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November 2011 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.

Dairy Margin Accounts 101

Nov 28, 2011

A look at the basics of maintaining a margin account for hedging milk and feed prices on an exchange.

Katie Krupa photoBy Katie Krupa, Rice Dairy
The increase in price volatility has sparked the need for many dairy producers to create risk management plans to maintain a viable business. Risk management plans are as diverse as the dairies implementing them, but many strategies involve hedging milk and feed prices on an exchange.
 
When a dairy farmer hedges on an exchange, he or she must fund and maintain a margin account. The term “margin account” refers to an account that must be funded when trading on an exchange.
 
When a dairy producer initially sells a contract to hedge his or her future milk price, he or she has to fund a margin account. This is called the “initial margin.” The initial margin is typically less than 15% of the full value of the contract and is similar to a deposit for the contract. It allows the buyer/seller to hold the contract. Regardless of whether someone is buying or selling a futures contract, the initial margin must be paid by both parties.
 
When placing a trade on the Chicago Mercantile Exchange (CME), the CME backs each trade, guaranteeing that the buyer and seller will pay or be paid what is due from the contract. Because the CME backs each trade, it requires both the buyer and seller to fund a margin account (initial margin) to secure the trade.
 
As the market fluctuates, the margin account must be maintained until the contract expires or is lifted. Since the trading prices for a given contract can move daily, the value of the contract can also change daily, and if the market moves against the contracted position, additional funds need to be added to the margin account. That payment is a maintenance margin, or more commonly termed “margin call.” The term “marked-to-market” refers to the daily margin account adjustment based on the current market price.
 
Every futures contract requires the buyer/seller to fund a margin account and deposit an initial margin when the trade is placed. Currently, a hedger in the dairy market will need to contribute $2,025 for every contract he buys or sells.
 
So, if a dairy producer hedged 200,000 lb. of milk per month for six months, the initial margin requirement would be $12,150 ($2,025 per contract x six months). After the initial margin is paid, the dairy producer will need to fund the margin account if the market moves against his hedge. The amount of funds required depends on the volatility of the market.
               
In addition to futures contracts, options can be used by dairy producers to protect against price volatility. The simplest strategy is to buy a put option. It offers price protection for a premium payment. For example, a producer could buy a $15.00 put option for $0.40 per cwt., which is $800 total for 200,000 lb. Because a put option protects the price from moving lower without limiting the upside, the producer will never have to add more money to the margin account (i.e., no margin calls).
 
Although there is no exact rule for how much a producer will need for a margin account or a hedge line of credit, a common rule of thumb is $2.00 per cwt. For a 1,000-cow dairy, producing 70 lb. per day, that is about $500,000 for 100% of the farm’s production for one year.
 
But as price volatility increases, typically the amount of funds in the hedge line of credit will need to increase to cover possible increases in both the initial margin requirements and possible margin calls. Buying put options is a great strategy for a producer with either no line of credit from his lender or a limited line of credit.
 
Historically, margin accounts and hedging have been misunderstood and subsequently avoided by many dairy farmers. Given current price volatility, many dairy businesses will need to create and implement a risk management plan in order to remain profitable and solvent.
 
For many, that means trading milk futures or options on the exchange and maintaining a margin account, and for the lender it often means providing a hedge line of credit. The good news is that there are various strategies available to dairy producers through brokers, co-ops, milk plants and government insurance.
 

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. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at klk@ricedairy.com.Visit www.ricedairy.com.

Risk Management in the Aftermath of a Computer Crash

Nov 21, 2011

Following the debacle of Oct. 28, USDA’s RMA allocated additional subsidy money, so that $7 million was available for the Livestock Gross Margin for Dairy program. This time, $7 million lasted for 51 minutes.  

 
Marv Portrait 4By Marvin Carlson, Dairy Gross Margin, LLC
 
In the spirit of the upcoming holiday season, here is the Past, Present and Future of Livestock Gross Margin (LGM) for Dairy:
 
Past: Oct. 28 – The Risk Management Agency (RMA) computer system crashes, resulting in a hodgepodge of frustration, anger and sleeplessness. A quote from Farmshine by Sherry Bunting: “One observer described it like ’Black Friday’ with a line of 200 shoppers waiting for the doors to open at 5 a.m. to buy 20 television sets at Sears, only to learn they were selling since 4:30 a.m.”
 
Present: Nov. 18 – There was again great demand for LGM-Dairy insurance. Following the debacle of Oct. 28, the RMA allocated additional subsidy money, so that $7 million was available. This time, $7 million lasted for 51 minutes.  
 
Dairy producers have become savvy regarding the value of risk management and have allocated funds to a budget line item to help them accomplish margin management.  The increasing popularity and value of the LGM-Dairy product as part of a risk management plan means demand outstrips supply.  
 
Future: Nov. 25 - Go shopping early! Participate in the “real” Black Friday!  Help your local retail businesses get in the black for the first time this year and buy milk products for gifts!
 
The Long-Term Future and status of dairy programs in 2012. You are well aware dairy government program funding has become political. The “Super Committee” budget recommendations will soon be known. Who knows what they will suggest? It also looks like future subsidy funding for LGM products is also political. Contact your Congress-person to make your thoughts known. Do not underestimate the power of a phone call, email or letter. 
 
Hopefully, Congress is receptive to suggestions for reasonable funding allocations for this product. Maybe RMA, with a little nudging from Congress, will remove the pilot project status and make LGM a permanent crop insurance product. A statement from the Nov. 11 Farm News by Bruce Babcock, Iowa State University agricultural economist, gives insight to the current political landscape. “The only rationale for a new federal . . . program . . . is that it seems politically easier to defend than direct payments,” Babcock says.
 
Now that we know we can’t count on the government to save us from the volatility of this global economy by offering LGM-Dairy every month, we must be diligent in learning and doing our best to maintain our profitability through margin management. Remember, that is what LGM-Dairy offered your operation—a chance to lock in a reasonable margin between your feed costs and your milk revenue. 
 
You’ve heard the strategy, “Sell milk in the top third and buy feed inputs in the bottom third?” If only it was that simple! If only we knew when the market was hitting those thirds! In the absence of the LGM product, you must concentrate on learning about other risk management tools—options, forward contracts, etc., to achieve your goals for margin management.    
  
If you would like to receive our e-mail update, just send your request to me at: marv@dairygrossmargin.com.
 
Marv Carlson is with Dairy Gross Margin LLC in Sioux Rapids, Iowa. Contact Carlson at marv@dairygrossmargin.com or (712) 240-8395. Visit the firm’s website for more information: www.dairygrossmargin.com.

‘Elite Producers’ Are Challenged by Marketing Too

Nov 14, 2011

Even “elite” producers are challenged by today’s markets. Here are the most common comments and questions I heard from producers at Dairy Today’s Elite Producer Business Conference.

 
S Schulla Bio PictureBy Steven Schalla, Stewart-Peterson
 
Last week I had the privilege of attending Dairy Today’s Elite Producer Business Conference and visited with many of the country’s top dairy producers.
 
The conference had many engaging and informative speakers, and I’m happy to report that some of the top economists in agriculture see a bright future for the U.S. dairy industry. These analysts continue to see immense opportunities to grow dairy exports while working to maintain our domestic consumption as well.
 
However, these same economists also warned that markets that are increasingly dependent on foreign participation bringing additional risk in currency fluctuations and government trade policies. Thus, they said, being prepared for volatility through a strong financial position and risk management will be critical for producers who want to be part of this dynamic world economy.  
 
In talking with producers between sessions, it is easy to see that this kind of thinking is already underway. Many producers talked about how they’ve improved the tracking and reporting of the farm’s financial benchmarks. This not only keeps a lender happy, but also has provided some new insights as to where the operation can improve or grow to maximize profitability. 
 
The second part, the risk management part, has been a bit more challenging for producers. When I asked many folks about their experiences with marketing over the past few years, the answers were largely textbook frustrations of first-time experiences. Here are a few of my favorites that are easy to empathize with:
 
  • “I started following prices for awhile but I got busy with stuff and just didn’t have the time to keep up with it.” While managing the rest of the operation, it’s easy to understand that finding time to follow market prices, then design a marketing strategy, then execute and maintain the plan, is very difficult to do. To be a successful marketer, it takes daily review of market developments to assess the opportunities and risks they present to your dairy. This producer needs to make the full commitment to making marketing a daily task, or he could seek a trusted advisor that will be his “eyes and ears” and design specific strategies for the producer to review. 
 
  • “I check market prices every day, but you start talking about all these different strategies and I get lost so fast. . . .” Mastering the basic marketing tools requires practice and experience. Moreover, volatile dairy and grain markets are making it necessary to use more advanced strategies to maintain flexibility and lower upfront costs. This producer is on the right track by focusing time on learning the marketing tools and strategies instead of pursuing the “right” market outlook. Learning when to use each marketing tool, or several in combination with each other, will allow you to take advantage of price opportunities while still removing risk.
 
And here’s the quote with which I empathize the most:
 
  • “Dinner is pretty quiet when I’ve contracted some milk and it goes up two or three dollars and we’re paying margin calls.” Wow, talk about an uncomfortable situation. There are two things that grabbed me in this comment: First, managing the emotions of entering and maintaining strategies is much, much easier said than done. Second, pressure from family members or partners, who do not understand the process or the underlying goal, can compound the frustration. We’d encourage this producer to stick to his strategy and long-term goals. However, a key step will be to reaffirm the risk tolerance of the family and management team to avoid a sticky situation like the dinner described here. By understanding the long-term goals and what is required to reach them, the team can support making the tough marketing decisions, building confidence instead of casting doubt. 
 
These producers and many others shared that they want to succeed as marketers and risk managers. All the common constraints have limited that success. Each of these producers experienced different challenges. Identifying the constraints that hamstring your success is the absolute first step to improving results.
 
Next, create clear goals that the management team supports to address these challenges. This will set the stage to confidently execute strategies. Keep in mind, not only can you share financial goals, you can also share the responsibilities for reviewing the markets daily, or teach your partner useful concepts, like what a “margin call” involves.
 
Using these achievable steps will make it easier to boost confidence in your marketing efforts and see the bottom line results you desire.
 
Steven Schalla is a Market Advisor for Stewart-Peterson, Inc. He can be reached at 800.334.9779 or sschalla@stewart-peterson.com.
 
The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. 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. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2011 Stewart-Peterson Inc. All rights reserved.

Basic Concepts to Consider when Contracting Milk

Nov 07, 2011

To be a successful milk marketer, a dairy is well served to embrace several time-tested principles of managing milk prices.

 
Carl BablerBy Carl Babler, First Capitol Ag
 
Contracting milk is a very important management decision. Making a contracting decision requires thought and reason. To randomly decide to contract a quantity of milk for a period of time for a certain price can lead to frustrating results. Before taking on this challenge, it is important first define a few terms:
 
  • Contracting Milk an activity that fixes a cash price or establishes a minimum cash price with a milk processor. These contracts are binding legal agreements to deliver milk.
 
  • Financially Hedging Milk using the tools of the Futures and Options Market to set price or establish a minimum price on a quantity of milk for a period of time until milk is delivered in the cash market. 
 
  • Marketing Milk – using the tools of the Cash market (through a processor) or the Futures and Options Market to manage or control milk price. 
 
To be a successful milk marketer, a dairy is well served to embrace several time-tested principles of managing milk prices:
 
  1. No one knows where the milk price is going. Marketing must be accomplished in the absence of a perfect forecast.
 
  1. Price is right every day. Futures prices and forward contract prices are the aggregate of market expectations and should be viewed in regard to your cost of production and possible return -- and not in light of what your dairy wishes the price to be.
 
  1. Marketing requires decisive action. Marketing is not about watching, studying and discussing milk price change. It is about doing something with price (fix it or establish a minimum) and then go milk the cows.
 
  1. Marketing is about looking forward and being proactive. A dairy must constantly view the market opportunities offered forward and not be looking backward at what was or was not done with prices of the past.
 
  1. Marketing cannot be done by committee. A dairy must delegate market execution to one individual who operates within the marketing plan approved by the dairy’s management team.
 
  1. A dairy must develop a marketing plan. The plan shouldestablish the quantity to be priced, at what price, at what margin, for what budget, for what period of time forward and with which marketing tools (cash contracts or futures and options).
 
  1. Contracting milk requires reason. A dairy must have a reason or reasons for contracting price. The following is a short list of good reasons for contracting milk: profitability, price level, market fundamentals (supply and demand condition), price trends and seasonality.
 
  1. Scale up selling preferred. Selling or fixing price on a portion of dairy's production and adding on to the sale at higher price levels is better than waiting for a "home run price." Hitting singles and doubles is better than striking out while waiting for the home run.
 
  1. Minimum price strategies work best for milk marketing. The characteristics of milk price distribution over time favor marketing actions that allow for dairy to benefit from higher prices. Establishing a minimum price on all production is highly advised as a first step in milk marketing. Buying call options to cover cash contracts or sold futures positions is a good fit when pricing milk.
 
  1. Consistency pays off. Systematically applying a marketing plan over a long time period beats randomly picking and choosing when and what to do with milk price. 
 
  1. Have fun. When structure, purpose and a plan are at the center of milk marketing actions, then frustration can be replaced with fun. 
 
The above-listed considerations are not assumed to be all inclusive and other concepts may be equally essential. However, contracting or hedging milk price in the absence of marketing principles can lead to lost financial opportunity.
 
First Capitol Ag stand prepared to review the above considerations in detail with your dairy management team, contact us today. Call Carl, Chris, Kim or Karen at 1-800-884-8290.
 
Carl Babler is a senior hedge broker with First Capitol Ag. Associated with First Capitol Ag since 1990, Babler also is a part-time lecturer at the University of Wisconsin-Platteville and owns a 1200-acre grain farm. E-mail him at cbabler@firstcapitolag.com.
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