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1008 PD: Effective forward contracting equals forward profiting

Ben Yale Published on 30 June 2008

The Farm Bill requires that the USDA permit forward contracting of milk as an alternative to minimum prices.

Discussions, and past use, of forward contracts have generally meant fixing a price for a period of time. That should not be the case. Forward contracting provides the producer and the buyer the opportunity to formulate a means of pricing milk that arises out of a partnership of a shared interest in mutual profitability.

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The law requires that whoever seeks a forward contract must also present you with a contract of the same volume and time that will provide minimum prices under the order. Compute for each proposal what your milk price would have been for each of the preceding 36 to 60 months (the longer the better), using current or expected production and component tests. Assistance for this can come from the county extension agent, a producer trade group, a fellow dairyman who understands the process or even the company making the offer. Regardless of who provides it, it is critical to see how the two proposals can differ in the real world. Above all, do not rely on one month’s comparison or even an average.

Better yet, instead of just considering the two contracts proposed, offer your own contract. Nothing says that only buyers can propose pricing contracts. In conjunction with a professional who understands milk pricing, devise a formula that fits your needs and provides a competitive price to your buyer. This article cannot cover all one needs to know about pricing formulas, but here are some of the major points to consider in your own offer or counteroffer.

Price the milk free on-board (FOB), and let the buyer assume all risk of hauling. The price may be lower, but your net should be the same.

Use the prior month to set the price for the milk. For example, price August milk using the value of milk in July. In this way, both you and the buyer know what the milk will be worth before you ship it. Although there will certainly be some differences, over time at the same volume they should even out.

Ask for payment earlier than offered under the Federal Milk Marketing Order (FMMO). The rationale of later payment comes from the past when manual posting of weights and tests and manual computation of prices took time. Today, computers answer all of that in a matter of minutes. If milk is priced using prior months’ values, those are known by the 5th of the following month; full payment should only be a few days away. Of course, if the milk is pre-priced, the value of the milk will be known at the moment of the last delivery. Advances could be by the 16th of the month.

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Consider weekly pricing and settlement. Every Friday morning, the USDA reports a whole range of price series based upon the prior week’s activities. These can be used easily in any pricing formula. With forward contracting, there is no reason you cannot price milk each week and get paid weekly. Even without the weekly settlement, weekly pricing will ensure that both you and the buyer are closely in line with market prices.

Factor in the cost of feed in the formula. There are several ways this can be done, but the easiest is to use the milk-to-feed ratio as a cap and a floor. The USDA reports the average cost of feed rations for different protein rations. These can be found in the USDA publication Agricultural Prices. This monthly publication can be obtained online at http://usda.mannlib.cornell.edu/MannUsda/homepage.do. In your search, enter agricultural prices, and choose “Title Search.” After choosing agricultural prices, you choose the year, then the month. The ration price appears in “Prices” used to calculate feed price ratios. The range of the ratio you use in the contract is fully negotiable. The concept is to ensure the milk price does not go too low compared to feed costs while at the same time does not provide a windfall to the producer at the plant’s expense when the ratio is very favorable.

The use of the ratio can be explained by this example: Assume the agreed range of milk-to-feed ratio is to be 2.0 to 2.9. Assume further that this month the agreed formula yields a price of $17.00 and the ratio for the month is 1.9. To adjust the price divide 17 by 1.9 and multiply that by 2 for $17.89. Conversely, if the milk price is $18.50 and the ratio is 3.0, by dividing 18.50 by 3 and multiplying that by 2.9, the price would be $17.88. This is just one of several ways in which cost of feeds can be made part of the formula.

Negotiate who keeps the producer price differential (PPD). Using your scenario spreadsheets, factor in the PPD as announced to get a sense of what having or not having it would do for your net number.

Negotiate premiums for high- quality milk and higher premiums for higher quality milk. Quality has a value for both the plant and the producer; expect a share.

Mutually seek ways in which you and your buyer can do business so as to save costs and equitably share them. For example, having another tank at your farm might simplify hauling.

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Consider different prices for different portions of milk. Nothing says all of your milk should be priced the same. Break it up into portions of your supply, and come up with a range of prices such that at the end your individual farm blend is higher. This might prove to be a useful negotiating tool because the plant who is buying all of your milk knows that some will be worth less. It will overestimate the volume of excess and underestimate its value. By separating out the critical volume at higher prices and excess at lower prices, this can be avoided. Also, actually knowing what the extra milk will or will not bring could influence your production to maximize value.

Have a most favored supplier provision that ensures that you will receive the highest price for milk paid by the plant during the life of the contract.

Again, all contracts should be reviewed, if not written, by attorneys experienced in agricultural sales, and you should always understand clearly how each of the formulas work, and do not work, and what the clauses in your contract mean. In this way, the use of forward contracting can move you forward into profitability. PD

Ben Yale
Attorney at Yale Law Office

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