Perhaps you’ve dabbled in risk-management before, or know a friend, neighbor or brother-in-law who’s “played the market.”
In all likelihood, you’ve heard a horror story or two — or became one yourself. Milk was forward-contracted, and then the price skyrocketed and potential profit escaped. Or somebody “lost his shirt” because he couldn’t make the margin calls.
These things may have soured you to the whole concept of risk-management. But, risk-management is going to be a big part of the dairy industry’s future — and your future.
Why? The global credit crisis has put more pressure on lenders, and dairies will need to use risk-management to secure financing in the future.
The mechanics of risk-management are not that complicated. But, it’s the mental gymnastics and emotion that comes with making a marketing decision that can be a problem.
Here is how you can mentally prepare to use risk-management tools.
Have a plan
First, lay out your plan of attack.
No one can accurately predict where the market is going. But, you can have strategies set up in advance for what you’re going to do, no matter what the market does, says Scott Stewart, president and chief executive officer of Stewart-Peterson in West Bend, Wis.
Develop your plan based off of finances and not what you hear at the coffee shop. Create a risk-management planning team with your accountant, lender and broker.
Once the team is assembled, work through possible scenarios and choose the best risk-management tool for each circumstance, says Stewart.
“Without a written plan in place, you may make an emotional decision in a stressful situation that might not be the best thing for your operation. In all likelihood, you’ll get burned and it won’t work out,” says Eric Meyer, a risk-management consultant with FC Stone/Downes-O’Neill, Chicago, Ill.
Laying out a plan in advance takes the emotion out of making decisions. And, a plan will give you confidence and stop you from second-guessing yourself.
Admittedly, developing a strategic plan takes a lot of work and mental energy. But once you have a plan in place, it becomes as simple as: If the market goes up a little, I’ll do A. If the market goes up a lot, I’ll do B. If the market goes down a little, I’ll do C. If the market goes down a lot, I’ll do D.
With all of this strategizing done in advance, in an unemotional way, you are prepared to act as various market scenarios unfold.
Don’t forget to include both milk and your feed inputs in your plan. “If you don’t, it could be very dangerous for your business,” says Phil Plourd, president of Blimling and Associates in Cottage Grove, Wis.
Involve your lender
The capital outlay required for risk-management and margin calls tends to be the biggest stress factor for dairy producers. Your goal is to alleviate this stress.
To do so, involve lenders in the planning process. “There are financial requirements to risk-management, and if your lender understands what you are trying to do in advance, they can set up a risk-management line of credit,” says Meyer.
Risk-management plans have been derailed in the past because the lender was not part of the process. “If your lender isn’t involved, you may reach a point where the amount of money is too much for the lender to swallow, and you have to get out of the hedge and you lose your position,” says Meyer. “Involve your lender from the beginning.”
Depending upon your personality, you may or may not be comfortable with margin calls. Learn the different strategies available and add the ones you feel comfortable with to your plan. “Remember that when it’s all said and done, the cost of the margin call money is only interest,” says Chris Atten, hedge consultant with First Capitol Ag in Galena, Ill.
Stick with your plan
Be consistent with your marketing strategy and trust the plan that you’ve made. Consistently using a risk-management plan delivers consistent returns.
Take a cue from other businesses, such as restaurants and end-users of products, which use risk-management tools every day to lock in consistent profits. “They aren’t doing it because they know prices are going higher,” says Plourd. “They do it because they are doing their job, managing their business and managing their profit margins.”
In order for companies to offer $5 pizzas or $3 meal deals, they have to know what their costs are going to be ahead of time. “They are managing to a price point,” adds Plourd.
Sometimes people are skeptical that buyers offering forward contracts have some kind of inside knowledge. “They think if someone is offering a contract at $2, they must know the price is going to $2.50. You have to understand companies are in the same boat as dairy farmers — they don’t know more than anyone else; they are just trying to protect their business,” says Meyer.
Now that you’ve done the legwork, it’s time to put your plan into action.
As you do so, “change your mind-set — you are no longer a price-taker, you are a price-maker. It doesn’t matter if you have 60 or 6,000-cows, it’s about net profitability,” says Plourd.
Resist the fear of leaving money on the table. If you locked in a price that leaves you a profit, is it really a bad decision? Meyer asks.
Stop getting hung up on missing out or second-guessing yourself. No one can know exactly where the market is headed. Instead, focus on what could go wrong in the market, adds Atten. “Milk could go to $10 per hundredweight and corn could go to $6 a bushel — this is reality.”
Understanding risk-management tools and developing a plan does not happen over night. “But, you as the producer have to take it to the next level,” says Meyer. “Fear of starting keeps people from starting.”
And, understand that doing nothing is still doing something.
Certainty vs. opportunity
There is a trade-off in the whole process of using risk-management tools: certainty vs. opportunity. Different people will value these things in different ways.
Nylund Dairy in Hilmar, Calif., sees risk-management as a form of insurance. Like the deductable on your auto insurance, how much risk do you want to take? And, how much do you want to spend to cover that risk and what percentage do you want to cover? asks Josh Bernard, herd manager at Nylund Dairy.
Nylund Dairy is in the process of developing a risk-management plan that should provide a constant cash-flow rather than riding the highs and lows of the market.