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Buy low, sell high

Mike North Published on 21 September 2009

There is an old saying in the trading world that many people have heard before. “Buy low, sell high!” The premise, of course, is that you take home the middle, the margin, the change or however you care to refer to it.

Running a business operates much on the same concept, whereby we work to add value to a cheaply bought input and sell the finished product at a much higher value. Dairying is one of those businesses.



We hope to sell milk at a much higher price than what it cost to produce it. Obviously, the current environment hasn’t presented too many producers with such an opportunity to do so as we look forward.

But how do we best manage the current environment as it changes? Everyone hopes for a change to the current situation, but no one really knows for sure what those changes will look like.

Will feed prices rise dramatically sooner or faster than the price of milk? Will it perhaps work the other way around? Will there be immediate change or subtle? Lots of questions; few answers.

However, that does not mean that the idea of managing the margin in dairying has lost its value. In fact, it has taken on a much greater purpose. In the last several articles that we have shared, our discussion has dissected the history and functionality of futures contracts, buyer/vendor contracts, options, etc.

Let’s spend some time understanding how the use of these tools can work together to accomplish the goal of managing the chunk of margin that separates feed purchases from milk sales. To understand how to best manage this margin, we must first acquaint ourselves with its history.


Please see Chart 1*. This chart illustrates a 10-year rolling weekly margin of Class III milk price over feed cost (replacements and dry cows excluded), factoring in an average daily production per cow of 65 pounds per day. Obviously, everyone’s numbers will vary, but for the sake of finding a national benchmark, we will use Chart 1.

Notice the peaks and valleys to the margin. The best margin opportunities perfectly correlate to the three-year milk price cycle. While it is impossible to continually run your business at the peak of this chart (no one has that good of timing), it is possible to position ourselves closer to the peaks than the valleys.

And what becomes abundantly clear when comparing this to a milk chart is how much more the price of milk contributes to the margin than does the price of feed. However, since this is a margin discussion, it is imperative that we do not overlook the contribution that feed price has.

What do we do about this? To answer that question, let’s refresh our discussions of contracts versus options. In a previous issue, we determined that the best time to use such a contract (whether a futures contract, feed purchase contract or milk contract with your buyer) is when the market is at an extreme.

In other words, when feed prices are extremely low and/or when milk prices are incredibly high, we serve ourselves well to use a contract to “lock-in” or establish a firm price. With regard to options, we described how the option serves as insurance against adverse price movement (rising feed prices or falling milk prices).

Put options are best purchased to protect milk prices that are average to above-average, while call options are bought to cover average to below-average feed costs. Additionally, options serve as a wonderful tool to protect any production or feed that we are not comfortable locking in.


For example, a producer may not be comfortable locking in hard prices on 100 percent of his milk production. Perhaps that comfort level ends at 75 percent. The last 25 percent would be a great candidate for option coverage.

Enough refreshers, let’s dig deeper. In 2006 and 2007, margins rose dramatically. Prior to that period, feed costs were historically low. This allowed producers the opportunity to lock in feed prices with the contracting tool of their choice.

At that same time, producers were encouraged to use put options to protect potentially falling milk prices. Though the put options expired without any notional value, their value came in allowing producers to participate in the rising market.

As margins peaked and began to fade, milk prices stabilized in the upper tiers of historical price levels while feed prices climbed. The dramatic rise in feed price relative to the historically high milk price began to erode profitability and took the margin of milk-over-feed from $16 per hundredweight to $10 per hundredweight.

During that time, contracting milk was warranted and opened the door to many of the opportunities that we have dissected in previous articles. At the same time, producers who were purchasing feed were buying call options to protect themselves from potentially rising feed costs.

No one hits a home run in this process every time, if at all … except by luck. Please notice that the premium spent for puts on milk and calls on feed was lost in both cases. Some dairymen are quick to point out that their milk buyer or feed vendor may not allow them to write a contract directly with them.

This inability to contract would force them to use futures contracts. However, their bigger issue may be their ability to manage the cash flow requirements that come with taking such actions. In such a situation, the exclusive use of options is warranted.

For producers using such a strategy, their milk checks shrunk as prices fell and their feed bills grew as prices rose. However, the option positions employed in place of any contracts have produced results that handsomely compensate for the market’s relentless movements.

Options become an attractive choice for producers with a limited cash flow because there are no margin requirements attached to the purchase of options and no market losses to cover. The only cost associated with the purchase of options is the premium paid and the transaction fee. Consult a risk management adviser to walk you through this process.

As I discuss this strategy with different groups, I am commonly asked “When? When should I be looking at taking such actions?” Let’s analyze statistics to find the answer.

When reviewing the 30-year history of milk prices (a compilation of Minnesota/Wisconsin pricing, BFP pricing and now Class III pricing), it becomes amazingly clear (see Chart 2*) when producers should be addressing price opportunity. Notice how the curve rises dramatically from $10 per hundredweight to $13 per hundredweight.

For nearly 30 years, roughly 70 percent of producers’ milk checks have been constructed on a base price (excluding premiums) of $13 per hundredweight or less. Notice how the curve flattens after $13 per hundredweight as it approaches $16 per hundredweight. This $3 per hundredweight space represents 22.5 percent of historical payments.

However, in those same 30 years, producers have only received milk checks with a base pay greater than $16 per hundredweight just 7.43 percent of the time. Some will argue that these numbers should be weighted for inflation. That argument does little to explain the $10 pricing that we experience today.

Quick analysis of this curve illustrates why producers should get very serious about milk pricing opportunities when prices breach $16 per hundredweight and be quick to apply put options to any prices below that.

Before we go any further though, let’s remember our discussions about the volatility profile of milk. If you begin making sales at $16, it is wise to purchase call options in conjunction with those sales since a chance remains that the market can go higher. With regard to feed, a general rule of thumb is $2.50 corn and $200 soybean meal.

If futures prices are at or below these levels, contracting them becomes a statistically favorable play for users. The decision to contract feed in these ranges can also be managed by the use of put options to allow for greater capture of downside opportunity.

On the flip side, price levels above these points warrant the use of a call option strategy to manage potential rises in price. Of course, what is best for your neighbor may not be the best for you. Strategies will vary from one producer to the next according to contract availability, comfort level of all involved parties, cash flow, risk tolerance and emotional capacity to handle market movements (we’ll talk more about that next time).

Regardless, take some of these guiding principles and manage the margin that marks your success. PD

*References and charts omitted but are available upon request to

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