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A more certain outcome

Monday, June 29, 2020   (0 Comments)
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Risk management is a necessary part of modern milk production

Mark Stephenson, director of dairy policy analysis, University of Wisconsin

You have invested time to read and learn about better production practices. You have a nutritionist and other consultants who advise you on various aspects of your business. You own sufficient equipment capacity to be able to plant and harvest your crops around uncertain weather. And, you may or may not regularly manage price risk.

Do you regularly use risk management?

Many farmers are regularly using risk management products. By February, all of us knew that we were heading into a very bad market in March and April. But those who had protected prices by participation in some combination of the Dairy Margin Coverage (DMC) program, Dairy Revenue Protection (Dairy-RP) insurance, Livestock Gross Margin (LGM) insurance, futures, options or cash forward contracts knew they would be shielded from price movements that might otherwise badly damage or destroy their business.

Other farmers may have dabbled with risk management in the past, but the take-away from their experience was that premiums cost money. And the futures markets were forecasting a continued recovery of prices from the fourth quarter of 2019 right on through 2020. After five tough years, why spend a dime on anything that probably wouldn’t yield a payment? But that isn’t risk management and that was before the pandemic.

If the pandemic isn’t one of the best examples of the unknown, then I don’t know what is. Futures opinions started sliding in late January and continued right through mid-April. The markets lost $6 per cwt. over that time and expectations of $11 milk would put many farmers out of business. But the folks who spent 15 cents to buy $9.50 margin coverage under DMC would have the sting taken out of those prices. And the farmers who realized they could net a $16 price floor for 2020 by investing in Dairy-RP in the fourth quarter of 2019 could sleep at night.

What’s the game plan?

First of all, I’m just going to tell you that DMC is a good investment. It doesn’t matter if you’re large or small, securing a $9.50 margin floor on your first 5 million pounds of historic production for 15 cents is a good buy. DMC doesn’t rely on futures opinions to put that floor down; Congress made that available under all circumstances.

The next question is, “What else should I do?” First, you need to know something about your cost of production. You should know what your total cost per cwt. is and it would be good if you had some idea about how much of that total cost is variable. Variable costs are those that are immediately incurred in the production of 100 pounds of milk. Fixed costs are those that you have committed to, at least in the short run, that you will incur whether you produce the milk or not.

For example, if you decided to build a new parlor a couple of years ago, you are depreciating that investment over many years and consuming the capital slowly whether you milk cows in the facility or not. That cost is fixed. Variable costs are the ones that can be avoided tomorrow if you decide to no longer milk that cow. Feed, labor, utilities, veterinarian, etc., are examples.

In the short run, it may make sense to continue milking a cow even though her milk income is not covering your total costs of production. In the long run, that strategy puts you out of business because you can’t replace capital. But in the short run, if her milk sales are at least covering her variable costs, then any income she produces above that contributes something toward the fixed costs.

You should never spend a dime on risk management if the net price you are protecting doesn’t at least cover your variable costs of production. Even if the futures market shows that the Class III price is $11 and dropping, if your variable costs of production are $12, don’t participate! Sure, the price could drop further, but it might just as likely go up from there. 

Don’t ever lock in a price by selling a futures contract or signing a fixed price forward contract if it doesn’t at least cover your full cost of production. Under that scenario, you will guarantee yourself a loss.

If the price is below your full cost of production but greater than your variable costs, it may make sense to put a floor under prices to protect against downside risk. This can be accomplished by purchasing a put option, buying Dairy-RP insurance or a couple of more involved strategies. I wouldn’t always put a floor under prices in that scenario, but it can make sense to do so.

The bottom line

Risk management is a necessary part of modern milk production. In the extremely volatile price environment in which we live, taking steps to ensure that your business can survive the next downturn is critical. If your farm doesn’t have a marketing plan that you are regularly updating and following, then it’s time to make a study of marketing and add a member — such as a broker — to your consulting team. Risk management should be pursued with as much diligence as you have worked for better production practices.

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