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1608 PD: Seat belts on roller coasters

Mike North Published on 06 November 2008

If there is one thing that catches my daughters’ attention when we head to the fair, it is the rides. The constant commotion of screaming riders, flashing lights and the thrill of watching machines thrash back and forth, round and round, and up and down has them begging to go for a ride. One of their favorite rides is the mini roller coaster. They spend their time looking for Mom and Dad as they smile and wave from the vantage point of their steel cocoon.

You can imagine my amazement as these same girls become deathly afraid of riding their bikes (fully equipped with brakes and training wheels) down the slightest of road grades. However, after joining them for a roller coaster ride this summer, I realized why they have such confidence – the lap bar and safety belt they wear. They are tied into those machines so tight that any amount of g-force seems manageable. Their confidence made them almost invincible – until they experienced the Tilt-a-Whirl!

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Little did I know that my county fair experience would parallel this year’s milk market. The flashiness of $21 Class III milk had many drawn like a moth to flame. The degree of producer confidence in milk price created a level of invincibility unparalleled in history. However, the waving and smiling that took place on the way up quickly evolved into a ‘commotion of screaming riders’ as prices quickly departed from summer highs. Were you wearing your seat belt? Let me rephrase that – did you have a marketing plan? Were you taking appropriate actions as the market thrashed back and forth and up and down? Unfortunately, many did not.

Though the opportunities of summertime highs are behind us, how do we move forward? For many it will begin with acknowledging that they need to place a higher priority on their marketing activity. This is perhaps the greatest struggle for the busy producer. For others, it will be a process of tweaking their approach to marketing. Still others will have to begin creating a plan to address these volatile times.

Let’s first address the priority issue. An average 400-cow dairy, running a barn average of roughly 80 pounds per cow per day (lbs/cow/day), experiences a $10,000 monthly revenue increase for each additional dollar of price captured. If you are finding it difficult to prioritize your marketing efforts, hire someone who can devote their total attention to it. If they are capable of achieving only half of that dollar, they were well worth the expense. Many solve this problem by working with a dairy broker or market adviser. Their experience will likely save you the time of having to sort through all of the information necessary for making a quality decision. For a fraction of the expense of adding an employee, they can help you manage your marketing priority and be a conduit for vital information in your marketing activity. As with any priority, action must follow; a priority not acted upon is no priority at all.

Let’s address those who are tweaking their marketing efforts or perhaps formulating their marketing plans for the first time. There are no two years alike in marketing. Each year takes on its own set of conditions, events, biases, etc. It is important to annually revisit the successes and shortcomings of your marketing activity. In each instance, write these victories or follies down and file them. You will come to that fork in the road again. Writing them down will also help you overcome the pitfalls and mistakes that are common to the haphazard market participant.

One of the greatest pitfalls for those marketing commodities is emotion. The drama of the marketplace plays emotional chords like the greatest harpist. Another common mistake is something I like to call “analysis paralysis”, also referred to as information constipation. It is possible to research too much. Spending countless hours researching market information can often lead people to doing nothing as they try to sort through conflicting opinions and dubious assumptions.

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The other great stumbling block for many is knowing where to start. Many simply don’t know enough about the marketplace, its tools, or the opportunities that exist. This hurdle can only be overcome by becoming a student, asking questions and taking the time to think through the different scenarios that are presented.

To overcome these pitfalls, one must act – and in such a manner that you do not get pulled back into these common mistakes. You need a strategy. A strategy offers a controlled means of executing milk sales without giving in to random and emotional acts. There are several to choose from; this article will not serve as an exhaustive list by any means. You may already successfully employ methods of marketing milk that can work independently or in tandem with the strategies presented here. Regardless, here are five strategies that you can use to secure your marketing efforts:

Selling prompted by fundamental indicators
This approach to pricing milk focuses upon the fundamentals of the milk market (those factors that affect the balance of supply and demand). Demand for U.S. milk and product can be gauged by monitoring Consumer Price Indexes (CPI), exports and general economic conditions, among others. However, the available milk demand information is difficult to use for pricing purposes.

As a result, the market has a more intent focus on supply factors such as milk production, cow numbers, production per cow and monthly cheese production. The change in important supply fundamentals must be observed closely. When a decreasing trend in these areas shifts to an increasing trend, the dairyman is prompted to make milk sales. One pitfall to this strategy is that dairymen are sometimes slow to trigger sales as a result of the time delay that exists between the day-to-day activity of the marketplace and the monthly release of fundamental dairy industry information.

Seasonal selling strategy
The strong seasonality of the milk market often allows for pricing opportunities of expected milk production. Typically, the milk market will move higher between June and October of a calendar year. If the market is showing signs of seasonal behavior as we work our way into fall, a dairyman would be prompted by this strategy to price the milk to be produced between September of the current year and June of the following year. This opportunity can be captured with milk futures contracts or forward fixed cash price contracts with his processor.

Note: February through June is normally the lower part of the seasonal price pattern (see Figure 1). In a year such as this when the markets move opposite of the norm, we refer to it as counter-seasonal. This strategy should not be used in such a time.

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Cost of production plus margin of return strategy
This strategy focuses primarily upon a dairy operation’s cost of production. To employ this strategy, an accurate accounting of real costs is a necessity. Upon full definition of the production cost and an agreed-upon margin of return, a milk selling price objective can be set. These price objectives now serve as a trigger point to make milk sales with cash contracts or futures contracts as prices would allow.

This approach is very numerically driven and thus quite mechanical. Each sale executed with this approach works to secure a profitable outcome on the quantity of expected production that has been priced. Here again, price risk has been managed. The obvious pitfall of this strategy is that the market may not reach the desired level of profitability in the marketplace, thus leaving the dairyman exposed to continued price risk.

Technical chart signal strategy
This strategy focuses on the Chicago Mercantile Exchange (CME) Class III Milk Daily Price Chart. Applying simple technical price trend analysis to the milk price chart will provide selling points for the dairy’s milk. For example, let’s apply a 40-day moving average (MA) to a major price up-trend in the milk market. If daily milk price closes below the 40-day MA, dairymen would sell 6 to 12 months of milk production with a Cash Forward Contract or Class III Futures Contract (see Figure 2). This approach requires price charting and technical price analysis experience.

Historical price range strategy
This strategy focuses on the historical price range of the USDA Class III Milk price announcements over a period of time. Having available historical price information is critical to this approach. Figure 3 represents the historical price distribution since 1980. To effectively use this strategy, a dairyman must determine their price objective triggers in one of the upper tiers of the market price range. Orders are then placed at these objective triggers. Once the market achieves the predetermined trigger levels, the milk is priced in whichever environment the orders were placed (futures or buyer contracts). Being a willing seller at target prices is required.

Pricing milk requires a methodical approach or system. After choosing which strategy or strategies to implement, dairymen must familiarize themselves with the obligations that come with each pricing action taken in their marketing plan. If contracts are written with their creamery/co-op/cheese plant/etc., they will need to understand the terms of the agreement. They will need to identify what limitations the buyer will put on their marketing efforts as well (i.e. what percentage of their production will be allowed for contracting). They will want to understand the pricing mechanism (i.e. whether milk is contracted on Class III prices, cheese values, etc.) that is used and the fee structure (i.e. cost per hundredweight of milk) that is attached to their actions.

If producers are using milk futures contracts, they should develop an understanding of futures market margin requirements and how their brokerage house handles these requirements. They should become familiar with the settlement process and how their funds are handled. These considerations, among others, must be made before any strategy is executed.

Once a marketing plan is established, it must be worked into your operating budget and fit within your cash flow limitations. There is nothing more defeating than solid marketing intentions met with an inability to finance them. With regard to these intentions, though this should seem obvious, dairymen should not contract a hard price with their buyer or sell futures below breakeven cost. In such an instance, it is recommended to either purchase Class III milk puts or enter into a minimum price contract.

If you are using futures markets, be sure to secure a credit line that is large enough to handle the volatility of today’s market. Bankers, very typically, are willing to arrange lines of credit for these activities if they are properly educated as to how these funds will be used to strengthen the farm’s balance sheet by securing profitable returns. And naturally, be prepared for the costs of marketing (interest, option premium, etc.) as you pursue your marketing strategy.

A budgetary guideline to your marketing activity can be to appropriate 5 percent of the projected face value of your milk. In other words, if milk is at $20 per hundredweight, be prepared to spend $1 per hundredweight to market that milk. Marketing is a part of any successful business. Pricing milk in a volatile marketplace can serve producers well when coupled with a solid strategy. Pricing decisions are to be looked at as final price commitments and not treated lightly. They are a seat belt, designed to keep you held firmly in place so that you too can enjoy the ride of the milk price roller coaster. PD

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
Milk Marketing Specialist
First Capitol AG

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