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0209 PD: Keep some powder dry!

Mike North Published on 14 January 2009

When crossing a river to engage the enemy, Oliver Cromwell was quoted as saying to his troops, “Put your trust in God; but mind to keep your powder dry.”

These words, which directed and readied his troops during his Irish campaign, can be well applied to the very volatile milk market. The history of the milk market, though brief, has been one of wild price movements that stretch from heart-stopping lows to euphoric highs.

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The unprecedented volatility experienced in 2008 has taught us two things – you need to be in partnership with a banker (one that understands hedging and the tools in the marketplace) and you need an appropriate line of credit to match your marketing efforts. Why is this so important? The answer is simple. Because of the nature of the milk market, which I’ve discussed in previous Progressive Dairyman articles, there is a huge propensity for market action to take prices to elevated values. Couple that with volatile feed prices and profit margin opportunities can become hit or miss.

Therefore, managing profit margin with the available market tools (contracts, futures and options) is good business. If you make commitments to your milk buyer in the form of a contract, you will want to manage the potential opportunity that may exist with call options. If you are selling futures contracts, you may do the same. Perhaps you only want a minimum price established and seek to only purchase put options. You may take equal actions with your feed. Regardless of your strategy, you will need capital to finance the initial actions you take and further capital to manage those actions.

And unless you have a crystal ball and can accurately predict market tops and bottoms, be prepared to make an ongoing investment in the form of futures margin or option premium to defend and enhance your bottom line. This past year was filled with stories of producers, co-ops, country elevators and end users alike who had positions established in the futures markets at profitable levels and were forced to liquidate those positions because their credit lines were exhausted. Further, many producers found it difficult to lock in prices on their inputs or production because their vendor or buyer was unwilling to accept the market risk of offering such an opportunity.

Does this warrant inactivity? Absolutely not! Sports provide a great example of why you need to be in the marketing game. Whenever your favorite team assembles to challenge an opponent, notice who is getting paid for the game. Is it the mass of fans in the stadium or the 10 to 20 athletes that are engaged in the competition? So, too, must we engage the opportunities when they arise. However, there is nothing worse than taking these very appropriate actions, only to be forced out of them by your lending institution or brokerage firm.

How can this be prevented? Here are some tips to keeping enough powder in the keg and making sure there are no misfires. Establish a relationship with a broker and lender that understand your business and the broader agricultural picture. Their understanding was critical during the market craziness of 2008. Ag lenders understood the cyclical nature of your business and acted promptly to extend credit lines for your marketing efforts. Hedge-minded, agriculturally focused brokers are also important. Seeking counsel from someone that is only interested in selling you the next hot market pick or someone who doesn’t have any understanding of your industry often leads to not having a marketing plan or becoming distracted in your efforts to execute it.

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These two individuals, a good ag lender and a hedge-minded ag broker, constitute the other two-thirds of your margin management team. If you don’t already have a relationship with such professionals, get one. Your hedging account needs to be part of a pre-determined plan. Be sure that everyone is on the same page from concept to execution of your marketing/margin management plan. Establish with your lender and broker what tools (futures, options, contracts for physicals or a combination of these) will be used. Define your commodity, quantity and price risk. Outline your cash market actions and your hedging mechanics.

Stay the course of the plan and avoid the hype and emotion that often enters the market during extreme moves. Create an environment of accountability by matching your cash commodity position with your hedge positions. Many marketing plans have been hijacked by this lack of coordination. You must be in constant and continual communications with your lender and broker to overcome this hurdle. The three of you must function as a team to ensure that the appropriate actions are being taken. If they are not, position sizes can become speculative and the leveraging effect of the marketplace can work to not only produce a loss, but amplify it.

One way to enhance communication between the broker and lender is to arrange for duplicate brokerage statements and tax documents to be sent on your behalf to your lender. Be sure to create a separate line of credit from your existing operating line of credit for marketing. It should be available for the sole purpose of hedging/marketing. How much should be available? For corn, options contract users should establish a marketing line of credit of $5,000 per 10,000 bushels. For futures, you need $4,000 per 10,000 bushels for your initial futures position and then enough capital to withstand a $4 per bushel market move ($40,000 per 10,000 bushels).

Bear in mind that these numbers represent extremes that you may never meet. For milk, options contract users should plan to spend $0.50 per hundredweight (10,000 cwt x $0.50 = $5,000) initially and another $0.25 (10,000 cwt x $0.25 = $2,500) for each dollar that the market rises from your initial action. For example, if you were to purchase a $16.00 put for $0.50 cents per hundredweight and the market would rise another $6, be prepared to spend an additional $1.50 per hundredweight to elevate your price floor levels to $22 per hundredweight. Historical price activity would suggest that you prepare for a move to such a level.

Construct your credit line to accommodate such a move. Futures contract users should allow $10,000 to meet the performance bond requirement as well as enough capital for a market movement to $22 per hundredweight. Build confidence with your lender by creating a third-party security agreement. This allows your banker to transfer funds on your behalf directly to your brokerage account without the ordinary paperwork. Equally, it allows the proceeds from the brokerage account to return to the marketing line of credit before being paid to the producer.

These agreements provide the banker with the reassurance that the money will come back to the bank from the initiated marketing activity and provides complete transparency of the marketing results. Just remember that the market can go farther than you think it can. If you’re not prepared for the worst-case scenario, if you are not operating from a comprehensive plan, if you are not communicating with your lender or creating the transparency to maintain his trust, you’re not going to have enough powder to fight for the profits that let you live. PD

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UPDATE: Since the publication of this article, Mike North has left First Capitol Ag and is now the president of Commodity Risk Management Group. Contact him by email.

Mike North
Senior Risk Management Adviser

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