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Coping with dairy price volatility reviewed at expansion symposium

March 8, 2012 | 0 comments

Based on current numbers, Jim Mlsna expects that his family's 600-cow Ocooch Dairy near Hillsboro in Vernon County will be operating at a loss in the fourth quarter of 2013.

The prospect of those numbers prompted Mlsna to observe that "we're a strange breed" in his presentation at a panel program titled "Providing a Path to Growth and Opportunity - Risk Management and Dairy Price Volatility."

The panel discussion took place during the Dairy Business Association's 7th annual expansion symposium. By that comment, he meant that, unlike in most other endeavors, many farmers depend on a second job or source of income to keep themselves economically viable.

On the farm he founded in 1978 with 21 cows and 120 acres while he was a practicing veterinarian, Mlsna began working with put and call options in the 1990s as a way to protect his financial bottom line - a venture he described as "a learning experience" for himself and for the parties involved with those risk management tools.

Now with his third broker, First Capitol Ag of Platteville, Mlsna described how he has learned to evaluate both brokers and farm lenders.

He recommends asking both brokers and lenders to explain why they are in that profession and, in turn, they should not hesitate to ask their farmer clients why they have chosen to be in farming.

At a minimum, brokers and lenders need to understand farming in general and the schedule of their individual clients so they can maintain communication as necessary, Mlsna stated.

He stated, "Bankers are the most important partner. They need to know agriculture and stick with you during calamities."

"Farmers are artists but they don't want to admit it," Mlsna suggested. For the most part, they like to work with animals and machinery, like being outside, are self-driven and often blunt, want to be a boss or leader, and do not want to punch a clock to define their working day, he indicated.

Since 2011, Ocooch Dairy has emphasized margin management to track and forecast its financial performance, Mlsna reported.

This involves hedging both on milk sale prices and feed purchases and is anchored on a simple software program provided by First Capitol Ag, thereby taking away some of the emotion as decisions are made, he explained.

New Avenues for Price Protection

Ocooch Dairy no longer trades milk contracts on the Chicago Mercantile Exchange but does some forward contracting with its milk buyer, Mlsna noted. A drawback to the latter is that "once the milk is sold, it is sold," he remarked.

With the aid of the software program, however, quarterly margins are being predicted for both hedged and unhedged positions in the commodity markets, Mlsna said. "You learn margin management by doing it."

Mlsna estimates that he spends about 15 hours per month reviewing the data provided by the software program, which costs $750 per month.

He said the data is reviewed at farm team meetings but decisions are made after the meetings, not during them.

Based on his experiences so far, Mlsna says "I no longer look back. It's done. Live with it. We're set for a year ahead now."

He acknowledged that Ocooch Dairy enjoyed a 15 percent return on investment in 2011 but emphasized that it was "an unusual year" not likely to be repeated very often.

To help determine the operating margins, Mlsna uses the actual production costs for all of the corn and the portion of the soybeans grown on the home farm's 550 tillable acres (130 different fields on the rolling terrain) and another 700 rented acres.

For put and call options, he limits the cost to 30 cents per hundred of milk.

Mlsna advises fellow farmers not to depend on the government for financial support. "Government is not innovative or efficient," he commented.

From his belief that "there's more to farming than farming," Mlsna urges all farmers to be prepared for the death of the farm's current leader.

To accommodate that, he suggests having a management team in place and being sure that the young partners on the farm "know the numbers" that pertain to the farm's operation.

Multiple Perspectives on Market Risks

Fellow panelist Porter Little, now a dairy industry consultant after a 38-year career in the Farm Credit System, pointed out that risk management must be viewed from several perspectives because it involves more than one party.

For the dairy sector, those parties include milk processors and lenders but there can also be differing concerns and risks, he noted.

A fluid milk processor is generally subject to only short-term risk but a cheese manufacturer faces multiple risks on an inventory that might be aging in storage for up to 12 to 36 months, Little observed.

He said lenders may also differ in how they view a client but that they generally are looking for equity, not for leverage.

Options, hedges, forward contracts, and margin calls are also in the picture but the bottom line that lenders are looking for is some assurance that their dairy farmer clients are operating with a locked-in profit margin, Little explained.

In some cases, it might come down to a question of selling cows, selling feed or running the feed through the cows to obtain a profit from the sale of milk, he indicated.

As a result of the severe erosion of equity suffered by dairy farmers because of the very low milk prices in 2009, lenders are asking more questions, Little said.

They want their clients to know their costs of production and they are taking a closer look at the human, management and financial resources, he reported.

Little and Mlsna agreed that lenders and borrowers need to know where the other party stands and that surprises should be rare, not common.

Little said the parties need to know one another quite well, to be open to obtaining information from experts in their fields and to realize that no single tool is likely to satisfy all of their needs.

Risk Management Not a Cookie Cutter Venture

There is no cookie cutter formula for risk management because each party must approach it differently but every one needs to manage to protect a margin - a task that starts by understanding their own business, according to Sara Dorland.

Dorland is a managing partner in Ceres Dairy Risk Management LLC. Previously, she was the risk management director at Darigold Cooperative in Seattle for 10 years.

Uncertainties underpin all risk management decisions along with the possibility of regret, which adds a human element, Dorland observed. "There's a nagging voice that says 'I left money on the table.' But you need to keep that one in check, however."

The choice comes down to accepting or mitigating the market risks, Dorland emphasized.

She cited the likelihood of mismatches due to the floating of either product prices or input costs if both of them are not addressed with a risk management tool.

Dorland said the dairy market has a variety of risk management tools but often the challenge is how to use them.

She mentioned the daily dairy markets, puts and options, hedges, forward contracts, and the relatively new swaps (negotiated futures contracts generally involving processors and end-users).

External Factors a New Risk Ingredient

But it's also "a different world" from even five years ago because of events around the world that influence milk prices and much more, Dorland stated.

Among the factors "not in your control" are dairy and agricultural production in New Zealand and South America, the debt crisis in Greece, ocean temperatures and government policies, she pointed out.

"The global dynamics changed in 2004-05," Little agreed. He cited the European Union's cutting of subsidies for milk production and the price spikes of over $2 per pound for Cheddar cheese and non-fat dry milk in 2007 as a couple of examples.

If only 2011 is used as a gauge, the U.S. dairy sector is faring quite well, given the exporting of 3.24 billion pounds of milk solids - the equivalent of 13.3 percent of the year's milk production - during the year, Dorland said. "That's a pretty remarkable feat."

But the record milk prices that those exports spurred were offset in large part by high input costs, Dorland observed. She also noted that the U.S. government is no longer the market for milk powder.

Regarding milk powder, Little observed that the United States has yet to establish a trade volume or become a dependent supplier in world market for which demand for the product is increasing.

The U.S. still has to overcome "the unreliable supplier image" that it acquired in the 1990s, he commented.

Eyeing a Target in

a Risky Market

The cumulative effect of domestic and world-wide changes obviously means that dairy producers do not control milk prices, Dorland pointed out.

Because of that, they should at least use the available risk management tools to "set a target price," she advised.

To a question on what would be a reasonable percentage of potential income to forfeit by using the tools that can lock in a price, Dorland said no more than 70 to 80 percent of one's production should be committed to a locked-in price.

Forward prices should not be obtained at below the average price for milk, she added.

"Know where you stand," program moderator and First Capitol Ag marketing specialist Mike North advised. "Choose and use the tools based on your own situation. The key is to address risk by yourselves. The government does not."

North cautioned dairy farmers not to believe that a new era of higher milk prices has been secured.

In reviewing about 30 years of prices, he noted that a majority of the months have been in the range of $11 to $13 per hundred and that volatility dropped them into the $9s per hundred for four months as recently as 2009 and lofted them above $21 for two months in 2011.

To obtain some relief from such volatility, don't look to Washington, DC for policy changes as a solution, North stated. He said it's up to producers themselves to use the available tools to manage at least some of that volatility.

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