It is a classic Hollywood scene. A soldier is caught in crossfire, trying to determine the best way out of his predicament. The soldier knows that sitting idle will be the death of him if he does not identify a way out. It appears that all angles present some degree of risk, but one must be chosen. What is next? What’s his plan? Time is of the essence. Creating a plan in such an environment would be stressful, to say the least, but still necessary.

North mike
President / Commodity Risk Management Group
For nearly 20 years, Mike North has educated and guided dairymen and farmers in their efforts to ...

The soldier is not often given the luxury of acting on complete and perfect information or on a timeline of his choosing. He must rely on his experience, training and gut to make sound decisions as the moment arises.

General George S. Patton was quoted saying, “A good plan, violently executed now, is better than a perfect plan executed next week.” A quick look around and dairymen find themselves in a similar pickle as they analyze the potential of 2012 and attempt to work out a plan of attack for the coming year.

If we are to navigate our way toward safety and/or prosperity, we must first understand and estimate our risk. No doubt, you have read about or watched the unending coverage of the debt that plagues Greece, the Eurozone and consequently the rest of the world … even the U.S.

No one knows the absolute outcomes of all of this but, short of predicting, we should all expect growing uncertainty, which almost always has an immediate impact on demand. It was a retraction in demand, coupled with an estimation of tight grain stocks, that brought the dairy market to its knees in 2009.

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While the U.S. enjoyed strong summer pricing, demand for product on the world stage presented a different picture. As domestic cheese prices hover at levels near $1.70, world markets have slipped to prices below $1.60. After adding freight, it becomes difficult to project a strong export scenario without some decline in price.

The story is true of butter as well. While our prices climbed north of $2, world prices were slipping. Compound these facts with growing production in Europe (14 percent), Oceania (12 percent) and here at home, and there will be a growing amount of milk to meet a softening demand for product.

And in some cases, we do not need any more products. American cheese inventories have grown to levels that have not been seen since the late ’80s. Additionally, market watchers have still not grown comfortable with available grain stocks, maintaining a premium in those prices.

Speaking cyclically, 2012 will be the third year after 2009 and the next projected low in the historical three-year milk cycle. Given that markets have followed this trend for several decades, it bids honoring the possibility of a move lower.

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Typically prices work towards $20 per hundredweight (cwt) pricing and then fall back towards $10-$12-per-cwt pricing. There are no absolutes, but a certain level of respect should be given to a trend with that long of a history. ( See Figure 1 .)

There are a wide array of pitfalls that we face in 2012. Milk prices hover around $16.70 for the year’s average (hardly near historic highs), while corn prices continue to maintain levels between $6 and $6.50.

These are hardly what dairymen have been hoping for.

However, taking a stance to manage margins for the coming year may not be about getting what we want but, rather, about avoiding what we don’t. Like the soldier, there is some degree of risk with each angle we consider.

However, so as to not get caught in another 2009-like environment, let’s review what choices exist and discuss some of the associated risks so as to identify what route works into your situation best.

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Feed
Purchase feed from local vendors and book the commodity for delivery throughout the year. Given the recent break in corn prices and the strong seasonal tendency for soybean meal ( see Figure 2 ) and the greater protein market to bottom out in October, this consideration has real merit.

Several of the previous years have allowed dairymen to do effective fall booking of soybean meal or protein equivalents relative to the prices that were afforded later.

The risk (of course) is that prices, inspired by some outside influence, fall precipitously to lower levels.

We suggest the purchase of put options in tandem with your purchase to counter this potential risk.

Obviously, if your bias is that feed prices are going lower, booking them seems rather nonsensical to you. However, you cannot rule out the unpredictable nature of the market and the volatility that amplifies its movements.

If you find yourself thinking the market is preparing for a plunge, purchasing call options on feed to protect from rising costs in the coming year is a rather inexpensive way to ensure that things do not become grossly out of hand.

An example of such a strategy is to purchase call options in July to cover your needs into summer. Presently, July corn futures are at $6.70 per bushel. You can purchase a $7 call and sell an $8.50 call for an out-of-pocket cost of $0.35 per bushel.

Other strategies are available to make coverage less costly but should be discussed with your risk management adviser.

Milk
Selling milk to either your buyer (provided they allow such activity) or via the futures market allows you to lock in an average price of $16.70 throughout the year at the time of this writing. The natural concern of anyone choosing this road is that prices do as they did this January and move rapidly toward $20 per cwt.

This, of course, is of little concern if milk prices continue the pattern of the three-year cycle. The risk that prices move higher after your sale can be managed by purchasing call options above current levels.

An example of such a strategy is to purchase a $17.50 call and sell a $20 call for a net cost of $0.55 per cwt. This allows producers the ability to lock in today’s price while gaining $2 of the $3 available in a move to $20 per cwt.

If you are concerned that volatility could provide either a substantial move higher or an equal move lower, you are likely better served by a put option strategy. The issue many have with current put option offerings is that the level of coverage, in combination with the premium, is both unattractive and not cost-effective.

That statement, of course, is relative to today’s environment. If systemic selling enters the market, even something like a $14-per-cwt put option may look attractive. However, much better opportunities exist at the time of this writing.

One example would be to use what many refer to as a “fence” strategy. For example, a producer may establish a minimum price of $16 by buying a $16 put while at the same time establishing a maximum price of $18 by selling a $18 call. The initial cost for this strategy is $0.35 per cwt at the time of this writing.

This type of strategy allows the producer to minimize further erosion in his milk price at the expense of potentially sacrificing upside potential beyond $18.

In effect, the risk and potential reward are “fenced-in” going forward. This strategy involves margin and other risks that should be discussed with your risk manager before initiating, but has proven to be a good strategy when prices have reached and/or are coming off cyclical highs.

If this strategy is outside your cash flow or comfort limitations, pursue something simpler. For example, a $15 put can be purchased for the calendar year at a cost of $0.55 per cwt. Obviously this provides less coverage, but caters well to tight cash flows.

The greatest risk in this environment is to do nothing. Like the soldier, remaining in the crossfire only increases your risk of experiencing harm. This article isn’t meant to answer all of your questions, but rather kick-start the conversation if you haven’t already done so.

Adequately assessing your ability to source and price feed together with your willingness and capacity to address milk price will be critical in your movement to safe territory. It should be everyone’s goal not to totally eliminate risk but minimize it wherever possible, so as to create elements of predictability while allowing for better opportunity at a later date.

If you have been postponing this discussion, hopeful of better opportunity, get started. Sit down with your risk manager or marketing adviser and have some serious conversations. But do not sit idle; bullets are flying. PD

References omitted due to space but are available upon request to editor@progressivedairy.com .

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 .

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Mike North
First Capitol Ag