Dairy Initiatives

Dairy

Department of Animal Science

D A I R Y   I n i t i a t i v e s   N E W S L E T T E R
V o l u m e   1 0      I s s u e   2       S u m m e r   2 0 0 1

Why Would I Want to Lock in
My Milk Price?

MARGOT RUDSTROM
West Central Research and Outreach Center, University of Minnesota

More and more dairy producers are contracting with processors to sell milk. Why lock in a milk price and miss the opportunity to profit more if milk prices were to rise? The reason is the flip side: price can also decline.

Up to 1986, milk prices were fairly stable (Figure 1). Government support prices hovered around $11 to $12/cwt. As the support price for milk dropped, however, milk prices became more volatile. From December 1998 to November 2000 the Class III price went from an all-time high of $17.34/cwt. to an all-time low of $8.37/cwt.

Like it or not, volatility is here to stay. If you want or need more predictability in your life, cash forward contracts can help you to manage that volatility.

FIGURE 1. Milk prices have become incrasingly volatile since 1986.

Kinds of Contracts

Cash forward contracts offer you a specified price for future milk production to be delivered to the buyer's milk plant. Offered prices can change daily. Contracts may be offered for individual months, six months, or even a year.

Most cash forward contracts are for a guaranteed base price related to the Class III milk futures contract price. You are still eligible for the same premiums and discounts (for milk composition and quality) as are producers who do not forward contract.

Some milk plants offer a type of cash forward contract called a floor price contract. The buyer uses Class III put options to set a floor for the milk price. If the milk price rises, you get more than the floor price. If the milk price falls below the floor, you get the floor price.

What's a Good Price?

Your milk check is based on the price of Class III milk, which has 3.5 percent butterfat, 3.1 percent protein, and 5.9 percent other solids. The price you actually get differs from the Class III price because of differences in milk composition, somatic cell adjustments, producer price differential, and plant premiums. The difference between your price and the Class III price is called the mailbox differential or basis. Your basis changes monthly because milk composition and producer price differential change monthly.

Most cash forward contracts are based on a Class III price. Track your basis monthly. Then use Table 1 and the information you've collected on your basis to estimate your future mailbox price. Use this information to determine what might be an acceptable price for a cash forward contract for your milk.

Advantages

A major advantage of cash forward contracts is their flexibility. While futures contracts and options require relatively large fixed quantities of milk (for example, 200,000 pounds for a CME (Chicago Mercantile Exchange) Class III milk futures contract), cash forward contracts can be for much smaller quantities - as little as 10,000 pounds of milk per month.

Another advantage of cash forward contracts is that they are simple to use. You just need to ask the milk buyer what contract price is being offered. You don't need to establish an account with a broker, nor do you need to maintain margin accounts as you would with options.

Disadvantages

Disadvantages of cash forward contracts include the fact that you are normally not allowed to get out of the contract. That means you are locked into delivering milk to the buyer you contracted with. It also means you forgo opportunities to take advantage of rising milk prices (unless it is a floor price contract).

There is a way to take the edge off this disadvantage. Since offered contract prices can change daily, you can accept more than one contract price for a given month. For example, say that you accept a contract price of $13.00 for the following August on 10,000 pounds of milk. A few weeks later you see that Class III milk futures have strengthened and the buyer is offering $13.75 for that same month. You might decide to contract another 10,000 pounds.

If you choose to use this strategy, however, be aware that most buyers limit total contracts to less than 100 percent of your expected monthly production. A general rule of thumb is contract no more than 70 to 75 percent of your expected production.

Definitions

BASIS: The difference between the price for Class III milk and what you get for your milk, due to differences in composition, quality, etc.

CASH FORWARD CONTRACT: An agreement with a processor to sell a certain amount of milk at a specified price during a specified period.

FLOOR PRICE CONTRACT: A cash forward contract that specifies a minimum price rather than a set price for milk. The producer may get more than the minimum if milk prices rise.

MAILBOX DIFFERENTIAL: Same as basis.

SELLING A FUTURES CONTRACT: Obligates the seller to accept an agreed-upon future price for future milk production.

BUYING A PUT OPTION: Gives the owner of the put option the right to sell a futures contract at an agreed-upon price.
  

Quick Tips for Contracting Milk

KNOW THE PRICE YOU ARE TRYING TO PROTECT. You need to cover your costs of production, debt repayment, living costs, and so on. If you lock in a profitable price you won't lose money.

UNDERSTAND YOUR MAILBOX DIFFERENTIAL OR BASIS. Overestimating your basis will result in a lower than expected mailbox price. Underestimating your basis will result in a higher than expected mailbox price.

LEAVE SOME ROOM. Most milk buyers will not let you contract 100 percent of your expected production. Leave yourself some room in case you have unexpected drops in production.

READ THE CONTRACT CAREFULLY. How much milk are you contracting? Which months are included? Is it a base price contract or a floor price contract? Is the contract price based on Class III price or some other price?

D A I R Y    I n i t i a t i v e s    N E W S L E T T E R
Volume 10    Issue 2    Summer 2001