How to talk to a lender about hedging

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When a farm owner or manager embarks on a capital project or planned expansion, the lender will likely require assurances that a structured plan is in place to remove as much risk as possible, assuring repayment.

Having a collaborative discussion with your lender about your dairy’s milk and input price risk-management strategy, and its impact on profitability and net worth, is a key component of acquiring the capital necessary to fuel the dairy’s growth.

Today’s dairy businesses are faced with unprecedented price volatility for both milk and inputs. Volatility can significantly slow growth, and even destroy a dairy’s net worth. Prudent risk-management strategies, including using hedges such as forward contracts that closely emulate the dairy’s milk price and feed cost, can significantly smooth out and protect the farm’s longterm profitability and ability to grow equity.

Be armed with right information

When meeting with your lender, be armed with a budget based on your farm’s actual cost of production. Include a forward-contracting strategy that is anchored to this budget.

Set target price levels that deliver effective predetermined margins using hedges that closely emulate your farm’s pay price, while delivering returns that satisfy both lender requirements and your profit expectations.

Going into the meeting, have a mind-set of an educator and be prepared to explain the available risk-management strategies. Often, loan officers will be unfamiliar with these opportunities and in some cases, will not understand how they can benefit the dairy and reduce repayment risk. If this isn’t your strong suit, a milk broker or professional risk-management strategist could be invited to participate, as well.

Additionally, be prepared to offer a detailed review of the dairy’s cost of production.

Livestock feed is key

How the dairy’s largest cost — livestock feed — is evaluated is key. Inventoried purchased feed has a known cost, but the “cost” assigned to home-grown feed can create confusion. Lenders may assign unrealistically high feed values to home-grown feed based on the day’s prices on the CME Board that could significantly overstate its cost. As a going entity, the dairy’s home-grown feed is committed to the cows, so the value of the feed sold commercially is irrelevant.

“Market cost” pricing for feed can make a farm’s equity look better to a loan officer because it is carrying a valuable asset on its balance sheet, but it distorts the true cost to produce a hundredweight of milk, making milk market price hedging opportunities look unattractive or event unprofitable.

Risk management removes the farm’s milk and input price risk to assure solid financial performance. By hedging, the business is removing speculation and bringing greater assurances that prices received in the future will make your capital investment a success — a goal that will undoubtedly align with your lender.



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