Managing Both Sides of the Coin: Risk vs. Opportunity

Published on: 17:24PM Feb 10, 2013

Guidelines on how to approach marketing decisions for milk and feed.

chip whalen thumbBy Chip Whalen, CIH

Many dairies are no doubt thinking about how to protect their profitability right now. Milk prices have declined from late last year while feed costs have recently increased. It is easy to get lost in all the confusion and not feel confident with how to approach marketing decisions, although there are some guidelines that can be followed, which may help.

First, it is important to know what your forward profit margins are projected to be out in the future. A margin model can be built which essentially organizes both your costs and revenues by production periods into a tool that will provide forward visibility of your profitability. Using the futures market as a price discovery mechanism, this model by extension becomes a margin discovery tool that can help you make better decisions about how to protect your forward profitability. While no one knows for certain what prices will do in the future, it is possible to put prices and profit margins within an objective context that can be evaluated to inform the decision-making process.

As an example, looking at a long-term chart of milk futures will show you that prices do not spend much time above $20/cwt. or below $10/cwt. Similarly, if you were to look at a chart of corn futures, you likewise will observe that prices above $8.00/bu. are quite high from a historical context while prices below $3.00/bu. (at least nowadays) are quite low.

Profit margins can also be examined this way. A profit margin projection can be compared to similar profit margins for that particular production period over some past historical timeframe, and ranked to determine how relatively strong or weak the current margin is.

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Spot margins in the first quarter of 2013 are now being projected at a loss of $0.13/cwt. for a model dairy operation which ranks at the 30th percentile of the past 10 years. This means that 30% of the time within the past 10 years the dairy was losing more money during the first quarter, while 70% of the time the dairy was more profitable. By contrast, a projection of profit margins in the fourth quarter of 2013 is currently $2.53/cwt. for the same model dairy that ranks at the 90th percentile of the past 10 years.

Why are the two profit margins so different? For one, it has to do with revenue projections. Class III Milk futures for February and March are in the low $17.00/cwt. range while those for October, November and December are about $1.00/cwt. higher. Feed cost projections also factor into the difference. While nearby corn and soybean meal prices are trading over $7.00/bu. and $400/ton, respectively, new-crop corn and soybean meal futures are priced at discounts of $1.40/bu. and $70/ton to spot levels.

Whether or not Class III Milk will still be over $18.00/cwt. come the fourth quarter, or for that matter corn remains below $6.00/bushel, is anyone’s guess, and it probably doesn’t make much sense to spend too much time at this juncture being concerned with it. What does make sense to focus on, however, is the fact that the profit margin being projected based upon the relationship of these prices is currently at the 90th percentile of the past 10 years for the fourth quarter.

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We often like to think of risk and opportunity as opposite sides of the same coin. Looking at the-fourth quarter profit margin, you might say that there is 10% opportunity for the profit margin to improve from current levels while the risk is 90% that the margin will be worse. When considering contract alternatives to manage this margin, it may make sense to preserve some opportunity for the margin to improve; however, it is probably much more important to address the greater degree of risk that is implied by the historical level of profitability. Viewing your marketing plan through this prism helps to make more informed decisions on how to protect both costs and revenues in the profit margin equation.

Continuing with the example of the fourth quarter, protecting milk might consist of some sort of minimum price or "floor" around current future price levels with a maximum price or "ceiling" above the market. As an alternative to simply locking in the milk price, which most dairies are hesitant to do anyway, this addresses the risk that profitability will deteriorate should milk decline much from current price levels. Yet it still leaves open the opportunity for higher prices to be realized if the milk market increases.

On the feed side of the equation, meal prices at about $368/ton and corn prices around $5.70/bu. suggest different approaches. Similar to milk, $368/ton is a historically high price for soybean meal, so a defensive strategy that protects some upside risk but leaves open a lot of downside opportunity might be considered. With corn, a more neutral type of strategy would seem to fit around what has been a slightly above average price in recent history.

As a new contributor to this space, I read through some of the recent articles submitted by others to the "Know Your Market" column. One in particular that caught my attention was written by Katie Krupa. She discussed the idea of remaining flexible to make adjustments with a marketing strategy. I think this is a key concept to grasp. With any marketing decision, you make contracting choices based on the information available to you at that time. As we all know, however, markets, prices and therefore profit-margin projections change as new information becomes available to the market. The whole point of "managing" margins is being flexible to make changes as conditions warrant.

Whatever your strategy happens to be, it is important to have a plan and stick with it in order to be successful. It is also important to weigh the costs and benefits of different contracting alternatives against the implied risk vs. opportunity profile of the marketing period being considered. Fortunately, there are tools and approaches available that can help inform better decision making.

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or [email protected].