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Know Your Market

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Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Fantastic Forward Margin Opportunities Lie Ahead for Dairy

Mar 22, 2013

Right now, projections are very favorable for strong profitability later in the year.

chip whalen thumbBy Chip Whalen, CIH

A lot of producers, particularly in the Midwest, can sympathize with what New Zealand dairies are currently experiencing as the country has been crippled by a significant drought this season.

While the situation is obviously regrettable for those producers whose pastures are no longer able to support the dairy herd, the resulting increase in dairy cow slaughter and lower milk production there is becoming a boon to dairy producers here in the U.S.

Summer Class III and Class IV Milk futures contracts at the CME have rallied more than $1.00 per cwt. recently, and despite an increase in corn prices over this same period, projected forward profit margins have improved significantly.

In fact, current projections for a model dairy operation reflect forward margins above the 90th percentile of the past 10 years in the second half of 2013 (see graph). Even nearby margins in Q2 are projecting a much better scenario than what dairy producers have had to endure through the first quarter of this year.

Whalen chart 1   3 22 13In reading past posts to this space, more than a few have touched on the notion that the market does not always reflect the reality on the farm. While this is certainly true -- and there is a difference between the price of an exchange-traded futures contract and the price a dairy pays or receives for its feed or milk -- there is still a relationship between the two that can be demonstrated by a strong historical correlation.

Assuming one accepts the fact that their costs and revenues correlate with exchange-traded futures prices and that their dairy operation can be modeled to reflect their unique local market characteristics, the futures market’s function as a price discovery mechanism becomes a profit margin discovery mechanism by extension. The role of the market therefore is to signal whether it is profitable or unprofitable to produce, store or process a commodity in a deferred time period based on one’s particular circumstances.

I have also read here previously that it is not wise to try guessing whether the market is right or wrong about its current price projections, or for that matter to try timing the market in anticipation that prices should rise or fall from current levels. This is sage advice given that the futures market discounts all known information by all participants who collectively participate in the price discovery process.

Whalen chart 2   3 22 13As such, it is probably a waste of time to try second-guessing whether or not the market is correct about the assumption that Class III Milk, for example, is going to increase from around $17.00 per cwt., currently based upon March futures, to over $19.00 per cwt. by early summer, based on June and July futures. In other words, the market has already discounted this expectation that, based upon the current drought in New Zealand and associated loss of milk production there, prices should rise over the next quarter as a result.

Similarly, is the market correct that corn prices based upon the current forward futures curve will decline over $1.50 per bu. from current levels to the lower value projected for new-crop? This is based upon the assumption that we will plant a large crop this spring and weather will cooperate over the summer to allow stocks to rebuild in the upcoming year.

That assumption may or may not play out over time, but the point is that this is the best guess of collective wisdom today based upon all market participants. For both milk and corn, these are also probably fair expectations based on what we know right now. We cannot know what the future holds, and it is not a productive exercise to try guessing either. It is important to understand that the reason why it is called a "futures" market in the first place is because the market’s job is to anticipate what will happen based on where things stand today.

The other role of the market, besides being a price discovery mechanism, is to allow an efficient transfer of risk between parties. As a dairy, you have risks of both rising feed costs and lower milk prices based on the business you are in. It is possible to protect these risks using a variety of different contracting alternatives, both on the board as well as in your local cash marketplace. We cannot know what the future holds for the market on either the cost or revenue side of the equation; however, we can project what forward margins are forecast to be based upon current futures prices and then execute contracts based upon these prices.

As of right now, those projections are very favorable for strong profitability later in the year. Our clients are taking advantage of these opportunities. I hope you are as well. Another writer in this space correctly pointed out that these opportunities don’t often last and can disappear quickly. As the saying goes, you have to "make hay when the sun shines."

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.

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