Hedging: A sustainable Business Practice

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Hedgers enter transactions to avoid potential future losses. Speculators enter transactions to “beat” the market. Hedging results in a known price today for something you will sell or buy in the future. The transaction replaces uncertainty with greater certainty. Conversely, doing nothing to insure against loss is speculating.

Today, bankers hedge interest rates. Manufacturers hedge energy prices. Ethanol plants hedge corn prices. These and other hedging transactions occur to manage a margin and avoid financial loss. Each is an example of protecting against adverse prices in the future to gain a measure of certainty, and recognition that potential advantageous prices later on may not be realized.

Most dairy farmers are hedgers, too, whether in milk or inputs. They forward-sell their milk in an effort to insure against a loss. They give up the potential of higher prices in the future to have a measure of price certainty today and to avoid unprofitable lower prices later.

They execute these transactions by forward contracting milk with their cooperative or handler, or by directly taking positions in the Chicago Mercantile Exchange’s futures and

options markets. About half the time, the hedge results in “leaving money on the table.” However, most of the time, the hedge results in the dairy achieving some measure of  profitability, if input costs are hedged in tandem with milk prices.

Milk price volatility

With the phase-down of dairy price supports, a shift to “justin-time” inventories, and the reduction in trade barriers and subsequent globalization of milk markets, milk price volatility

has increased substantially. Milk price volatility is now part of our business culture. More and more dairy farmers will find it necessary to follow oil companies, feed mills, airlines, dairy manufacturers and countless other industries, and hedge revenue and input prices.

Many dairy farmers consistently take positions on their input prices. Recognizing that livestock feed is the biggest input, many dairies either grow a significant portion of their feed (a natural hedge based on planting and harvesting costs) or lock into feed prices with a local dealer. They may also forward contract diesel and even lock in cropping expenses. Right now, some dairies are considering moving short-term variable-interest debt to longer-term fixed interest

debt. These are all forms of hedge transactions. It is my impression that far fewer dairies hedge their milk price than hedge input prices. But with the volatility in feed, interest rate and energy prices, the marketplace is demanding that milk prices be hedged in tandem with these input prices. Going forward, a dairy’s successful hedging strategy will include transactions on both milk prices and input prices to manage a consistently profitable margin.

Objectives

For a dairy farmer, a hedging strategy can lead to:

• More price certainty

• Opportunities to manage a consistently profitable margin

• Preservation of the dairy’s net worth

• A happy banker

• A sustainable dairy operation

At the end of the day, hedging milk and input prices together can help to ensure successful dairies in uncertain domestic and global markets.

Edward Gallagher is president of DFA Risk Management (www.dfariskmanagement.com), which offers customized risk management programs to aid producers in managing dairy risk.



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