California dairy farmers say the risk management tools they use to protect their profit margins do not work as well as they should because of a widening disparity between what they earn for their milk and the price in the federal orders, which is the index they use to hedge their milk.
Frustrated with the inconsistencies of the two pricing structures and an inability to predict the differential between federal orders and California milk prices, Fresno County dairy farmer Steve Nash says he's having second thoughts about continuing to use these financial tools.
"I'm fed up with it and I'm not going to do it anymore," he said. "I've done this about four, five years and I feel pretty comfortable with it, but it's just not working."
Nash said he's been buying put options to hedge the future price of milk and then selling the calls. This strategy allows him to buy a floor price for his milk. But with high milk prices last year, Nash said he lost money doing that.
"I was told by our creamery that no one made money in risk management last year," he said. "And I thought that was the way to go. We had listened to banks and consultants and various news articles that we should be doing it—protect our margins, right? But risk management is not managing the risk anymore, and that's a problem that's got to be addressed."
Michael Marsh, CEO of Western United Dairymen, said his organization is well aware of the pricing disparity that Nash referred to and has asked the California Department of Food and Agriculture to consider adjusting its milk pricing formula to address the problem.
CDFA rejected a petition from WUD and other dairy organizations to hold a hearing on changing the milk pricing formula in December and again last month, although Marsh said WUD will petition the department again.
In their letter to CDFA, the groups contend that California's Class 4b whey price is often so misaligned with the federal Class 3 price—the comparable price in the federal orders—that the disparity "severely hinders a California dairy farmer's ability to make effective use of dairy futures to hedge their milk and help to protect themselves from negative impacts of narrowing margins due to volatile milk prices and rising feed costs." They noted that during the last four months of 2011, the state Class 4b price has averaged $2.63 lower than the federal Class 3 price.
Marsh said the price for federal Class 3, which is milk used for cheese, "is kind of a ghost" because cheese manufacturers outside of California often get out of their milk pool when the price of Class 3 milk gets above the price of federal Class 4—milk used for butter and powder. By jumping out of the pool, Marsh said, cheese manufacturers do not have to pay the federal regulated minimum price.
"So you don't have any idea what the farmers are actually getting paid—if they're getting paid the higher whey value or not," Marsh said. "In California it's really tough for plants to depool, so we think the regulated minimum price is the price the farmers receive for their milk. Outside of California, it's not necessarily the case."
He said WUD would like the state's regulated minimum price for whey to mirror more closely what actually occurs in federal orders "but at a rate that we think is justifiable so that we can take into account the effect of depooling by the cheese plants."
"Because we're so far out of sync with what the regulated minimum price is in federal orders due to the difference in the whey value," Marsh said, "risk management tools, unfortunately, just aren't as effective for Californians as they might be for somebody in a federal order."
But Marsh said WUD continues to encourage California dairy farmers to make use of those tools and, if possible, to get good contracts for corn, soybean meal and other feeds.
Regardless of the price disparity issue, Leslie "Bees" Butler, a dairy economist at the University of California, Davis, said he would be irresponsible if he didn't advise dairy farmers to do risk management. He also said producers should not view risk management as a tool by which to make money, but rather as protection against losing money.
Merced County dairy farmer Bruce Burroughs said he has been doing risk management for at least five years and wishes he had done more of it before the big milk price collapse in 2009. He noted he did secure several contracts with Hilmar Cheese that year that set a price for about 35 percent of his milk, and those cheese contracts "probably kept us from going bankrupt."
"(Risk management) is absolutely insurance, and that's why you do it," Burroughs said.
Jamie Bledsoe, a Fresno County dairy farmer, said he's been doing risk management for the last two years and has hired a consultant to help him do it better. He noted he has about 20 percent of his corn price locked in for the year but is "extremely confused" about what to do with his milk due to the big differences between the federal and state milk prices. He acknowledged risk management tools aren't perfect right now but said "if we're going to be in this business, we have to try to all get our heads around it."
Butler said the only way to fix the pricing disparity is for California to join the federal orders, which has beten debated before. Burroughs supports the idea—not because he thinks federal prices are better but because joining the federal orders "will allow us to have a much better hedging situation," he said.
"You have to have real numbers that you can work with, and we just don't have them now," Burroughs said. "I want a single pricing structure so that the hedging is based on the same price for everybody."
Butler said there are tradeoffs to going that route. One of the advantages of California having its own pricing system is that it allows the state to experiment with it without disrupting surrounding federal orders such as Oregon, Washington, Arizona and Utah. Another advantage is that the state can make changes to the system much quicker through its hearing process than the federal government could do, he added.
Marsh said if the state were to join the federal order, it would have to consume most of the milk it produces because many out-of-state processors would not buy California milk, which would be priced much higher due to extra transportation costs.