While the need for risk management may be acute, milk producers historically have not been well prepared to operate in a market economy. Yet dairy farmers and processors today enjoy an opportunity to hedge milk prices over the next year and a half.
The opportunity to reduce price risk comes in a rare package that blends market price discovery with government involvement. Indeed at a time when much of the livestock industry is calling on the government to ensure "transparency" in market pricing, the dairy industry has the full co-operation of an established government pricing process.
Sid Sprecher explains.
Farming brothers Dan and Steve Smits, the management of their milk cooperative, a nearby commodity broker, and a Chicago floor trader are members of a small revolution that promises to bring the nation's dairy industry into the marketplace.
For years America's dairy farmers essentially produced for the government. Subsidies were set at profitable levels and when the marketplace failed to absorb the ample output, the government absorbed the surplus. The result was mountains of cheese, butter and dry milk that eventually flowed into consumption channels as blocks of charity cheese or school lunches or foreign aid. There was little volatility in the price of milk. But in the late 80's the government began to lower the safety net. The price of milk began to swing dramatically, too dramatically says Alto Dairy Co-op's Jeff Montsma for the fiscal health of dairy producers.
Montsma: "...And as of the late '90's we've seen prices as high as $17 to two years later, go as low as $8. So, you're talking 45-50% price swings. Most dairy producers can handle about a 20% price swing, based on the profitability. Some, maybe, have leveraged a little bit more can't but typically, the average producer can't handle the 40 or 50% price swing, thus the risk management tools that we have available are a good option for them."
The risk management tools employed by the co-op are derived from the open outcry sessions of the Chicago Mercantile Exchange. Although other exchanges had tried to establish futures contracts for dairy products, the Merc's 1996 launch of contracts on two classes of milk may well be the best bet to survive. The contracts were a response to the market volatility caused by the rollback of government milk subsidies. But government milk pricing policy still plays a critical role in the trading of the futures instruments.
For purposes of government subsidy payments the USDA each month calculates prices on four classes of milk. Class 1 milk is for fluid milk only. Class 2 is milk destined for yogurt and ice cream. Class three is for cheese. Class four milk becomes butter and non-fat dry milk.
The Merc trades futures contracts for only class 3 and class 4 milk. Part of the reason is the fact these classes of milk are more storable and are more reflective of broad market demand.
Indeed retail trends can have profound effect on prices. Should a fast food chain decide to offer, or cancel, a special on cheeseburgers the economic impact could ripple back down the pipeline into the milk parlor.
While the government no longer provides much of a subsidy, the data it gathers and the price calculations it makes are important. The monthly price it issues is the settlement price for the Merc's futures contracts.
Unlike grain and oilseed futures traded on the Chicago Board of Trade, there is no physical delivery. Commodity broker Phil Plourd says cash settlement is one of the best features of the milk contracts.
Phil Plourd: " ... So, you have perfect convergence of the two marketplaces. So, it works out very nicely for producers. We don't have to worry about delivery because delivery is not an issue and we don't have to worry about a divergence between the futures price and the cash market price because they are indeed one and the same, on the final day."
Recognizing the potential value of the milk futures contracts to both producers and processors Plourd's associate Roger Blmling devised a contract that allows co-ops like the 1,200 member Wisconsin-based Alto Dairy to offer its members a forward price.
That's an important benefit to many co-op members. Because the futures contracts are traded as 200-thousand pound units, the output of about 120 cows, many smaller dairy operations can't use them.
Blimling: pacing bite
But the co-op can take a position in the futures market and offer a proportionate piece to members as a forward price.
Co-op members Steve and Dan Smits operate a 500 cow milking operation. To lock in a forward price they need only look at the Alto WEBSITE to see what the co-op is offering and pull the trigger. Over the course of the year the brothers say they forward price 30 to 90 percent of their milk. The practice has been profitable.
STEVE SMITS: "About a year and a half ago, we did a lot of traveling. I was out in California, Indiana, Michigan and we saw the growth that was going on out there. And by what you read in all the papers, magazines, you knew that milk production was going to be awfully high and prices were not looking good. We didn't think that they were going to go all the way down to $8.57 but we knew they weren't going to be good. And by foreseeing that in advance, we could lock in a price that was profitable to us. When other farmers were getting $8.57 last fall, we were getting $12.00."
Dan Smits: "It allows you to sleep at night. It ….you know your costs….you know your….what your outputs are going to be from the farm. It just makes planning so much more easy."
The Mercantile exchange is optimistic that it may have found a winner.
The open interest on the milk futures contracts is now greater than that of the older lean hog contract, and traders like Kirk Crook see nothing but up side for the instruments.
Kirk: " ... our open interest in the milk is over is roughly 14-thousand contracts. For any contract of that age, that's pretty incredible growth. The potential is still there. We're getting new customers every day. The industry people are constantly in contact with us about what they can do to increase milk volume."
That market interest ensures the viability of another management tool to farmers who know reducing risk at every opportunity is critical to sustaining their operations.
Steve Smits: "…We've got our bank loans locked in at a guaranteed rate rates for a number of years. We contract our fuel inputs. Our LP is contracted. Our diesel fuel is contracted for the year and we forward contract our protein needs for the year and also our cottonseed needs, everything that comes onto the farm. And, I feel if we're going to contract everything that comes onto the farm, why not know what you're going to get paid for what you ship off the farm."
For Market To Market, I'm Sid Sprecher.