Managing the Friend You Have in Volatility
Aug 26, 2013
Although most dairy producers likely share a negative connotation attached to price volatility, it can actually be more of a friend than an enemy.
By Chip Whalen, CIH
As I write this article, corn futures are currently up almost 30 cents while soybean meal prices are trading around $9.00 to $23.00 per ton above Friday’s close.
After being out of the office last week, I returned to find that the Pro Farmer annual crop tour pegged projected yields for both the corn and soybean crops below current USDA estimates, which were already low to begin with, relative to market expectations in the August WASDE. With temperatures tomorrow in Chicago expected to approach a record high for this date in August, there is growing concern that the weather is not providing the best finish for either crop as we near harvest later this fall.
The current state of affairs is a sharp departure from fairly recent assumptions that yields well above trend might still have been achievable if only the weather would have cooperated. Such is the fickle nature of commodity markets and price trends – particularly during the volatile summer growing season.
Volatility is, of course, nothing new to those who follow the agricultural markets and is something that has required more skill to navigate and manage with the expanding price ranges we have experienced over the past several years. Most people have negative connotations when it comes to volatility, which is probably because it is often portrayed in that light.
As an example, I don’t believe I have ever the term "volatitlity" mentioned by the news media in the financial markets on days of sharp stock market advances. It is, however, the default label attached to events such as "flash crashes," "Black Mondays" and the like. The fact of the matter is that volatility has nothing to do with price direction. It is more the speed of that direction which determines whether or not a market is volatile. Soybean prices advancing $2.00 a bushel in the past two weeks certainly qualifies as passing the volatility test, and while corn prices have not witnessed the same type of strength, they nonetheless have advanced about 12% in the same span of time.
Although most dairy producers likely share the negative connotation attached to price volatility, it can actually be more of a friend than an enemy. As a margin manager, a dairy will likely make pricing decisions on its milk and feed costs simultaneously as a result of a margin opportunity presenting itself, irrespective of the price levels of the individual commodity prices that make up the input and revenue side of that margin equation.
While the strategies may differ on protecting feed costs versus milk revenues as a result of market bias, the point is that an initial position will result from a margin opportunity showing up – not because I think it’s time to buy feed or price milk independent of one another. As market prices change, subsequent opportunities may present themselves to enhance that margin over time.
As an example, many of the clients we work with shared the negative outlook on feed costs earlier this year with expectations that we would realize record large crops this season. As a result, the strategies they employed were more defensive in nature – protecting against higher prices while allowing for the opportunity to achieve lower prices should the markets decline.
With prices trending lower and margins improving through the month of July, an opportunity presented itself to strengthen those hedges by making adjustments to the initial position structure.
Similarly, there has been a recent sharp decline in milk prices following expectations that increased feed supplies resulting from large crops would eventually work to expand milk production later this fall and over the winter. Initial milk hedges taken earlier in the spring and summer because of the same margin opportunity then allowed dairy producers to add flexibility back to those positions should a price recovery then ensue. This now appears to be taking place, with Class III futures up sharply in the past two sessions.
Some people might view this as speculation, but I see it differently. Speculation is the assumption of risk where a change in price direction will necessarily lead to a gain or a loss in the market. Hedging is the transfer of risk where a position is taken in the market to lock in a price or protect an opportunity (in this case a favorable forward profit margin).
In the above example, the initial position is created because a margin opportunity presented itself that was attractive for a dairy to protect. The subsequent adjustment to that initial position – strengthening a feed hedge or adding flexibility back to a milk hedge – is a function of working with what the market allows you to do. This goes to the heart of what being a margin manager means, namely, managing a position through time and price to improve on the margin opportunity that initially presented itself. It is allowing market volatility help you improve your profitability over time. Is volatility your friend or enemy and how well are you managing it?
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 firstname.lastname@example.org.
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