Cross-hedging offers a way to control prices in a complex ration by coupling corn and soybean meal futures and options hedges with cash forward contracts.
By Will Babler, First Capitol Risk Management, LLC
The high cost and high volatility of feed is one of the main challenges faced by dairy producers when working to manage their profit margins (see figure 1 below).
While the industry does have considerable vertical integration, most dairies must still buy some or all of certain feeds on the open market. It is no longer enough to treat feed purchasing as its own endeavor, given the risk of getting “legged’”– that is, buying feed high and having milk unsold only to watch the price drop.
Simply put, feed and milk hedges most be considered in conjunction in order to effectively manage margins in today’s volatile price environment. Placing these feed hedges requires careful consideration of the ration, price correlations and other physical trading factors.
Dairy producers face a unique challenge in hedging their feed cost when compared to cattle, hog or poultry producers. Dairy cows are fed a much more varied diet, which can also change seasonally based upon changes in prices and availability of various feeds.
Dairy producers need to take steps to hedge a ration made up of not only corn, meal and forages, but also an ever-changing mix of DDG, corn gluten, canola meal, cottonseed, almond hulls, byproducts, etc. At times, many of these common dairy feeds can be hedged in the cash market, though this comes at the cost of flexibility when considering transactions are typically limited to fixed price forwards, if they are offered at all. Often a compelling alternative is to cross-hedge these commodities in the futures and options market.
Using a financial instrument as a hedging proxy for a related, but not identical, physical commodity is defined as a cross-hedge. The intention of the cross hedger is to rely on correlations between the underlying commodity and the proxy to offset the cash flows associated with the future purchase or sale of the underlying commodity.
Dairy producers can effectively cross-hedge grain, protein and corn silage using the futures and options markets for corn and soybean meal. A simplistic view of a given commodity, such as canola meal, is that it typically holds portions of its value on an energy basis and on a protein basis. Given that corn is a heavily traded proxy most linked to energy value, and soybean meal is a heavily traded proxy linked to protein value, these two instruments should be considered for the cross-hedge.
The next step is to determine the appropriate weightings since they aren’t always intuitive – a 1,000-ton purchase of canola meal doesn’t require a 1,000-ton purchase of soybean meal. There are several means of calculating the appropriate weightings. We recommend that dairy producers work with their risk management advisors to understand these methods and the risks associated with them before diving into fully hedging their ration. Once this is understood, producers can proceed to hedge their net corn and meal exposure for their entire ration.
One of the primary benefits of having the ability to hedge a physical ration with financial tools is flexibility. Here are a few examples of where utilizing financial tools can work to a dairy producer’s advantage when cross-hedging their full ration:
- Availability of Forward Contracts – At certain times, physical suppliers are unable or unwilling to sell fixed-price forward contracts for various commodities. By utilizing financial hedges, the dairy producer can still maintain protection from higher prices and/or lock in feed costs against milk sales in order to manage his or her margins while waiting for cash contracts to become available.
- Availability of Supply – In some market circumstances, prices may be high and availability of supply may be scarce. In these instances, it is a benefit to lock in a physical contract to ensure supply, but this comes with the baggage of also having locked in the high price. One means to mitigate this risk is to lock in the physical contract and then hedge with short futures, puts or put spreads in order to maintain downside participation.
- Basis Trading – If the basis for a particular cash commodity is tight, it may be in the interest of the dairy producer to remain patient to lock in the price. This waiting game can be problematic if the flat price is attractive or if the producer has a margin he or she would like to lock in versus milk. By cross-hedging the purchase with long futures, calls or call spreads, the producer can manage the flat price, protect a margin and wait for basis to improve.
- Optionality – The cash market is usually made up of spot or fixed price transactions. When using financial tools such as options, there is greater flexibility and opportunity to participate in lower prices while still maintaining upside protection.
- Ration Flexibility – Cross-hedging a ration allows for a certain amount of flexibility in making changes to the physical ration as time progresses. Assuming the relative balance of energy and protein are fairly consistent, a cross-hedge on the net open corn and meal exposure may allow for substitution in the ration for an overall lower cost of feed.
With domestic and global grain stocks at historic lows, it should be expected that volatility and high prices will persist. In this environment, it is important for dairy producers to increase their focus on effectively managing the cost and price risk of their feed ration. The approach discussed here has correlation, basis and other risks, but in our view, these risks are offset by the benefits of potential price protection and hedging and trading flexibility. We strongly encourage dairy producers to take the time to learn more about these tactics.
Will Babler is a principal partner at First Capitol Risk Management, LLC. Contact him at 815-777-1129 or at firstname.lastname@example.org. Visit the company’s website at www.firstcapitolrm.com.