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How to manage price risk during the cash flow crunch

Mike North Published on 20 July 2010

What is it about the fear of loss that is so strong? Why do we spend so much time worrying about what we could have had? “If only I had...” or “I should have...” or “What if...” have become classic lead-ins to what might have been. Life is full of such stories. Nearly everyone can tell you about “the one that got away.” I cannot tell you how many times I have heard dairymen reference the fact that they will not let great opportunities get away from them again. The scar of 2008 has led many to consider this idea of price risk management. Margin management has become a household term and made its way to the agenda of many “free lunch” meetings. Many are ready to address the prices that are staring us in the face now.

However, large cross sections of producers are held up by a crazy little creature called cash flow. Because many producers are still healing from the wounds inflicted by the 2009 equity blowout, they are ill-equipped to add new costs to their cash flow. Does this mean that producers should avoid risk management?

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Hardly! It simply means that they must manage prices of milk output and feed input within the constraints and comfort of their chosen financier.

First, let’s address the banker. For many, their banker can be their greatest advocate of risk management solutions. For others, the banker can be their greatest hurdle. If you intend to begin addressing price opportunities and employing price risk management strategies now while cash flow is tight, you must work with both types much more closely. Here are a few pointers as you work alongside this very key player in your management team.

First, with regard to your new intentions, it is important to clarify what you are doing and to have a written plan of action. There is no room for speculation, which is part of the reason some bankers are opposed to your participation. Leave speculation to the producers who don’t address price. Margin/price risk management is a process of creating predictability to the operating margin/cost/revenue of your business. A written plan will help outline your activities and provide insight into market opportunities and how you plan to handle them. Any banker who is lending money in the current climate will like the premise of predictability. In fact, lenders themselves have their own means of managing risk. They require financial histories, tax documents, analysis of current economic conditions and other reports to judge the risk that they are accepting in making a loan. If you can help them eliminate some of the credit risk that comes with your loan, you are much more likely to get their participation.

You must be transparent and fully intend to manage the scope of your business price risk – nothing more, nothing less. That can be aided by maintaining a separate line of credit with your banker and a security agreement between you, your broker and your banker. This allows the bank to see exactly what is being done and to receive money first to pay down the hedge line of credit and then to distribute in accordance with your needs. These simple actions allow lenders the peace of mind that there are no games being played with the dollars set aside for risk management. The bottom line in this activity is to communicate to your banker that you are seriously engaging the price risk that is inherent in your business with a plan of attack that protects their seat at the table.

Next, any conversation that I enter into with producers always, and ultimately, leads to the question “What will this cost?” You have heard the phrase, “There is no such thing as a free lunch.” You will not get something for nothing. It is as true for risk management as anything else. You will spend money; there is a cost to being involved. However, who experienced the greater cost – the producer who in 2008 sold milk and paid the marketing fee or bought put options and paid the premium? Or the producer who did nothing? Even though there is no check to write for doing nothing, there is often a massive opportunity cost associated with it. It is OK to spend money on marketing. It should be built into your budget as a normal expense to doing business. No business survives without allocating resources to marketing, so count on it. Have a plan for it.

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Finally, with cash flows tight, many have become quite creative in their local cash purchases of feed. The exchange of manure for corn stalks or silage has become a common swap among cash crop and dairy producers. Producers have set up payment plans for locally grown grain and silage to both balance their own cash flows and the income of their row crop neighbor. Producers have also used contracts with their milk buyer to lock in milk prices. Though these actions come with a fee (which in some cases can be substantial), they are often offset by future milk checks and require no immediate payment. These cash-flow-friendly approaches may seem like strategies that could be used year-in and year-out. However, not every situation calls for just one single approach.

I remember often being caught in peculiar situations on the farm where a tool was required and all I had nearby was a crescent wrench. Although I made it into a multi-tool, it could never pound as effectively as a hammer and it could never pry as effectively as a crow bar. Not all situations call for the same tool. You can work with local growers for feed pricing or your milk buyer for contracting. There will be a cost or mark-up associated with doing that. You can use call options (for which you will pay a predefined premium) to manage that same seasonal tendency. You can use futures contracts to lock prices in. However, if cash flow is tight, this is not a very good tool to use for your risk management needs, as there may be potential future cash flow draws associated with that position that cannot be completely quantified up front. There are times to use each of these tools independently and times when they can or should be used in partnership. Consult your broker as to what strategy will work best for your situation in today’s market.

The bottom line in all of this is that there is no lost cause. Just because milk prices are not at $20 per hundredweight (cwt) and corn prices are not at $2 per bushel, the current situation does not excuse you from planning, working out the administrative details and taking action. Quite contrarily, you should be running at full speed. The milk market has recovered $3 to $4 from last year’s lows. That is no small feat considering the supply of product stacked up in warehouses. Use this opportunity to work together with your financial partner to hammer out some low-cost solutions to your risk management needs. Don’t wait for things to get better – make them that way. 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
  • Mike North

  • Milk Marketing Specialist
  • First Capitol Ag

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