How quickly things change! Last year, the dairy industry experienced severe heat and drought conditions in many areas of the country. This year, with increased moisture throughout the Corn Belt, analysts are forecasting nearly tripling corn stocks from one year to the next.
Weather conditions in the United States and globally influence fast-changing market dynamics, leading to increased volatility in markets ranging from dairy to feed and energy. These sudden shifts put some dairy producers in a difficult position, especially in predicting or locking in future margins.
The desire for upside potential in dairy risk management strategies is rising as dairy producers increasingly need predictability and the ability to prevent negative returns. And, of course, the desire remains to capture better results if the markets are giving them.
A situation in which milk production is hedged but feed costs have increased leaves a producer vulnerable to lower margins, or even potentially negative margins. Fortunately, to avoid the uncertainty that lies ahead with milk and feed markets, you can employ strategies to strengthen your risk management plan.
Buying a call is a simple risk management strategy that gives upside for your fixed price milk hedging strategy. This strategy allows you to participate in rising markets as they occur. Buying a call involves premiums, like insurance, which can be pricey compared to other upside strategies. This approach can bring additional dollars to your hedged milk, if a market rally occurs.
If your milk is unhedged, another alternative is buying a put — setting a minimum price for your milk. Like the prior strategy, buying a put involves paying a premium.
An alternative milk risk management strategy that would include some upside participation is buying a put and selling a call. This is similar to the strategy above, but the upside potential in your milk market is limited because of capping the upside. Capping your upside participation results in lower premium costs, which often makes the strategy more appealing to dairy producers.
For dairies that market to companies offering risk management programs, the above examples can be executed via a milk forward contract. These strategies are available with no upfront costs or margin calls with many cooperative forward contract programs.
Similar to the need for upside participation in the milk market, many dairy producers are interested in downside participation for feed prices. There also are strategies available for these concerns. For example, you can purchase a call option on corn to allow for downside participation if the corn market moves lower.
The value of adding upside opportunity to your risk management strategy may be useful in times when the milk market increases substantially or the corn market decreases. For some producers there is additional value in the peace of mind that their operation is protected from lower markets, but they can benefit on any upside the market gives.
Kim Parks is vice president of DFA Risk Management,which offers customized risk management programs to aid producers in managing dairy risk.