Risk management in dairy

On a rising tide of interest in the way other countries – mostly the US – manage dairy market volatility, DairyCo is investigating which mechanisms for managing input and output costs could be introduced or promoted in British dairy markets.  Here, AHDB DairyCo’s Richard Veit examines some common mechanisms and finds they could benefit all systems of dairy farming.

Forward Contracts

The most simple and commonly used risk management concepts is forward contracts, where buyers and sellers agree terms of delivery (ie, quantity and price) in advance. Prices tend to be in line with market prices and fixed on the date of agreement. With this type of contract, the buyer gives up the possibility of benefiting from lower prices should the market price fall, but benefits from price certainty. Likewise the reverse is true when selling forward, with the buyer giving up the possibility of benefitting from lower prices in exchange for price certainty.

Across the US agricultural sector, including dairy, some farmers are known to be forward contracting both their inputs and outputs, locking-in profit margins ahead of production.

While a forward milk price may be harder to obtain in the UK, it might be possible with some milk purchasers, depending on individual contracts.

Futures Contracts

Futures are standardised, legal contracts based on the delivery of a specified quantity and quality of a commodity, at a predetermined date, with the price agreed in advance. Unlike forward contracts, few futures contracts actually make it through to expiry and physical delivery, as they are traded by speculative investors and therefore closed before they reach maturity.

The value of the contract is negotiated at a futures exchange, which acts as an intermediary between the buyer and seller, and is based on the present-day value of the physical item. Futures contracts can be used by those actually involved in the supply chain (such as farmers and manufacturers) who are looking to reduce their risk and exposure to market volatility through ‘hedging’. Hedging allows both buyers and sellers to lock in a price for the future, as with forward contracts.

Options

Options act as a form of price insurance, protecting against adverse price movements while at the same time allowing the holder to benefit from favourable movements. Options give the right but not the obligation to buy or sell an agreed quantity at a pre-determined price. A seller of a commodity can use options to create a price floor for their produce, allowing them to still benefit from any price increases. By contrast, a buyer of a commodity can use options to set a price ceiling, while maintaining the ability to take advantage of falling markets.

The benefit of options over futures is that the holder is given the choice, as opposed to the obligation, of whether they wish to exercise the contract. Hence, they provide greater flexibility to the holder than using futures alone.

The Dairy Futures Market in Britain

While futures markets for grains have been trading for as long as exchanges have been operating, futures markets in dairy products are relatively new. There are only two exchanges in Europe where it is possible to trade dairy futures: the Eurex and NYSE Liffe.

The Eurex exchange, based in Germany, launched Skim Milk Powder (SMP) and butter futures in May 2010. These are designed to reflect prices in Germany, France and the Netherlands, and hence are calculated using a matrix of prices from the three countries. Futures are traded in Euros per tonne and in contract sizes of 5 tonnes. The Eurex exchange also introduced a futures market for whey powder in September 2012, again based on contract sizes of 5 tonnes and traded in Euros per tonne.

NYSE Liffe launched an SMP futures contract in 2010, traded on the French exchange in Euros per tonne. The contract is for free physical delivery within a 150km range of Hamburg, Antwerp and Rotterdam with a contract size equivalent to one truckload (24 tonnes).

Accessing Dairy Futures markets

Dairy Futures in both of these European exchanges were introduced only recently and, as such, the markets could be best described as being in their infancy. Speculative trading has yet to penetrate these markets, without which cash flow remains low, reducing the ability to use the markets as a hedging tool for farmers and manufacturers. Options are not currently available in either European exchange, and are unlikely to be introduced while futures trading remains low.

However, activity in the US gives us a glimpse of the potential. There, dairy futures have been operating for around 20 years. Removal of price support and a subsequent increase in volatility of dairy commodity prices within the US in the early ‘90s led to the development of Cheddar Cheese and Non-fat Dry Milk (a similar product to skimmed milk powder) futures contracts in 1993. A contract for milk was established in 1995 and as the dairy market has developed, additional lines have been added, including options.

According to the Dublin-based FC Stone Commodity Services, dairy farmers in the US typically hedge between 40% and 60% of production using the futures markets, securing a base price for a proportion of their product but allowing the rest to be subject to market forces[1].  Farms producing around 50 million litres of milk or more a year are able to access market directly, while smaller businesses are more likely to use forward contracting programmes through co-operatives or processors.

New Zealand also has a functioning dairy futures market, and was the first to open a market for Whole Milk Power (WMP) in October 2010, followed by SMP and Anhydrous Milk Fat (AMF). The development of WMP futures by the New Zealand exchange was driven by the importance of WMP exports from the region and developed to meet market demand for a risk management tool specifically for the product.

Fonterra is currently trialling its Guaranteed Milk Price Scheme to its farmers in New Zealand for the 2014 season. The scheme allows farmers to lock in contracts at a set price for a proportion of their output, with prices paid based on kilograms of milk solids. Fonterra hedges its own risk and exposure to market volatility through offsetting its purchases through the Futures market.  

Managing feed and protein costs

Feed often makes up the single biggest cost to dairy farms, and the weather in 2012 was an unsavoury reminder that even on specialist grass-fed systems, buying in feed may be unavoidable.  While managing output risk is more advanced in the US than in the UK, there are a number of ways in which farmers can be proactive in managing  input costs. Three broad strategies are outlined below:

  1. Buy forward

    As mentioned above, locking in to a price allows costs of production to be mapped in advance. This can be done either through a Futures Contract or a Forward Contract, securing delivery for a specified date at a specific price.

    A development to the ‘buying forward’ strategy is to buy a proportion of your feed requirements forward at regular intervals; a strategy referred to as ‘averaging’. The concept of averaging is to reduce volatility in the market by taking the average price over the period.

    In a rising market, averaging can also help reduce the overall cost of feed compared with buying all of your input requirements at the end of the period. In a falling market, averaging will result in a higher total cost.
  2. Buy forward and use an ‘Option’

    Options can potentially be used in two ways by a dairy farmer wishing to guarantee a source of feed.

    First, for a dairy producer who knows in advance he will be buying significant quantities of feed, options can be used as price insurance. They provide price certainty while leaving the opportunity to benefit if the market price falls.

    Second, for a grass-fed system, options can be used to give the right to sell grain at a later date – without the obligation to do so (as a Futures or Forward Contract would). In this sense, a grass-fed system can forward buy grain if they suspect or fear it will be a bad weather year, but will be also be able to sell this grain should they not require it. Using an option therefore allows the producer to sell the unwanted grain at a specified price and date.

    It is important to note that options come at a cost, which should be factored in to the business plan.
  3. Other strategies

    Farmers who join a buying group may have better opportunity to use these tools. A buying group can allow them to benefit from economies of scale, as well as potentially access specialised marketing and professional expertise. Allocating the responsibility of sourcing feed requirements to another party can also help with time management, allowing a greater focus on other aspects of the business. A potential disadvantage is that this strategy reduces the level of control over grain purchases and the price paid for grain.

In summary

Volatility has grown significantly in both dairy and commodity prices in recent years, making it increasingly important that appropriate risk management strategies are put in place to help reduce the level of exposure to market movements. This is not only limited to strategies to sell your output, but also to mitigate volatility to input prices.

So when will the futures market reach the stage when British farmers can really benefit? Speculators tend to get interested when the market is actually using them. But the supply chain only really starts to use the mechanisms when there’s enough liquidity. This means growth does tend to be organic.

At the moment, the markets are young and will gradually take off if some success stories start spreading. They key is to start using them through a local, trusted merchant or vendor –making sure you have a sound understanding of the tools and choices on offer beforehand.

This article featured first in our electronic newsletter Dairy Leader. Click here to subscribe and receive Dairy Leader directly to your inbox.

 

 

Notes:

[1] FC Stone, Commodities risk manager John Lancaster speaking at the 2012 Dairy UK conference, Birmingham, 4 September 2012.