The year of 2016 has brought a cash crunch for many dairies as extremely low milk checks through the first half of the year led to negative margins. The recent rally in milk prices, combined with now-depressed feed costs, is finally bringing some relief – along with more attractive forward margin opportunities.
However, with cash flow still restrained, many dairies may be unable to meet the capital requirements associated with using the futures market to capture improved forward margins. In addition, they may not be comfortable committing to forward sales and volume requirements with a creamery.
For cash-strapped dairies, swaps may offer a better solution.
For years, corporations and government entities have taken advantage of swap agreements in the financial markets to manage their interest rate and credit default exposure. More recently, these tools have proliferated in the agricultural markets, and many dairies are now beginning to appreciate the potential of swap agreements to manage fluctuating milk prices and gain greater control over their profit margins.
Find flexibility in the space between
While not as widely used as futures contracts and forward agreements, swaps are something of a hybrid between these two hedging vehicles.
Both the size and terms of a swap agreement can be customized to match the particular needs of the contracting parties; however, many agricultural swap agreements are standardized to mimic an exchange futures contract, which gives the issuing party an equivalent vehicle by which to hedge their risk against the contracts they commit to with counter-parties.
The mechanics of a swap are similar to a forward agreement or futures contract. They require establishing a financial relationship with the counter-party, submitting financials to determine creditworthiness and entering into a “master agreement” that spells out the exact terms of contracting between the two parties.
With a futures contract, the contract is “marked-to-market” daily; any gains or losses from the previous day’s settlement are paid out or paid into an account with performance bond requirements. Although a swap agreement may function this way, more common is a single-settlement procedure upon termination of the agreement.
This could either occur at the swap settlement date or ahead of that term based upon mutual agreement between the two parties. Unlike the account margining process and daily settlement procedure that regulates futures contracting, debts and credits get built up in these agreements. That is why financials are required when initiating a relationship with a swap provider.
This single-settlement procedure is very similar to the way a forward agreement would work in the cash market. But unlike with a forward agreement, the dairy has no obligation to deliver physical milk in the cash market.
Instead, upon termination of the contract, the swap results in a purely financial settlement. If the market goes up between the time the contract is executed and settled, the dairy will owe the swap issuer the difference between the contract price and the actual futures price at expiration. If the market moves lower, the swap issuer will owe the dairy the difference.
A swap can also be structured with option features incorporating minimum and maximum price levels that may not be available at a creamery. In this way, swaps offer a great deal of flexibility, especially for operations looking to leverage limited capital or direct available cash into other purposes, like paying for feed at harvest or covering other operating expenses.
However, they are not without some drawbacks. Because the issuer may have to margin the position on behalf of their counter-party over the life of the contract, the execution costs for a swap will typically be higher than the cost of a futures trade.
Hedging June 2017 milk futures: A practical example
An example may help illustrate how a swap agreement can help dairy producers manage risk. Let’s say a dairy operation is looking at projected forward milk margins into next summer and notices an opportunity to protect a historically attractive return in the second quarter of 2017.
Knowing that they will secure most of their forages at harvest time, the dairy wishes to limit their exposure from a decrease in milk prices before it is contracted for delivery to a local processor. June 2017 Class III milk futures are trading at $16.50 per hundredweight.
As an alternative to selling a futures contract on the exchange, or entering into a forward agreement directly with a creamery, the dairy can place an offer to execute a swap agreement for a standardized contract on Class III milk that mimics a CME group futures contract.
If the CME June futures price were to breach the level of the offering price in the contract, the offer could be accepted, and the dairy would formally enter into a swap agreement with the issuing counter-party.
If the market goes down between the time the contract is executed and settled, the swap issuer will owe the dairy the difference between the $16.50-per-hundredweight price of the contract and where the June 2017 Class III milk futures settled at expiration. If the market goes up, the dairy will owe the issuer.
Because the financial settlement of the contract will not occur until expiration, the dairy will not have to pay the issuer until they receive their milk check next summer. As a result, the dairy would be able to allocate capital that would otherwise be required for margin calls to farm operations or other important expenses.
This works both ways, however. If the market instead moves lower, they will not be accruing capital on a daily basis from their hedge that they could withdraw and use, as they would with a futures contract.
Swaps offer flexibility
Swaps offer dairies a way to customize an agreement that best fits the needs of their operation, including the flexibility to choose a settlement date closer to the receipt of a milk check without the restraint of volume requirements with a specific creamery or the daily margining requirements associated with the futures market.
In the current environment, this may fit well with where many dairies find themselves: between poor operating margins and stronger projected forward margin opportunities. 
-
Chip Whalen
- Vice President of Education and Research
- Commodity & Ingredient Hedging LLC
- Email Chip Whalen
