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Why It’s Important to Hedge Your Milk-Feed Margin

Jul 02, 2012

Milk prices are improving, but, in reality, the milk-feed margin is shrinking. Protect your profit margins now.

Katie Krupa photoBy Katie Krupa, Rice Dairy

Given the current volatility for milk and feed prices, now would be a good time to review the importance of hedging the milk-feed margin. Some people only hedge their milk price, while others only hedge their feed price. Due to increasing price volatility, it is important to understand and manage both the milk and feed prices.

While there are several different strategies you can employ to hedge your milk, the concept and process is fairly consistent. Producers make milk and sell that milk. Risk management is used to protect the future sale price of that milk.

On a broad scale, feed hedging is more popular for dairymen than milk hedging, but it often happens more naturally or even without notice. Many producers will book several months’ worth of purchased feed with their supplier, grow a portion of their feed needs, or even fix their basis.

While these types of hedges may be done without a lot of preparation, they are still hedges and will ultimately impact the feed price.

When hedging either milk or feed, you want to make sure you are managing both sides of the equation: milk and feed. For example, if you only hedged your feed price, and then milk and feed prices declined drastically, you can end up with high feed prices (which are hedged) and low milk prices. Or if you hedge only your milk price, then prices move significantly higher, you may be stuck with low milk prices (hedged) and high feed prices.

Both of these scenarios could have been avoided if the milk-feed margin was analyzed and both the milk and feed prices were hedged when the opportunity existed. Although it is not necessary to hedge your milk and feed on the same day, it is important to understand the current relationship between the milk price and feed price, and it is important to be realistic about your price volatility risk. In other words, if you catch yourself thinking, “There is no way the milk price will go to $13.00,” that should not factor into your risk management strategy. Both milk and feed prices can drop or rise rapidly, and without a foreseeable reason, so create a strategy that works at all price points.

So where do you start? I suggest starting from scratch and assume you have nothing hedged for milk or feed, and that includes no home-grown feed. To get a better idea of what our opportunities are to hedge milk and feed, and the margin between the two, I look at a milk-feed ratio.

In order to do this, I convert the protein and energy requirements in your ration to just corn and soybean meal equivalents. This milk-minus-feed calculation gives us an idea of where the milk-feed margin has been in recent years and where it is currently trading in the futures market. While each farm is different and their price needs will vary, we can get a pretty good idea of what the future opportunities are by looking at this margin, and some basic farm financial data.

Recently the corn futures price for the upcoming month has increased nearly $1 per bu. in less than two weeks. While the milk futures price has also increased, it has not increased as quickly as the corn price. This discrepancy had resulted in a decrease in the milk-feed margin. I point this out because many producers are relieved to see milk prices improving, but in reality, the milk-feed margin is shrinking. While this may not be an issue if your feed prices are already fixed for the upcoming months, if you have to purchase some, or all, of your feed needs, your profit margins may be negatively impacted.

To get started I suggest working with someone who has an understanding of both your milk and feed price risks for the upcoming months and upcoming years. A professional should be able to help you get a better understanding of your risks, and once you understand your operation’s risks, you can then work to manage them. Producers who are managing the milk and feed risks often hedge further out, and are even hedging 2013 prices. Your risk management choices are plentiful, and while that might seem overwhelming at first, it allows you to get a better hedge strategy for your unique operation.

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. You can reach Katie at klk@ricedairy.com.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.


 

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