A common misconception in dairy is that movement in the CME Group corn market will have an immediate impact on CME dairy futures. There is no denying the impact of feed input prices on a dairy operation, but there is more to the equation than the notion that if one goes up, so must the other. To appreciate the relationship between milk and feed prices, we need to understand the data and what affects price movement.
Correlation is the degree to which two markets show a tendency to vary together, or to move in tandem. In reviewing correlations between nearby Class III milk futures and corn futures during the last five years, the two markets were just above 70 percent correlated.
This lack of correlation makes sense considering the variables affecting price. In dairy, cash market movement has a substantial impact on the current milk price. In corn futures, weather, supply and demand, and cash prices impact daily price fluctuations. Neither market should affect the pricing of the other at this point in time.
A stronger correlation
Perhaps a better way to understand the relationship is to compare CME futures prices further into the future. Eliminating factors that contribute to volatility in the near-term contract, such as cash prices, improves the correlation between milk and corn dramatically.
The relationship between feed costs and milk production is stronger based on futures price data for corn four to five months in the future and milk production nine to 10 months in the future. A more defined relationship is apparent between corn futures and Class III milk futures, as the cost of feed inputs has a direct impact on dairy margins and increasing or decreasing milk production in the future.
However, the correlation and best timeframe to use is ever-changing as purchasing patterns vary throughout the dairy industry and from one season to the next.
What does this mean?
While you shouldn’t use the corn market to hedge or contract future milk prices any more than you would use the CME cattle market, you should utilize the price movement to understand possible market direction in milk markets.
Understanding that a relationship exists should weigh into when and how to hedge both inputs and outputs or hedging a margin. For example, if the movement of the corn market affects CME Class III milk futures, hedging corn but not Class III may leave your operation open to greater risk.
When developing a hedge plan and determining targets for hedges, it is important to know that more than one indicator should guide how you anticipate the direction of milk futures. Other factors can influence market direction from day to day, resulting in volatility and margin fluctuations.
A sound strategy is to leave room in your hedge plan for quick market changes, and be reactive to shifts in the market when hedging the inputs and outputs separately.
Kim Parks is vice president of DFA Risk Management (www.dfariskmanagement.com), which offers customized risk management programs to aid producers in managing dairy risk.