You have most likely heard the expression that bigger isn’t always better. In my conversations, I find that many dairymen tend to disagree with that statement. Economies of scale spread over sound management have allowed producers over the past five years to not only expand their herd size, but also their productivity (see Chart 1). And despite efforts to keep cow numbers at bay, growth has continued among varying geographies and herd sizes.

This growth is not about production or the efficiency of management. Productivity takes a back seat to profitability as dairymen look to maximize the return on their investment. If you examine Chart 2, you will notice a migration of the ever popular (though widely disputed) milk-to-feed ratio away from the all-milk price. As witnessed in the chart, though marginal profitability has decreased, the gross profitability has increased for most dairymen. So long as this continues, expansion will also. If you have come to a crossroads where you are considering an expansion to grow this return, there are some simple understandings and considerations that must be made.

You will be making an incredible commitment of capital for steel, concrete, comfort and technology. To adequately protect the equity in this investment, we must address the margin of opportunity made available in the marketplace. What do I mean by this? Since your greatest revenue comes from the sale of your milk … and the greatest expense comes from the feed you use to get it, you must adequately protect both in order to protect your margin. The process of securing such protection forces you to ask a series of questions:

1. Will I be raising my feed, or will I need to purchase the necessary ingredients for my ration?

2. Do I have the ability to contract feed ingredients, and if so from whom?

3. Can I contract milk with my dairy, and if so how much?

4. Will I be financing this expansion with leveraged capital or out of existing cash flow?

Once these questions have been answered, we can begin looking more closely at the marketplace that we will be participating in. First, let’s examine the milk market. It is important to understand the distribution and price over time and how volatility affects its fluctuations. Currently the average of Class III milk is roughly $12.50. You will notice in Chart 3 that Class III milk price spends roughly 34 percent of its time below $11.50, 70 percent of its time below $13, and 90 percent of its time below $16.75. With the all-time low milk price recorded at $8.57 in November 2000, these statistics suggest that milk spends 90 percent of its time within $4 of its average. The other 10 percent of the time milk ranges from $4 to $9 from its average. Informed participants in the dairy market should then understand that if the market makes a move, it is likely to end by the time price reaches $17. However, if it should breach $17, how far it will go is unknown, but its stay is usually brief. There are a lot of statistics to chew through here, but there is a simple take-away – milk price movement above $17 should be allowed to run. Mechanically speaking, strong consideration should be given to the use of put options when marketing your milk. If contracting is a more appealing alternative, be sure to consider the use of call options as a means of participating in any further upward price opportunities.

As you may have picked up in coffee shop rumblings, several people believe that milk prices may now have reached a new plateau. Caution would be advised with this thinking. We have heard this several times in the past. However, commodity price history has proven that prices can soon after move lower and that overall price fluctuation tends to be more cyclical. However, let’s for a moment say that this standard of thinking is correct. Where would this new plateau be? We know that the current “home base” for milk price spans roughly $8 of the marketplace (from $8.57 to $16.75). If we were to expand that range by 50 percent and our average was the midpoint of that range, that would make the new average $14.50 with the high boundary now settling near $20.75. Currently, Class III milk prices for the period covering July 2008 through December 2009 (18 months) are averaging $20.27. Even when making an assumption that we have reached a plateau that is substantially higher than the historical norm, prices suggest that we would be near that new hypothetical top. What are you doing about it?

Just as important as protecting milk price is the importance of protecting your operation from escalating feed prices. Having a stable supply of feed at a known price is incredibly important if we are to manage the margins required to service the capital required for an expansion. This half of the equation is handled quite differently throughout the country. Some producers opt to grow their own feed. However, even these producers must assign a fair market value to that activity, as the return on the land must be factored in relative to the cost of feed. Others have negotiated relationships with neighboring cash grain operators. Still others purchase ingredients from a feed mill or co-op. Whatever the case may be, you have most likely experienced a rise in the cost of your feed ingredients in the past two years or are watching the horizon on your existing contracts with an expected price hike in sight.

Here again, it is important to understand price norms. Since the bulk of feed ingredients are equated back to corn and soybean meal equivalents, we can use these markets as a benchmark for our hedging and pricing activity. Soybean meal has spent the bulk of its existence trading in a range from $150 per ton to $200 per ton with sporadic movements to $300 per ton and the all-time high being set at $451 per ton in 1973. Currently soybean meal futures are trading near $400 per ton. With regard to corn, you cannot turn on a financial program or read a paper it seems without hearing something about its price. Never in our history has corn price been so high. However, the fact that these prices are so high has helped milk price to also move higher. As you have been following the progress of planting, emergence and plant development, you will notice that both corn and soybeans have had their fair share of troubles along their path towards maturity and harvest. With a growing demand for product, having supply takes precedence over the price of the supply. That is not to say that price is irrelevant. However, as we look at the current balance sheets, we do not want to be the last one in line to fill our needs. Establishing some form of contractual agreement for product is an advisable measure, even at these levels. But don’t let that be your last action. As with milk, use put options to keep yourself in the game should something major (embargo, government action against existing subsidy packages, etc.) bring about quick correction to these elevated price levels.

So what’s the bottom line? Margin management is key for anyone in the dairy industry, especially those who are planning or completing an expansion. Do not get caught addressing just milk or just feed … address both. If you do, bigger can make you better. If you do not, bigger can leave you battered. PD