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Taking a step back: The mindset of hedging

David Kurzawski Published on 30 April 2013

The dairy markets are no stranger to price volatility. Since as far back as the late 1980s, when the U.S. government lowered price supports on milk, dairy producers have dealt with mushrooming price uncertainty.

Over the past five years in particular, producers are getting a crash course in that sometimes fleeting fundamental issue of their business: producing milk for a profit.

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Although making the move from “price taker” to “price maker” seems simple enough, the issue of whether or not to hedge risk continues to baffle many dairy producers.

Many are not familiar enough with the various tools and strategies at their disposal, which breeds confusion and inaction.

But let’s dig a little deeper here. At the heart of the issue, dairy producers really have many misconceptions about risk, concerns about the cost of hedging and fears of loss on hedging transactions.

You have to first ask yourself: What is it that I’m trying to accomplish? An effective hedging program does not attempt to eliminate all risk – it attempts to transform unacceptable risks into acceptable form.

What is unacceptable to you? And what is acceptable? The challenge for you is to decide the business risks you are willing to bear and the ones you wish to reduce or remove by hedging.

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I find it helpful to break down your business into two risk categories: operational and financial. Operational risks are all those directly associated with the daily production of clean, fresh milk.

While problems, from a failed refrigeration compressor to a sick cow, are serious – they’re fairly straightforward. The financial risks are more evasive but no less serious.

To understand financial risks is to first accept that you have them. The shifting sands for dairy producers over the past several years is enough evidence that profitability on their dairy is more than luck or money made in real estate.

Be willing to recognize that the producer who does not take responsibility for his or her financial risks is really betting that the markets will either remain static or move in their favor. Ironically, not hedging is a form of speculation.

When it comes to markets, speculation is a dirty word. Many producers do not hedge precisely because they automatically believe they’re speculating on the price of milk if they participate in the market by hedging.

They believe that using futures or options introduces additional risk. In reality, the opposite is true. A properly constructed hedge lowers risk. Betting that the prices will arrive at profitable levels for you month-in and month-out is really the gamble.

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Those who understand and are comfortable with hedging as the opposite of speculating may still struggle with the costs associated with hedging. Admittedly, some hedging strategies do cost money – but consider the alternative.

To accurately evaluate the costs of hedging your production, you have to consider them against the costs of not hedging. The cost of not hedging is the potential loss your dairy can suffer if market factors move against your interests.

Next to costs, the failure to evaluate the performance of a hedge by the appropriate benchmark is a real problem. Many producers would rather not hedge – not protect the profit margin on a portion of their milk – than report a hedge loss.

Read that line again. This fear is due to widespread confusion over expectations. The key to properly evaluating the performance of all futures or forward-contracting transactions lies in establishing appropriate goals at the outset.

If you produce 40 percent Class III milk and you hedge 100 percent of that milk at an 80-cent-per-hundredweight profit (after considering adjustments for basis), then we need to be comfortable with those figures at the beginning and at the end (there are ways to make the hedge more flexible and allow for more upside, but for the sake of this article, we have to be comfortable with the concept of locking in a profit margin).

You need to be OK with the idea that you’re protecting a profit margin and removing volatility – not trying to beat the market. Market view is important, but it doesn’t necessarily make you profitable.

Market opinion, of course, is not a bad thing. In fact, as a dairy risk consultant, I spend a lot of time talking to producers about short-term and long-term price direction based on supply and demand assumptions.

Although it’s valuable to get a sense of market tenor, many dairy producers fall into a trap of trying to construct hedges on the basis of their market outlook.

The best hedging decisions are made when the producer acknowledges that market movements are unpredictable. A hedge should always seek to minimize risk first. It should not represent a gamble on the direction of market prices.

A well-designed hedge – one that considers the central aspects discussed above – reduces both risks and costs to your dairy operation. Hedging stabilizes earnings, frees up resources and allows you to focus on basic competitive advantages of quality and quantity of milk production.

No one will ever force you into protecting a profit, and no one will ever say you have to hedge 100 percent of your milk production. But take some time to review what risks you are comfortable with and which ones make you uncomfortable.

Make a plan. And reduce the number of truckloads that you’ll take whatever the market gives you at the end of the month. That is real speculation. PD

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David Kurzawski
Senior Broker
INTL FCStone LLC

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