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A Great Time to Protect the Milk-Feed Margin

Oct 02, 2011

Katie Krupa photoTo protect the risks that threaten the profitability and sustainability of a dairy, look at milk and feed prices in relation to each other.

By Katie Krupa, Rice Dairy

In my recent travels across the country, I have spoken with many dairymen (and lenders) who are growing increasingly nervous about the 2012 milk price.

This makes sense considering that the last time the dairy industry saw record-high milk prices, it was shortly followed by a devastating milk price cycle that some are still recovering from. The good news is that it's not too late, although the milk price has lost some ground in recent weeks, as have feed prices. In short, the milk-feed margin is trading at a decent level for dairymen.

In a calculation I use to judge the margin between the milk price and the feed cost, the 50th percentile is my benchmark for "good" or "bad" prices. The 50th percentile is currently around $9.00. As of the end of September, the average milk-feed margin trading for January-June 2012 is around $8.75, and the average margin for July-December is $9.45 (making the annual average $9.10). Although this margin may not look too enticing, for most dairies, that margin exceeds their break-even and enables them to protect profits and reduce volatility.

Let's examine where that margin price has settled in recent years. In 2010, the average margin settled at $8.72, and in 2009, it was $5.46. That is a significant swing in a short time frame. Obviously, 2009 was not a profitable year for the dairy industry, but was 2010? For a quick calculation, a dairyman could assume that if 2010 at $8.72 was a profitable year, 2012 with a margin of $9.10 will also be profitable. This is a quick, oversimplified calculation, but assuming no major changes to the operation or debt structure, it will work for most dairies. 

By using a risk management strategy that hedges the milk price and the feed prices, we are able to protect the margin between the two. Given the volatility in both the milk price and feed costs, I think it is crucial to hedge both milk and feed -- in other words, hedge a milk-feed margin.
 
Where to start? Although the 50th percentile mark is currently around $9.00, that number should not come into play when making a hedge decision for your farm. The percentile mark should be replaced with profitability. So, if a milk-feed margin of $8.00 results in the farm breaking even, $8.00 is the lowest margin price we want to protect. If $8.00 is break-even, maybe $8.50 is a "good" price for your farm. Determining a "good" price is based on the financials and goals of the business. Creating a hedge strategy focused on your farm’s financials will enable you to make the best risk management decisions for your farm.

How is the margin calculated? The numbers I have here are based on current trading prices for milk, corn and soybean meal. To determine an appropriate relationship between milk, corn and soybean meal, I analyzed feed rations for dairies across the country. For the rations fed, I converted the energy and protein in the ration to corn and soybean meal equivalents. This process allows me to hedge the majority of my feed needs by contracting only two commodities: corn and soybean meal. This process can be completed fairly simply for a dairy, so that it’s analyzing a milk-feed margin that is specific to its operation.   

Looking to the future, I see the continued need to hedge milk prices and feed prices to protect the dairy business. The volatility shows no signs of decreasing. Although it is still popular to look at milk and feed separately, I no longer think that is a good hedge strategy.

To protect the risks that threaten the profitability and sustainability of a dairy, we should look at the milk and feed prices in relation to each other. The good news is that the current trading prices for the milk-feed margin are at levels that are historically "good," and, more importantly, are probably "good" for your farm’s financials.

Katie Krupa is the director of producer services for 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 her at klk@ricedairy.com. Visit www.ricedairy.com.

 

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