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Managing volatility is not like predicting the weather

Editor Karen Lee Published on 19 January 2010

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Weathering a strong Minnesota blizzard to attend the Midwest Dairy Expo in December wasn’t any worse than the economic storm dairy producers weathered this past year.

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While the wind and snow blew hard outside and key employees remained home to keep the milk flowing, those at the Minnesota Milk Producers Association event learned how to secure a bright future for the year ahead.

They mingled in the trade show, bid high on butter and cheese at the scholarship auction and laughed at the comedic stylings of Minnesota’s own Tina and Lena. Yet most of the time was spent attending numerous educational sessions learning how to better care for cows, forages and the people on their farms. Two specific sessions addressed dairy’s economic cycles and how to manage them through marketing.

Understanding dairy cycles
Everyone is now painfully aware that economies flow in cyclical patterns. We’ve not only witnessed a low point in the dairy industry, but also on a national and global scale.

“It’s no good to think about yourselves as dairy people only,” said Dr. Michael Swanson with Wells Fargo Ag Industries. “Everything is connected; we just can’t see how. We’re as dependent on things made in Beijing and Dubai as we are in St. Paul and Washington D.C.”

Technically the recession ended in the second quarter of 2009, but that doesn’t mean everybody is happy, he said. Recovery for most depends on how much expansion occurs and how fast it happens. It will take some time for everyone to dig out from underneath where they’ve been because there’s simply too much debt out there.

“We went 25 years with very limited recessions. People got used to having a strong economy,” Swanson said, suggesting there will be more volatility going forward. The volatility in the economy will reflect the volatility occurring in commodity prices. Energy and biofuels will be a big piece of that.

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Agriculture has been connected to energy. At the end of 2007 and into 2008, crude oil and corn became connected in the market. “Corn is the biggest driver of the ag sector, both as feed and cash crop. When you connect energy and corn, you connect it to everything else in the ag market,” he said.

With bigger volatility it will be tougher to control margins, as there is no guarantee that the peaks and valleys in corn and milk will match up.

Swanson said exports are going to recover. They will be huge growth markets but very, very radical in terms of volatility.
Surviving the volatility will become more about margin management than predicting the future. Producers should find opportunities – when they exist – to buy and sell inputs and outputs, or get rid of leverage to survive.

“To become better margin managers, you have to start small, then expand on what works for you and leave behind what doesn’t,” Swanson said.

Managing risk
In his session, Phil Plourd of Blimling and Associates, Inc. also discussed volatility, mentioning it is still relatively new to the dairy industry.

“The dairy industry is about 100 years behind in terms of managing risk, unlike corn and coffee,” Plourd said.
He mentioned he’s had more opportunities to speak about milk marketing in the last three months than he’s ever had. However, last summer was when it really mattered.

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“To have a meeting five months after a collapse is not when to talk about risk management,” he said. “The time is when prices are high.”

There are two ways to manage volatility. The first is on a macro or market-wide level through regulated pricing, trade barriers or production quotas. There are only a few examples worldwide where these practices work – dairy in Canada and the European Union and sugar in the U.S. He said the reason it works in Canada is because the system is really, really rigid.

The other way is on a micro or individual level, impacting price movement on a firm-by-firm or farm-by-farm basis. This is done through forward contracts and buying futures. This way works in just about all ag commodities in the U.S. and energy products worldwide.

It’s a little more difficult in dairy, he said, because the dairy market is more volatile than other ag markets. Markets like corn and soybeans have relatively historic risk management.

From a political standpoint, Plourd said producers should hope for a reduction in the complexity of milk pricing.
In dairy, the futures markets tag along and reflect what is going on in world pricing. The corn model is more straightforward. It’s just the futures market. The price of corn today is tied to the futures market, plus or minus base.

“If we think about going forward, we should be rooting for some simplicity in the process. It would make the job of managing risk easier and reduce volatility,” Plourd said.

Meanwhile in today’s market, hedging should be looked at as a tool. It’s not magic, not a guarantee, not a solution for high prices and not for everyone all the time, he said. Contrary to popular belief, it is not gambling. Gambling is about taking risk, while contracting is about eliminating risk.

“If you don’t have pricing done for May 2010 milk, you’re basically gambling on the price you’ll receive,” he said. “Sure people use these markets to speculate, but when we approach this process it’s about eliminating risk.”

The mechanics of contracting are fairly straightforward. The math around this is not complicated, said Plourd. It’s the emotional and psychological aspect where things get mucked up.

The danger comes when people get caught on the wrong side of the market. His office is busiest when the market is going up. Then when the market goes even higher, people believe hedging doesn’t work and they don’t stick around for when it’s really needed – when the market is going down.

“This is not the time necessarily to go in whole-hog on risk management,” Plourd said. “It may be the time to set up a program and try just a little.”

He warned the tendency is to grab onto nearby months and not do anything about long-term high prices. “Once we start going, it’s down the road that you should be looking,” Plourd said.

However, it’s not all about capturing the highs – it’s about managing volatility and risk. The larger and more leveraged, the more likely it’s going to mean something to you, he said. PD

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