Account for milk check deductions in your risk management strategy

Chip Whalen for Progressive Dairyman Published on 18 December 2017

Recently, many dairy producers have seen their revenues decline as a result of milk check deductions. Dairy risk managers who want to protect their profitability must account for these deductions as they calculate their forward margins and consider adjusting existing margin management strategies.

Processing plants balance changes in milk supply against processing capacity and seasonal demand for end products. Spring flush brings more milk to plants, but plants compensate with longer operating hours or agreements with milk handlers to make sure all milk is processed. But demand for dairy products is seasonal and does not always coincide with spring flush.

As school season begins in the fall, fluid milk processors increase production, which pulls milk away from butter/powder plants. But even on a daily basis, regardless of season or supply of milk, plants will buy/sell spot loads to either fill an existing order or reduce excess supply. This is part of the business.

But what happens when all processors in a region are at capacity and unable to handle the milk supply? Plants with excess supply are forced to either dump milk or haul it long distances to find a home. Either way, they face additional costs, which are then passed on to cooperative members through milk check deductions, often labeled as “balancing plant costs.”

While national year-over-year milk production has been increasing steadily, the growth has been uneven; significant growth in the Southwest, Upper Midwest and Mideast marketing orders has been offset by lower milk production in California and the Pacific Northwest.

For example, in Michigan, a 3 percent annual growth rate in milk production has not been matched by a commensurate expansion in processing capacity, leading excess supply to be sold out of state and at discounted prices. This has put pressure on milk handlers in surrounding states.

Members of cooperatives in this area pay for this through deductions in their milk checks. In 2017 farmers in areas affected by surplus milk have reported deductions up to $1.90 per cwt from their milk checks.

Deductions add uncertainty

Just as milk supply and demand has varied by region, deduction amounts, durations and even communication with producers has varied from plant to plant. Some deductions were a one-time event, while others are ongoing. Some producers received advance notification about deductions and were given an idea of how long they will continue.

Some producers learned the bad news when they received their final monthly milk statements and have no idea what to expect going forward. What also may be frustrating for dairy producers is that these deductions are taken after the uniform blend price has been calculated, making them a variable risk to profit margins that can’t be effectively managed or controlled.

While dairy margins were generally positive for much of 2017, they were not overly strong. When you then account for the possible deductions, some dairies could have seen their profitability wiped out, and in some cases, depending on how the dairy had hedged, they could even have recorded negative margins for a given month.

Consider risk management strategy adjustments

For dairy producers facing these deductions, important risk management considerations must be addressed. First, to the extent that the plant has provided forward transparency on the size and duration, it is imperative to factor these deductions into forward margin calculations.

As an example, an Upper Midwest producer currently projecting an average margin of around 90 cents per cwt and facing a $1-per-cwt deduction, they are below breakeven by 10 cents.

These adjusted margin calculations impact the current risk management strategies in place to protect forward margins.

Assume a producer is short Class III milk futures, and this hedge is part of a 90-cent-per-cwt margin calculation. As a result of the mandatory deduction in the milk check, the producer is now looking at a loss of 10 cents per cwt.

Given that projection, the producer may want to adjust the hedge by closing out the short futures contract and replacing it with a long put option, so he/she can participate in higher prices and a positive margin should the milk market recover.

Another consideration would be whether or not any call options had been previously sold and at what strike price. This position may have been taken to help reduce the cost of a hedging strategy to establish a floor price under their milk by purchasing put options. It would be important to know the net price of the strategy, including the cost of the puts.

If this maximum price is now effectively below breakeven for that month or quarter after the deduction is calculated, a producer using this strategy may want to buy those call options back and close out that part of the position – particularly if the call options have decayed and are worth less than what they were initially sold for.

In addition to existing price hedges, this same approach would also apply to new positions in deferred periods. As an example, a producer contemplating a risk management plan might not know whether current deductions may continue well into 2018. As a result, added flexibility would be desirable to protect their milk price and allow for the possibility that higher prices could lead to improved margins.

Here, too, option strategies might be favored until the producer has greater visibility over the continuation of potential balancing plant deductions on future milk checks. While these deductions are not something producers can control or hedge against, it is possible to tailor existing or new price hedges to account for the impact these deductions will have on forward profit margins.  end mark

Disclaimer: There is a risk of loss in futures trading. The information contained in this article is taken from sources believed to be reliable, but is not guaranteed by Commodity & Ingredient Hedging, LLC, CIH Trading, LLC nor any other affiliates, subsidiary or employee, collectively referred to as CIH, as to accuracy or completeness, and is intended for purposes of information and education only.

Nothing therein should be considered as a trading recommendation by CIH. The rules and regulations of the individual exchanges should be consulted as the authoritative source on all contract specifications and regulations. Past performance is not indicative of future results.

Chip Whalen

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