Last year was a very profitable year for almost every dairy farmer in the U.S. Sure, 2007 feed prices were high and the cost of other inputs, like energy, also jumped. But that was more than offset by the high prices you have received for milk most of the year.

You are now faced with the pleasant problem of deciding what to do with the bumper profits reaped in 2007. You could use these profits to upgrade machinery, equipment, or facilities, expand your herd or purchase more land. Alternatively, you could use 2007 profits to retire debt and set yourself up to pay lower interest payments.

Invest in ethanol?

Some producers may consider investing some of their 2007 profits in ethanol plants. The thinking here is that the new enthusiasm for bio-fuels could result in some substantial returns on investment.

Before you buy interests in ethanol plants, though, ask yourself if making these investments make sense given that your primary business is dairying. Ideally, you should pick investments that promote the long-term success of your dairy businesses. 

One important principle of investing is to spread capital across multiple investments. This wealth-diversification practice has merit in that:

1.         It can protect investors from losing big portions of their wealth.

2.          It can stabilize returns when negatively related investments are used to construct portfolios. 

Keep in mind that negatively related investments stabilize returns, because the gains from some investments offset the losses on other investments. This countering of gains with losses reduces net returns, but it also keeps net returns relatively stable. Therefore, there may be less risk with diversification.

A natural pairing

The combination of dairy operations and ethanol plants might be seen as a natural pairing because dairies can make use of the distiller’s grains coming from the
ethanol plants. 

However, there is another way to look at dairies and ethanol plants.

Both dairies and ethanol plants use corn or other corn equivalents. This means grain price ups and downs should have similar impacts on the profits of dairies and ethanol plants. For example, high grain prices should erode the profits of both dairies and ethanol plants, while low grain prices should boost the bottom-lines of both. This positive profit relationship makes one wonder if it makes sense for dairy producers to invest in these plants. 

It is very advisable for dairy producers to invest some of their 2007 profits in something other than their dairy operations. Placing some of your wealth in alternative investments makes good sense in that it helps protect wealth and stabilizes income.

The question is whether it is advisable to invest in readily marketable mutual funds, as opposed to committing large sums of money to purchase an interest in an ethanol plant.

Capital needs

The answer to that question depends on how badly you may need the capital being invested in either mutual funds or an ethanol plant. If you are likely to need the invested capital to cover future short-run cash-flow problems (yes, milk prices can drop and cash-flows can again become tight), you should probably invest in mutual funds.

If, on the other hand, you are already well-diversified and hold readily marketable securities, such as mutual funds, you can probably afford to tie up some of your 2007 profits in a long-term investment such as an ethanol plant. If you do this, understand that it may be some time before you are able to regain this cash if you need it to fund your dairy operations.

Just remember, if you commit your 2007 profit to longer-term investments like ethanol plants, land, cows, machinery and so on, you run the risk of not having cash resources in the near term.

Bruce Jones is a professor of farm management at the University of Wisconsin-Madison.