Manage Your Price Risk - Can you afford not to hedge during these volatile times?

January 12, 2010 07:53 AM


Traders view Chicago Mercantile Exchange (CME) commodity prices and trade electronically. About 80% of CME's volume is traded by computers.

Three years ago, Utah dairy producer Ron Gibson knew almost nothing about risk management tools. Since then, however, he's become so adept that he earned $400,000 in hedging gains in 2009.

"I don't know what we would have done without the risk management tools to offset the losses we sustained in 2009,” Gibson says.

Like Gibson, you're probably looking more closely at risk management this year as a way to protect your bottom line. You're hearing buzzwords like "Upside Rider,” "Min/Max” and puts and calls. And why not?

After 2009's crippling losses and the continued price volatility that experts foresee, protecting profit margins has become "the name of the game,” says Eric Meyer, a risk management consultant with FCStone (formerly Downes-O'Neill).

That means managing risk both for input costs and milk prices to improve your profit margins. For many producers, however, that is easier said than done.

You're not alone if you fear the process, Meyer says. Maybe you don't understand risk management tools. You may worry about the amount of money required for margin calls on the futures market. Or you may suspect traders somehow know more than everybody else. You might remember "a brother-in-law who lost his shirt speculating in milk futures,” he adds.

None of these should stop you from learning to use risk management tools, Meyer says. "Can you afford not to hedge during these volatile times?” he asks.

Ed Gallagher agrees. "Prices are going to remain volatile,” says Gallagher, vice president of economics and risk management both for Dairy Farmers of America's (DFA) Farm Services Division and for Dairylea Cooperative Inc. "Severe price swings are making risk management programs more valuable and necessary.”

Volatility is not only assailing milk prices but also making it harder to lock in a fixed price with a feed or input supplier, Meyer says. Tightening credit and market uncertainty mean some feed and fuel suppliers won't allow forward contracting past three or four months.

Several avenues exist to help you manage your price risk. Many cooperatives, including DFA, Dairylea, Land O'Lakes and California Dairies, Inc., offer forward contracting programs for their members. Numerous brokerage firms also can help you forward-contract milk and feed.

Whatever route you take, don't put off managing the price risks your dairy faces.

"You can find a number of farms that spend a lot of time identifying ways to cut 10¢/cwt. from their production costs,” Gallagher says. "But they do not spend very much time at all understanding how to use forward contracting to put a floor on their milk price, when doing so could result in a hedge that can save them multiple dollars per hundredweight in their milk price if prices collapse.”

Gibson did take the time to understand—and it paid off with his $400,000 gains in 2009 (see sidebar). But it had taken the Utah producer almost three years of watching, learning and taking what he calls "baby steps” to manage his milk price risk.

"It's taken a lot of courage, but I decided to make sure that we never see $10 milk again on this farm,” Gibson says. "A lot of people, including 26 employees, depend on our business. It's my responsibility to ensure that we don't fail.”

Like Gibson, you can start to protect your bottom line by managing your price risk. You may prefer to simply fix a price with a forward contract on a small percentage of your production. You may move to a higher level of trading sophistication by using the increasingly popular tools of puts and calls that can capture upside potential and limit price drops. You can work through your co-op or a brokerage house.

What's important, Gallagher says, is recognizing that it's time to consider forward contracting—its learning process, commitment and costs—as part of the cost of production. "It will pay off when you have a program in place and milk prices collapse as they did in 2009,” he says.

The risk management efforts that netted Utah dairy producer Ron Gibson $400,000 for 2009 actually began during 2007, when milk prices were headed up.

Gibson was concerned about skyrocketing feed costs eating into profit margins at his dairy, where 1,400 cows produce 2.4 million pounds of milk each month.

Looking to offset those costs, Gibson began learning about milk futures, forward contracting and the market. He enrolled in Dairy Farmers of America's Dairy Risk Management Services program.

In October 2008, with $13 milk predicted, Gibson began locking in prices in the $15–$16/cwt. range on 25% to 50% of his expected milk production for December through July. "That was hard to do because prices were so high then,” he says.

In January 2009, with the distant months trading at around $14.50/cwt., Gibson contracted some of his summer and early fall production. By early summer 2009, he turned to puts—”basically a floor price,” he says—to cover the production amounts he hadn't yet contracted. His efforts paid off, although Gibson says, "I didn't always make the right decisions.”

Today, Gibson watches the market daily. He participates in a weekly conference call with Rice Dairy, a Chicago-based brokerage firm. "I'm surrounded by people to help me succeed,” he says.

Though bullish on 2010 milk prices, Gibson still wants the insurance that forward contracting offers. "This year, I'll again look at options to guarantee a price floor,” he says.


Bonus content:

Getting started:

Risk Management Services

Dairy Farmers of America - Dairy Risk Management Services



Ron Gibson of West Weber, Utah, used futures and puts to fix his milk prices, helping offset losses his dairy sustained in 2009.


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