I have been in and out of meetings the last couple of weeks, meeting with processors, bankers, and dairy producers. I’m seeing a common trend developing based on our current markets. It seems there is a lot of pressure being put on dairy producers, to protect milk futures. I agree with protecting profits, if done with sound reason and understanding.
My concern is that you are being pressured to protect milk far out into the future. Is this really giving you the best protection or is it protecting the bank? My concern, it’s doing neither. I fully understand the importance of having a sound relationship with your lender. However, please use caution when making the decision to move into the far months. Historically the premiums are too high, and it has a negative impact on your risk strategy.
Options for Protecting Your Revenue
Option A: Hard Lock your milk.
This is cheap at $.10 to $.15 cwt, but can be painful because we have high inflation, and can’t afford to miss out on higher milk prices. Also remember the creamery’s pay price will not necessarily be the price you have contracted. If we see another round of PPD’s you will most likely have to reduce that from your contracted price. If you don’t see a negative PPD when others do its most likely being hidden in other areas of the check, maybe your premiums are less.
Option B: Options Trading
You can buy a put and sell a call also known as ‘building a fence’. This cheapens the cost of buying a straight put. I call this the sound good/feel good option. Think back to how this would have worked if you started 8 months ago. You certainly protected your bottom but also set a limit to your topside. Milk hasn’t come down and only risen, now that milk is $25 cwt in the near term, how bad would the margin calls be?
Option C: Dairy Revenue Protection (DRP)
This is a decent option, there have been several scenarios, where I have utilized DRP. The biggest win for DRP is that you are getting subsidized floor on your milk. I like this option much more than using the fence strategy listed above. DRP does, however, have flaws, these flaws can be very costly. I have talked with several producers, who have moved away from DRP recently. The biggest issue is three month averaging. The next issue has been buying DRP and at the same time, or later, selling a call on the same milk. This is like building a fence. If the milk price rises above your call price, you are forced to pay margin calls. Also be cautious to the number of moves you are making with your broker, each move has a premium.
Option D: Livestock Gross Margin (LGM)
LGM dairy is the best option. My opinion is built on sound facts and figures analyzed since 2008. LGM dairy, like DRP, offers a subsidized floor on milk. The advantage to LGM is doing shorter segments vs quarterly segments. This mitigates the averaging affect that we see in DRP. If you have used LGM in the past, keep in mind, there have been several positive changes made in recent years. Give it a look and you too, will find it to bring the best value.
Cost Analysis
There is a cost associated with each of the options above. In some instances, its opportunity cost, in other instances, its premium cost. If you are using DRP or LGM (these are priced very similar) I can assure you that the premium is worth the value. The average LGM premium, using our strategy, from 2008-2021 is $.27 p/cwt. The 10-year average projected milk price, seven months forward, is $16.85, the 10-year low is $12.18. The spread based on the 10-year average as compared to the low is $4.67. The equates to a cost of $.057 per dollar of spread. We currently have milk trading around $23.50 in the future. This creates a spread of $11.32. Based on a cost of $.057 per dollar of spread premiums should be about $.65 p/cwt. This is right on target with where we are seeing premiums. Its much easier to make these decisions when we have good prices on the board.
I understand you can’t beat being right! What is a better option for your farm? Paying $.65 cwt today and having the option for better revenue later or paying $.10 to $.15 cwt today and possibly missing out on $1 - $3 in the future? Paying $.65 cwt isn’t enjoyable, but neither is missing out on $3 cwt.
I welcome the opportunity to discuss these options with you and learn about you and your farming operation. My promise is to add value to your operation, and to not waste your time. I would rather educate you on the options available and let you make a sound choice.
Give me a call at 715-456-5607.
Because I care!
Travis
