Understanding hedging tools and variables – from the Midwest to California – can help influence your basis risk, or the difference between cash and futures prices.
By Will Babler, First Capitol Risk Management, LLC
A sound dairy margin management strategy should first focus on managing the most significant and most volatile margin driver – milk price. Simply put, no other variable influences bottom-line results as much as milk price. Fortunately, futures and options tools are available to manage this risk.
Normally it is enough to just consider these tools as adequate hedging instruments without diving into the details of how cash milk prices and the milk check in your mailbox relate to the futures settlement price. However, when taking the next step toward managing margins, we need to consider the influence of basis risk, or the difference between cash and futures prices. Unless basis is understood, it is difficult to match hedging expectations with hedging results.
Federal Order Milk Basis Risk
A simplification of a typical Midwest producer’s milk check shows that the Class III milk price is the primary driver while the following also play an important role:
· PPD – producer price differential
· Components – fats, solids, protein
· SCC – somatic cell count
· Premiums – quality, volume, location or other premiums
· Deductions – hauling and other costs
Most of these factors, except for PPD, are relatively stable or seasonally variable aspects of a producer’s operation. It is important to understand the historical impact of these factors on past basis results as well as future basis expectations.
The PPD is variable based on market prices and utilization, which adjusts the pay price based on the value of other dairy products aside from cheese. Since these factors vary with market volatility, the PPD can have a significant influence on the realized basis and mailbox prices. In a narrow margin environment, it is important to take into account all the factors listed above, understand past basis history, and have a tool to project forward basis. Without taking these steps, a margin hedging program is unlikely to meet its expectations. See Figure 1 for an example of the basis variation introduced by just the PPD.
California Basis Risk
The California basis risk scenario includes many of the issues above. An additional complication is that this market is not Class III-dominated. The California order is driven by the equivalents of both Class III (cheese) and Class IV (butter and powder). Depending on price spreads, either the Class III or the Class IV equivalents make up slightly more than half of the pricing influence. With this in mind, California producers should be utilizing both Class III and Class IV hedging tools to manage their price risk.
Historically, the superior liquidity of the Class III futures market has led most California producers to focus on hedging with this tool. This approach has its place but, within a margin management context, the basis risk of hedging with only Class III could exceed the margins available in the market.
This points a California dairy producer toward taking into considerations the factors in the prior section and also seeking to manage the entire spectrum of his or her milk price risk by hedging in both the Class III and Class IV markets. Recent improvements in market liquidity for Class IV futures and options have made this approach much more practical. See Figure 2, which shows the reduction in basis risk by using a simplified hedge approach of 50% Class III futures and 50% Class IV futures. This approach has considerably less basis risk compared to hedging only with Class III.
Managing margins and price risk is an exercise in balancing risk and reward. Milk basis risk should be included in this balancing act. By properly understanding and quantifying this risk, a producer can improve the performance of his or her margin hedging program and, hopefully, have hedge results that meet initial hedge expectations. This is particularly important in a narrow margin environment where there is less room for error and all assumptions are important.