. come the fourth quarter, or for that matter corn remains below $6.00/bushel, is anyone’s guess, and it probably doesn’t make much sense to spend too much time at this juncture being concerned with it. What does make sense to focus on, however, is the fact that the profit margin being projected based upon the relationship of these prices is currently at the 90th percentile of the past 10 years for the fourth quarter.

whalen chart 6   2 10 13

We often like to think of risk and opportunity as opposite sides of the same coin. Looking at the-fourth quarter profit margin, you might say that there is 10% opportunity for the profit margin to improve from current levels while the risk is 90% that the margin will be worse. When considering contract alternatives to manage this margin, it may make sense to preserve some opportunity for the margin to improve; however, it is probably much more important to address the greater degree of risk that is implied by the historical level of profitability. Viewing your marketing plan through this prism helps to make more informed decisions on how to protect both costs and revenues in the profit margin equation.

Continuing with the example of the fourth quarter, protecting milk might consist of some sort of minimum price or "floor" around current future price levels with a maximum price or "ceiling" above the market. As an alternative to simply locking in the milk price, which most dairies are hesitant to do anyway, this addresses the risk that profitability will deteriorate should milk decline much from current price levels. Yet it still leaves open the opportunity for higher prices to be realized if the milk market increases.

On the feed side of the equation, meal prices at about $368/ton and corn prices around $5.70/bu. suggest different approaches. Similar to milk, $368/ton is a historically high price for soybean meal, so a defensive strategy that protects some upside risk but leaves open a lot of downside opportunity might be considered. With corn, a more neutral type of strategy would seem to fit around what has been a slightly above average price in recent history.

As a new contributor to this space, I read through some of the recent articles submitted by others to the "Know Your Market" column. One in particular that caught my attention was written by Katie Krupa. She discussed the idea of remaining flexible to make adjustments with a marketing strategy. I think this is a key concept to grasp. With any marketing decision, you make contracting choices based on the information available to you at that time. As we all know, however, markets, prices and therefore profit-margin projections change as new information becomes available to the market. The whole point of "managing" margins is being flexible to make changes as conditions warrant.

Whatever your strategy happens to be, it is important to have a plan and stick with it in order to be successful. It is also important to weigh the costs and benefits of different contracting alternatives against the implied risk vs. opportunity profile of the marketing period being considered. Fortunately, there are tools and approaches available that can help inform better decision making.

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com.

LGM-Dairy 101: What You Need to Know about this Risk Management Program

Feb 01, 2013

An LGM-Dairy expert explains the basics, including why you would -- and would not -- want to use the program.

ron mortensen photo 11 05   CopyBy Ron Mortensen, Dairy Gross Margin, LLC and Advantage Ag Strategies, Ltd.

Q. What should you and your lender know about LGM-Dairy?

LGM-Dairy is an insurance policy that guarantees the difference between the milk price (Class III on CME) and corn and soybean meal prices (CBOT). It is designed and underwritten by the USDA’s Risk Management Agency (RMA). Essentially, it is backed by the full faith of the government, just like crop insurance is for corn and other crops.

Buying a policy is a way to guarantee cash flow for up to 10 months. It is a floor price for revenue but does not put a cap on revenues. Therefore, the LGM policy can help you and your banker plan a minimum cash flow for your operation. In a volatile marketplace, this is a big "win-win" situation.

LGM-Dairy is available until the government subsidy money runs out. As of this month, $8.5 in subsidy is available. LGM-Dairy will be able to be purchased on Feb. 22 and, if subsidy money is available, again on March 22, 2013.

LGM-Dairy does not insure or guarantee milk production. It insures the potential changes in milk prices and feed prices. For example, if the price of milk (Class III) goes up and feed goes down, you will not get an indemnity payment. If milk prices go down and feed prices go up, you will get a payment depending on how big a deductible you used.

The milk price is based on the CME price, not your mailbox price. Likewise, the feed prices are based on the CBOT price, not your local price. Please note LGM-Dairy has a limit of 240,000 cwts. (or 24,000,000 pounds) per producer per year.

LGM-Dairy is very similar to using options. LGM-Dairy is like buying a milk put, a corn call and a soybean meal call. If you compare buying these options to LGM-Dairy, the insurance policy can be as much as $.60/cwt cheaper (zero deductible). The difference is LGM-Dairy is subsidized if you purchase a policy covering two or more months. The subsidies range from 18% for the zero deductible to 50% for the $1.10 deductible. If you purchase a policy that includes all 10 months at a zero deductible, generally it will be significantly cheaper than purchasing options over that same 10 month period.
 

LGM-Dairy averages the indemnities for each month, unlike the options. Said another way, the policy averages each of the months’ gains and losses when determining if an indemnity is paid and how much is paid. Be sure to understand how the premium and coverage changes based on the duration of the policy and the deductible.

Besides choosing the deductible and the months covered, you can design your own feed plan. For every 1,000 cwt’s of milk, LGM-Dairy allows you to manage the risk of 130 to 1,361 bushels of corn. For the same 1,000 cwt’s of milk, you can include between .805 to 13 tons of soybean meal.

Q. Why would I use LGM-Dairy?

You can manage your risks for up to 10 months. That means you can cover the first six months, the last three months or any months you need protection. This flexibility allows you to manage short term or long term. It is easier to buy LGM than to buy options, especially in the far out months. Sometimes the lack of liquidity at the CME makes it difficult to buy options in the deferred months. If you look at buying options, the bid/ask spread can be a little wide.

Your banker would have no worries about borrowing to meet margin calls in a hedge account. The premium for an LGM policy is a known expense and is due at the end of the coverage period. For example, a policy purchased on Feb. 22, 2013, will have the premium due in February 2014. This due date is even for policies that only have a few months covered.

You can monitor the policy after the purchase and you can share this information with your lender.
Simply go to Dr. Brian Gould’s website, or our website and click on premium estimator. Enter your existing policy—month(s) purchased, amount of milk covered and amount of corn and meal covered. As the policy progresses, the site will tell you the potential for an indemnity.

Q. When would I not use LGM-Dairy?

When you develop a marketing plan, it may make sense to sell milk a portion of your milk on a cash contract or futures contract because the profit margin is attractive. One of the marketing ideas I like is to sell one-third of your milk with contracts or futures and use LGM-Dairy or options on one-third of your production. If the market goes up, you only have one-third of your milk sold. If the milk goes down, you have two-thirds of your milk protected.

Possible outcomes for Indemnity Payments (subject to deductible):

Mortesnen   LGMpossible outcomes 1 30 13

Ron Mortensen is principal of Dairy Gross Margin, LLC, an agency that specializes in LGM-Dairy products, and owner of Advantage Strategies, Ltd., a commodity trading advisor. Contact him at
ron@dairygrossmargin.com or visit www.dairygrossmargin.com.

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