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Lessons learned from the good times … and the bad

Mike North Published on 24 February 2014

2014 will be one for the record books. Never in history has a year started with Class III milk above $20 per hundredweight (cwt) and Class IV milk just shy of $22 per cwt. It is a start that many have been praying for. It is a start that many have needed. But we have seen similar starts like this before.

The year was 2008. World markets were frothy. Economic conditions suggested things were only getting better. Dairy products were in high demand. Milk prices were on the rise. Times were good. Enter 2009. All of those things that seemed like a reality in 2008 became at best a fleeting hope just months later.

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Milk prices plummeted. Feed prices ran high enough for long enough that the higher cost structure was baked into the cake for the coming year. We need go no further in discussing the outcome for dairymen. Fast forward. What can we learn from those days? How do we make sure we don’t repeat the many mistakes that were made?

Hedge both sides of your operation. Dairymen often live in one of two camps. Each camp is driven by either fear or greed and can often be separated by regional location or business model. The first group is really aggressive in buying and contracting feed while being reluctant to address milk price. The second is quick to address milk price and often more relaxed in handling feed cost.

The challenge with camping in either group is that today’s volatility will catch up with you. Your feed cost may be covered, but how well does that serve you after milk prices fall substantially? Likewise, you may have milk price contracted, but is that where you wish to be if feed prices spike?

This is the danger of the current environment. Feed prices have softened and present a favorable outlook for the dairyman. Milk prices have soared to record-high levels.

Your profitability lives in the middle. If you are caught living in either of those camps, it is time to tear down the tent and capture this margin opportunity by managing both feed cost and milk price.

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Prices don’t last. In the summer of 2008, Class III futures through the balance of the year and throughout 2009 offered prices of $20 per cwt. This made many complacent about taking any action at all.

Demand seemed so robust there would be no way the good times could come to an end. Sadly, not only did those prices not come to fruition, but change came to the market abruptly. Prices do change.

It was once mentioned to me that those changes often come at a time and in such a way as to hurt the most people the fastest. Presently, there is a great deal of discussion about why prices not only need to stay here but improve.

China has been a fantastic buyer of milk powder specifically but also of dairy products in general. Export of U.S. products has risen dramatically to help fill the void created by the 2013 New Zealand drought. This has allowed the market to transcend its normal seasonal pattern, which would have peaked around October and produce record-high prices in January.

These same situations dominated the 2008 run. We are here, but how long will buyers, both foreign and domestic, be willing to stick around at record levels? Things changed in 2008 and will likely do the same in 2014. Be prepared.

Markets cycle – The nature of free markets is such that price movements extend in both directions farther than many believe possible and then retreat before most believe they should. The milk price explosion of December is a prime example.

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You would be hard-pressed to find anyone who in advance expected such results. However, this is not the first time such surprises have been put in front of us. As mentioned in the previous paragraph, great opportunities were offered for a period of 18 months for those who were willing to accept them.

While no one knows what the future holds, getting married to one price point in the market will be a disappointing proposition at the least and business-ending at most. It came as no surprise to the objective spectator that the frothy 2008 milk pricing came to an end.

You may have heard the expression that the cure for high prices is high prices. Likewise, the cure for low prices is low prices. So like 2008, the prices of 2009 did not last forever (though the pain experienced in it lives on).

The message here is that prices move from highs to lows and back again. Historically, milk markets have a tendency to travel in a $10- to $12-per-cwt range. Most recently, that has tightened to a $6-to-$7 range.

Ultimately, don’t be taken by surprise by such a move lower. Upon arrival at such a level, don’t get so down that you believe we are stuck there. Where we fall in that range can help dictate how aggressive or passive you must be in managing milk and feed prices.

Be flexible – One of the biggest complaints I field from producers is that the actions they took cost them money. That, by the way, is the commentary held for periods in the market when prices moved in a direction they did not expect.

Rarely does anyone start a conversation with the money they made by managing a risk that fully materialized. We, by nature, have a fear of loss. It is what leads us to correctly address the risks that exist in the marketplace.

However, when marketing/risk management efforts are taken that do not produce the result that led us to those actions, we tend to focus on the monies spent to initiate or maintain the action. Often, this disappointment comes when we become overconfident in the position we take.

We have found that one of the best ways to both manage risk and our fear of loss is through the purchase of options. If the risk materializes, you are covered from the level you chose. If the market throws you a curve ball, your loss in the option is confined to the premium you paid and the transaction costs attached to it.

Ultimately, you have the flexibility to entertain movement in both directions. 2014 is a year that is offering a perfect environment for their use. The year started with very high prices, but deferred pricing is much lower.

You can effectively protect yourself from the risk of a market correction while at the same time keeping the door open for movement toward January levels.

With the start to the year we have had, it is hard to be anything but excited about the current situation. However, times change. Use the lessons learned from the past to successfully navigate the future. Have a great 2014. 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
Sr. Risk Management Advisor
First Capitol Ag

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