Both 2009 and 2014 are termed “black swan” events in the dairy markets. By definition, both were unexpected and had huge effects on profitability.
In 2009, because of the financial market collapse, the global dairy trade froze and
exports were unable to move. That caused dairy markets here to plummet and losses to sky rocket. Some farms went out of business; others took years to recover due to the loss of equity and loan restructuring.
The opposite happened in 2014. China went into a buying frenzy early in the year, pushing dairy markets to never-before-seen heights. Profits went into the stratosphere for some, but not for all farmers.
Those who weren’t able to take advantage of these market highs had done the “right” thing by either hedging or protecting downside risk with options. If they chose the option route, they probably paid for put
options by selling calls. That gave them a $15 per cwt floor but capped their upside at $20. When prices shot to $25, they were unable to capture that profit.
In some cases, farms lost 50% of what is typically 10 years of profits with that risk management strategy. “Some dairies lost $3 to $4 per cwt, and for large dairies, that adds up to some staggering sums,” says Greg Bethard, chief financial officer for Pagel’s Ponderosa Dairy and Dairy Dreams located near Kewaunee, Wis.The dilemma is what to do about it. Buying put options, particularly in a down year like 2015, can cost 60¢ to 80¢ per cwt for a $15 floor, he says. That gets expensive, especially if you’re trying to protect against that rare black swan event that only occurs once every decade or so.
A second option is to have massive amounts of working capital and cash stowed away for that rainy day when black swans darken the skies. Lenders typically recommend $200 to $500 per cow in working capital. But there is no one-size-fits-all recommendation because each farm is different in terms equity, debt structure and profitability. Bethard says a third option is the farm bill’s Dairy Margin Protection Program. For $6.50 margin insurance, premiums are 9¢ per cwt for the first 4 million pounds of annual milk production, and 29¢ thereafter.
In a year like 2015, when put options are expensive, the Dairy MPP makes sense. In years when the futures markets offer cheap put options, they might offer better downside risk protection. The decision point comes each summer during the MPP sign-up window July 1 through Sept. 30. The point of all of this is that no single
approach works for every farm every year. Milk markets are fluid (pun intended) and volatile.
The reality is that black swan events like 2009 and 2014 do, can and will occur again.
First, know what your operation’s tolerance for risk is. Then, have a strategy in place for the eventuality that a black swan will again darken the horizon.