Controlling Our Dairy's Risk

January 4, 2013 11:28 AM
Controlling Our Dairy's Risk

How a Wisconsin dairy expanded—and remained profitable—using risk management.

Hoping for the best has never been part of the business philosophy at Wisconsin’s United Pride Dairy.
Before neighbors Jon Pesko and Ed Jasurda merged their two dairies near Phillips, Wis., in 1996, they carefully assessed the risks. In the years after the merger, the new United Pride Dairy prudently increased its herd from 300 to 1,800 cows. But it was a 2010 expansion that proved the advantages of careful calculation.
That year, Pesko and Jasurda upgraded their double-14 milking barn to a 60-cow rotary milking parlor. They also built a 1,200-cow cross-ventilation freestall barn.
A new parlor and barn on the heels of 2009? When much of the dairy industry was struggling just to survive? Had Pesko and Jasurda become reckless gamblers?

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Far from it. With an eye to bringing the next generation of family into the dairy, Pesko and Jasurda saw expansion and technology as keys to long-term success. But they realized that with more dollars at risk and volatility increasing, their operation needed greater price certainty. It needed a formal risk management program.
"After 2009, it was tough to get a lender to talk to us about expansion," Pesko says. "We had to take out some of the risk. Until then, we only had limited use of marketing tools."
United Pride Dairy’s need led Pesko and Jasurda to hire Stewart-Peterson, a risk management firm. The dairy then added an adviser from Lookout Ridge Consulting to provide financial information such as projected production costs. The team expanded to include BMO Harris Bank, since the lender would provide the line of credit necessary to implement any market positions. Together, the group began to build a solid risk management strategy. The parlor and the barn got built.
"They expanded at the right time in the price cycle," says Stewart-Peterson’s Matt Mattke.
2010’s low prices presented maximum opportunity from a risk standpoint. "If you expand when prices are high, everything costs more, plus you put all those investments at greater risk should milk prices turn downward," Mattke says. "Having a risk management strategy in place allowed United Pride Dairy to do the expansion when prices were low."
Today, United Pride Dairy uses a blend of risk management tools to manage its price risk. On the milk side, Pesko and Jasurda have implemented put options, call options, futures and fence strategies. Using diverse tools allows them to blend the pros and cons of each. Some provide downside protection while others offer upside participation.
"Combining all of these tools helps provide United Pride Dairy with better weighted-average price scenarios in both rising and falling markets," Mattke says.
On the feed side, Pesko and Jasurda have primarily used call options, forward contracts and put options to cover their feed price risk. Forward contracts have allowed them to directly hedge products that don’t trade on the CME, such as Exceller Meal and corn gluten.
"Call options have been used to provide a worst-case ceiling price while leaving their downside open," Mattke says. "Forward contracts have been used outright and also in conjunction with put options. A forward contract and a put option together create a synthetic call option that provides upside price protection, while providing the opportunity to partake in lower prices if they are offered."
The foundation of United Pride Dairy’s strategy is ensuring that its cost of production is covered. Today, the dairy’s production cost is $17.30 per cwt., up from $12.50 five years ago.
When setting their risk-management price levels, Pesko and Jasurda look at the impact of various hedge positions on their overall weighted-average price. That’s the net average price received over time for all of the dairy’s milk production (or paid out for feedstuffs). The process helps them identify and address weak spots.
"If we settle on a price of $20 per cwt., that shelters us from loss and ensures a profit," Pesko says. "It’s not as high as some might get, but it keeps us moving forward."
Lookout Ridge Consulting’s Tim Swenson continues to provide financial information. Paul Salm of BMO Harris Bank stays in the strategy loop to ensure there’s adequate funding from start to finish. While they receive daily e-mails and a weekly call from Stewart-Peterson, Pesko and Jasurda aren’t preoccupied with the commodity marketing element of their business.
"We already have so much drawn out in advance," Pesko says. "Once every month or two, Matt and I will talk and discuss scenarios to accomplish our end goal."
Using a market scenario planning table, Pesko and Mattke analyze the impact a particular strategy will have on the dairy’s weighted average price. Those scenarios "allow us to decide whether to pull the trigger or not," Pesko says. "Ninety-five percent of the time, I’ve listened to Stewart-Peterson."
"We do not base our recommendations on where we think the price will go," Mattke says. "Rather, we accept the fact that multiple price scenarios are possible. We show them what the farm’s position will be in the future, depending on which scenario plays out. This gives United Pride Dairy two distinct advantages.
"First, it’s proactive. United Pride Dairy can think about a recommendation before it’s time to make a decision in the heat of a market move.
"Second, the decision making is about the math, not about an opinion on what the market might do."
The result has been sustained success for United Pride Dairy. "If you look at what we’ve done over the years, we haven’t made a lot of money with our risk management program," Pesko says. "That isn’t the point. We’re not trying to get rich quick. The point is to take out the low lows, like in 2009. You also have to give up the high highs, like in 2011.
"That strategy fits our business philosophy," Pesko adds. "You can roll the dice, but I like to have more things in my control. Risk management helps."

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