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COVID-19: Adjust dairy risk management strategies to limit losses

Progressive Dairy Editor Dave Natzke Published on 27 March 2020

In normal times, dairy risk management tools are a means to provide break-even protection and even lock in some profitability. With the current and likely prolonged impact of COVID-19 on dairy markets, producer should implement risk management strategies as a means to mitigate further losses, warns Marin Bozic, University of Minnesota dairy economist.

Bozic discussed dairy markets and risk management tools during a webinar, hosted by the I-29 Moo University and the Minnesota Milk Producers, on March 25. Slides from the webinar are available at the Minnesota Milk Producers Association's website, and video and audio is also available on YouTube.

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Milk markets impacted

The COVID-19 outbreak has already had a major impact on milk markets and prices, impacts that are likely to extend for some time. In late January, Bozic, like most dairy economists, was forecasting a strong year for milk prices, one which would help producers build equity and financially recover from several years of lower prices.

Bozic noted second-quarter 2020 Class III and Class IV futures prices have dropped precipitously due to the impact of COVID-19. From its quarterly average peak of $17.88 per hundredweight (cwt) in January, Class III futures for April-June 2020 averaged $15.52 per cwt as of March 25, a drop of $2.36 per cwt.

Likewise, after peaking at about $17.50 per cwt, second-quarter 2020 Class IV milk futures prices averaged $13.84 at the time of the webinar, a drop of $3.66.

The downward trend in milk futures prices extends all the way into the second quarter of 2021, with Class III and Class IV futures down 90 cents to $1 from previous peaks.

Consumption patterns have changed

Government action and social behavior has also dramatically changed dairy consumption patterns, he noted. With restaurant and school closings, food service consumption of dairy products has dropped, while retail sales of fluid milk for home consumption have skyrocketed.

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“Retail is a good story for us,” Bozic said.

After declining about 3.8% for all of 2019, U.S. fluid milk sales volume during the week ending March 15 was up 33.6% from the week before, with consumption up more than 42% in areas hardest hit by the COVID-19 outbreak. On a percentage basis, sales of shelf-stable milk are up even more: Overall sales were up 64.2%, with sales up 142% in New York, for example. Looking at other dairy foods, weekly retails sales of butter were up 85%, cheese was up 62%, processed cheese was up 72% and yogurt was up 41%.

However, even if retail sales remain strong, Bozic estimated about 30% of all dairy solids are consumed through food service channels. He said he believes long term, the impact will be an overall decline in dairy product consumption, especially if the general economy weakens.

Based on the potential toll of COVID-19 on human health and life, “April will be something we’ve never seen in our lifetime,” Bozic said. In addition, COVID-19 is not likely an isolated event from which recovery will occur quickly, but rather a triggering event that has the potential to have long-lasting impact, adding economic uncertainty.

Change risk management strategy

Due to that uncertainty, he urges dairy producers to take a long-term view when implementing risk management strategies.

“You use risk management, not to protect what you know, but to protect against what you don’t know,” Bozic said. “At times like this, you have to be humble and understand there’s more of what we don’t know.”

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To convert that into an action, Bozic recommended producers use a loss mitigation mindset, even if far-out prices do not ensure breakeven.

Dairy producers have multiple risk management tools available to them, used individually or in combination. They include the Dairy Margin Coverage (DMC) program, Dairy Revenue Protection (Dairy-RP), Livestock Gross Margin for Dairy (LGM-Dairy), futures contracts on the Chicago Mercantile Exchange (CME) and forward contracting with their milk buyer.

While Bozic primarily focused on Dairy-RP during the webinar, he called for a big shift in utilizing risk management tools, regardless of which one a producer uses. His advice: Start early and look at distant months.

In the case of Dairy-RP, that’s currently into the third quarter of 2021.

“In normal times, I would advise to use the last two quarters for break-even protection. If you see a price – corrected for your basis – that sets a floor that allows you to break even, take it. Keep your upside open, but cover your downside so you won’t lose money.

“If you don’t find what’s good for you, as you approach the quarter that you still don’t have protection for, two to three quarters out, go into loss mitigation mode. In that case, there’s no longer reasonable hope that you’ll always be able to recover your breakeven, but you still might be able to limit losses.”

Historical analysis

Analyzing hedging strategies using Dairy-RP on historical milk prices, Bozic said using Dairy-RP to protect distant months would have provided “clustered” indemnity payments, with payments in 17 of 47 quarters dating back to 2008, with an average indemnity payment of 73 cents per cwt.

If a dairy producer hedged nearby months, indemnity payments would have been received in 16 quarters over the same period, spread out over lengthier periods.

“Clustered payments work better because it gives you more money when you have prolonged, deep slumps like we are about to have under COVID-19,” Bozic said. “In extraordinary circumstances like those we are experiencing now, loss mitigation is a better mindset, even for distant quarters.”

He advised enrolling 50% of milk production at a production factor of 1.5 in 2021, allowing some maneuvering space if prices move higher.

And, rather than getting bogged down in a debate of “class” versus “component” coverage under Dairy-RP, Bozic suggested keeping factors simple to avoid decision paralysis.

“Micromanaging your risk management strategy is probably why right now you have a loss,” he said. “If you had put in place a strategy and put it on autopilot, you would be in the money for most of 2020.”

“If you think you know better than the market, go for it,” Bozic said. “But the world is such a complex place that no matter how well you understand supply and demand, no matter if you understand what New Zealand is doing and what Europe is doing and what’s happening with butter, there will be something out there from your blind angle that will hit you.

“The best strategy for risk management is humbleness,” he continued. “Keep it simple, and it will be effective. The core principles of risk management will pay off in the long term.”

Multiple years of lower milk prices has effectively diminished dairy farmers’ abilities to ride out the shock from COVID-19. And because the impact of COVID-19 has the potential to last a long time, price recovery could be very slow, Bozic warned. The situation has the potential to speed consolidation within the dairy industry, with those producers not utilizing available risk management tools the most vulnerable.  end mark

Dave Natzke
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