At Risk of Doing Something

December 6, 2008 10:15 AM


Marv Hoekema

With the financial crisis well under way, the ripsaw effect through the dairy market has yet to be fully understood and priced in the trade.

As feed markets respond in near lockstep to equity market volatility, the milk market for the most part has taken on a decidedly oversold tone in speculative bets that production will overwhelm supply.

Yes, Commodity Credit Corporation purchases of powder into government storage are going on at a fair clip. Simultaneously, seasonal drawdowns of butter and cheese and even a decline in commercial stocks of powder suggest the market remains quite balanced.

All of this is a result of uncertainty in the trade. Roughly translated, uncertainty means the field of play is not really understood. All trades and bets (at least in the milk market) are to the worst case, particularly since milk supply is continuing to expand.

This leads to sideways trade even though cash markets remain volatile. When this situation is combined with a volatile yet range-bound feed market, it becomes challenging to advise a feed leg knowing full well the current milk market means that feed contract might lock in a loss.

This is a tough market to approach, but the emerging guidance is as follows:

  • Feed markets seem to be forming a floor mirroring tentative stability in the financial markets. There is still broad uncertainty in equities and financial derivatives, which is going to keep feed prices and exchange rates quite volatile until some direction is established. While some suggest the bottom is in for feed, there are conflicting reports.
  • The issue is placing or adding to a feed hedge at an unprofitable cost. It then becomes a matter of scope. If a $25/ton movement in feed prices creates a catastrophic scenario for your business, then by all means hedge or contract the feed leg. If that movement means a loss but not necessarily catastrophe, then more flexibility is afforded and merited. The reason for this approach is that there may be more to gain on a feed market slide than there is potential for a milk-market uptick. With little confidence in the financial markets at this point, it may make more sense to ride the feed market lower (if that is your outlook) than lock in a loss.
  • The milk markets have diverged into two distinct camps. Too much overpriced powder has clogged the channels, enough to drive prices to what looks like near-support levels by year-end. Conversely, the butter and cheese stocks are quite competitive with good sales. As consumers receive substantial "relief” from higher gas prices, dairy demand outlook is fair to good in the intermediate term.

If the low is in, how long can it last? Without much visibility to the level of exports, it is impossible to say at this point. I recommend a fence strategy for at least a six- to nine-month period—buy puts and sell calls, and range to trade before obligations start on the short call position. Not only does this set a floor, but it can also be rolled in or out as market conditions change, while reducing option premiums for the longer-term positions. There could be worse prices ahead if exports deteriorate. But if they do not, then the market is currently oversold, which is why options make sense.

The ongoing punishment from milk:feed prices are sure to lead to a continuing downtrend in cow numbers. Looking forward, milk:feed price spreads are encouraging. The challenge is that not only are a great deal of forage costs already committed, but most of the ongoing expenses are also not going down in line with feed.

Uncertainty means preservation of working capital is the first priority while maintaining flexibility in your market plan to take advantage of movements. The worst-case scenario is hedging a loss. So your market plan needs to be flexible enough to roll into a profit should conditions change. That is the challenge.

Bonus content:

Click here to read about Feed Outlook on the USDA website.

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