Hedging your milk can be an effective risk management strategy with careful planning
Editor’s note: Chip Whalen is Vice President Education and Research at Commodity & Ingredient Hedging (CIH), leading the group responsible for developing and teaching seminars on commodity risk management; conducting and disseminating commodity market research; and producing the firm’s educational publications for agriculture producers and their lenders. Chip has been with CIH since its inception in 1999. Prior to joining the firm, he was a broker at Agri Analysis, where he helped clients identify and manage price risk using exchange‐traded derivatives, including futures and options. He holds a B.B.A. in finance from Loyola University and a Series 3 (National Commodities Futures Examination) License. He is lifelong Cubs fan still reveling in their long‐awaited 2016 World Series win.
For most agriculture producers, capital is an asset in limited supply. Hedging strategies, such as trading futures and options, require maintaining performance bonds, and these positions can become quite capital intensive. Moreover, longer-term positions can tie up capital for an extended period of time. Even strategies that are less capital intensive require producers to deposit and maintain funds in a brokerage account until the positions are closed out and converted to purchases and sales in the local cash market. That’s why successful, competitive agriculture operations make it a priority to ensure they are using their capital efficiently. With that in mind, we examine how producers can optimize their capital and take these considerations into account as part of their risk management plans.
Consider Your Credit Choices
But regardless of how your credit lines are structured, if you rely on a lender to gain access to the liquidity you need to fund your hedging activities, it is important that both of you understand the impact of those hedges on your net profitability. For example, a dairy operation might be short milk in the futures market, while simultaneously long corn and soybean meal as a way to secure an attractive feeding margin. As a borrower, you should be able to demonstrate to your lender the value of those positions as the market moves, by connecting them to the resulting change in your projected forward margins relative to the open market.
Make the Connection to Hedge Value
We can illustrate this connection by looking at hypothetical scenarios using a capital stress testing tool, such as CIH’s capital monitor. Figure 1 shows a hypothetical dairy that milks 3,200 cows producing 7 million pounds of milk per month. They are projecting and actively managing profit margins for the current spot Q3 period, as well as for deferred marketing periods through Q3 of 2018. About 42%-62% of their risk exposure is currently offset through hedge strategies made up of a combination of futures and options positions. The operation is projecting that these positions will generate an effective profit margin over the next year of $1,583,703. We can subtract the open market margin of $1,532,886 from that net margin to determine the present value of the positions, which is $50,817. In addition, we can see that $217,495 of capital tied up in performance bond requirements.
As the market moves over time, the projected profitability, as well as performance bond requirements, will change. Let’s say milk prices rise 10% across all contracts that are currently hedged. This scenario is illustrated in Figure 2. The net margin increases over $1.1 million to $2,718,658. Since the open market value has also risen, to $3,322,613, we know that the value of the open hedges has dropped by $705,590 and is now -$654,773. At the same time, the performance bond requirement has also increased by $889,355 to $1,106,850.
If prices remain at current levels, the dairy operation will be able to secure margins of $2,718,658 over the following year. Although the hedge positions lose value as milk prices rise, the operation participates in 63% of those increases. This improvement can be seen by measuring the change in the operation’s net margin, which increased by $1,134,955 as the open market margin rose by $1,789,728.
But, of course, price changes can go either way. Figure 3 illustrates the scenario where milk prices go down 10%. In this case, the short milk hedge position gains in value by $853,999, and performance bond requirements also go down, resulting in a $1,027,547 surplus in the brokerage account. However, the net margin deteriorates by $935,728 as 60% of the total projected milk production was unhedged and exposed to the lower prices.
As the market moves, a lot of capital can be tied up in unrealized hedge losses and performance bond requirements. But producers can mitigate the cost of capital while still protecting margins. For example let’s look again at the scenario shown in figure 2 where milk prices increase 10%, and the position became capital intensive. The operation could have purchased call options against some of the upside exposure on the short milk futures.
Figure 4 illustrates this adjustment. Comparing the performance bond requirements and P/L figures to those of Figure 2, we see that while the milk position will still lose money from the higher open market prices, the loss with the calls is smaller than without. $537,820 of negative equity accrues to the adjusted position value compared to the loss of $654,773 without the purchase of the calls. Also, because the purchased call options offset much of the risk on the short futures positions, the added performance bond requirement is significantly smaller: $617,450 versus $889,355.
Consider Alternative Contracts
Some dairies may not be comfortable with the performance bond exposure on hedging positions, or would rather allocate their limited capital elsewhere – such as investing in upgrades to their facilities or expanding their operations. These dairies might want to consider forward contracts with their coops and creameries or swap contracts with a financial intermediary, which might allow them to protect profitable margins without tying up capital. By contracting directly with a counterparty, the dairy doesn’t need to address performance bond requirements to initiate the contracts or maintain capital in an account to address daily settlement procedures as prices fluctuate.
While these contracting methods can free up capital to allocate elsewhere, they are not without other costs and risks. Forward contracts with a milk processor make the dairy captive to that buyer, who may or may not be as competitive with other alternatives in their local market. Swap contracts typically cost more to execute than similar strategies on the exchange through the dairy’s own brokerage account. Also, depending on the intermediary, there might be additional costs or limits on adjustments that can be made to an initial strategy at a later date. Moreover, with either forward contracts or swaps, there is a counterparty risk associated with the single settlement procedure upon delivery or expiration.
Despite their limitations, swaps and forward contracts can be valuable contracting tools, especially when used in conjunction with exchange-traded alternatives to create a more flexible strategy. As an example, a dairy might lock in a sale through a forward contract or swap agreement, and subsequently add price flexibility by purchasing call options in his own brokerage account. In this way, he need allocate only a limited amount of capital to address the opportunity cost of higher prices in a rising market.
Weigh All the Factors
As with any hedging strategy, there’s no one right way to allocate your capital. Determining the best solution for your needs will be a function of your operation’s margins and debt level, as well as a number of other considerations. But being able to quantify the impact of hedges on net forward margins can help facilitate communication with your lender and is a critical part of an effective risk management strategy.
If you have questions or would like more information about how to use your hedging capital most efficiently, please contact CIH at 1.866.299.9333.
There is a risk of loss in futures trading. Past performance is not indicative of future results.