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August 2010 Archive for Know Your Market

RSS By: Dairy Today: Know Your Market, Dairy Today


Competitive Pricing: It’s What Works for You, Not Your Neighbor

Aug 27, 2010

Spainhour PS jpegBy Jon Spainhour, Rice Dairy

One of the toughest issues that dairymen struggle with pertaining to risk management is their fear that they will be leaving money on the table that their neighbor didn’t. 
Many dairymen that we work with answer the following question with fear and hostility: “If you sell you milk at $16.00/cwt. and your neighbor sells it at $16.30/cwt., are you going to be able to live with yourself?” The typical answer is a resounding “Heck, no!”
While this is certainly understandable, as no one likes to feel like someone else got a better deal than they did, whether it’s buying a car or selling their milk, I think that it is an attitude that will soon prove to be damaging to the long-term profitability of dairymen who choose to subscribe to it.
It is my belief that as we move through time, more and more dairymen will begin to focus on what really matters most: their net profit margin. Focusing solely on getting the best price for milk will cause them to miss out on profitable hedging possibilities.
The very same dairyman who sold his milk at $16.00/cwt. may have a completely different cost structure and breakeven levels than the dairyman who sold his milk at $16.50/cwt. Depending on what his fixed and variable costs are, he may actually be making far more money that the dairyman who sold his milk at $16.50/cwt. 
Put another way, the first producer may have a breakeven level of $13.50/cwt. and he sold his milk at $16.00/cwt., representing at $2.50/cwt. profit margin. The second producer may have a breakeven level $14.50/cwt. and sold his milk at $16.50/cwt., representing a profit margin of $2.00/cwt. As you can see, the first producer was better off, although his milk price was lower than the second. 
Most producers will tell us that while they would consider this approach to “margin management,” they have two problems:
1) They don’t know what their breakeven is;
2) They don’t know how to hedge their variable costs. 
My solution to the first problem is to hire an accountant. They should be able to help you pinpoint both your fixed and variable costs and lay it out on a per-hundredweight basis. It may cost a little money to go through the process, but it is an expense well worth the money.
My solution to the second problem is to hire a broker who can help you fix your variable costs like corn and soymeal with futures. Other costs like interest rates, energy prices, hay and alfalfa can be fixed as well. Once you know how to establish these costs on a per-hundredweight basis and know the prices you can lock them in at, you begin looking at hedging your milk price. 
One of the easiest things you can do at this point is to establish breakeven levels, either through fixed priced or option contracts, and then buy Class III milk puts against that level. In this case, you can enter a particular period of milk production knowing that at worst case, you will break even on the year. The best case is that you will do quite a bit better than that if the price of milk rallies. 
Another approach you take after you establish where you can fix your input prices is to sell fixed priced futures contracts, assuming they are at levels that are higher than your input levels. 
In either case, you need to know your breakeven levels, and you need to be able to do that with a reasonable degree of accuracy, not a back of the envelope guesstimate.
Then you need to know how to fix those costs through either physical purchases or longer term purchase agreements. Then you need to make sure that you establish your milk price at the same time. Buying your corn and then waiting to sell your milk could be a risky situation. Do them both together, establish a profit margin, and then get back to doing what you do best: making milk more efficiently than anyone else in the world!

What in the World Will Affect Dairy Input Prices?

Aug 16, 2010

By Steven Schalla, Stewart-Peterson Inc.

While the Class III milk futures have been steady to a little higher with help from cheese and butter prices, the real action in the past two week has been in the grain markets.
It’s always amazing to see how quickly raw emotion can ignite a market –- most evident recently in wheat futures prices. With news of drought and wildfires in Russia and its government placing a ban on exports until the end of 2010, prices in Chicago exploded higher. As memories of the 2008 world wheat drought and subsequent price rally jumped into trader’s heads, they bought as aggressively as possible to capture the potential opportunity. 
Warranted or not, corn, beans and meal prices followed suit, with new crop corn futures climbing back over the $4.00/bu. mark. Even if you were concerned that your feed costs were at risk to turn back higher, it’s not likely that a Russian wheat drought was your reasoning.
Whether you are talking about grain or milk markets, unpredictable situations like this happen and can bring dramatic change to your profitability. This latest situation with grain prices is a textbook example of why Market Scenario Planning is critically important, not only for your milk price but also for your feed, fuel and interest rate inputs. 
In my previous writings, we’ve run through different Market Scenario Planning examples, the latest analyzing the impact of call option re-ownership after establishing forward contracts with the milk plant. The objective of this dynamic planning process is simple: to bring more certainty to an uncertain situation so you can make better decisions.
Regardless of what you think is going to happen with prices, how would an unexpected move affect your overall weighted average price? Doing this analysis helps you make other important decisions, like can I accept the potential results of this pricing strategy? Or, where is the right point to take action? Keep in mind that the factors that go into what is “acceptable” to you may be either financial or emotional, or both.  
Looking at feed corn inputs, there are several different price scenarios that could unfold this fall. From a fundamental standpoint, last Thursday’s USDA Supply and Demand Report estimated 2010-2011 corn carryout at 1.312 billion bushels. While this is a comfortable spot, any cut of supply or increase in demand (or vice versa) would likely cause a quick and sharp response from corn futures. At the same time, influences from outside markets such as the U.S. dollar and crude oil will continue to impact corn and grain prices. 
Our team believes that we’re in for another wild harvest season, with both $6.00 and $3.00 corn futures a real potential, depending on how different scenarios materialize.
Now I’ll be the first to admit that it’s a lot more interesting to try to speculate what will actually happen. It’s fun when you get it right and your decision-making goes well. But when any one of these different factors – or a factor no one expected -- becomes the main driver of corn price, it’s anyone’s guess what type of prices will actually materialize. And, all too often prices move quickly and your best feed buying opportunity is gone, just like that.
That’s where running price scenarios for feed in advance can help you. When you do this, you can be confident that you’re ready for whatever scenario unfolds. Here is a very simplified outline of steps we take to prepare for decision-making in an uncertain environment, using examples that address a concern for corn moving dramatically higher or lower:
1.      Analyze fundamentals and other market factors to develop 3 or 4 of the most likely price scenarios. Example:
a.       Scenario 1--Harvest yields are down along with a weak U.S. dollar, and corn goes to $6.00.
b.      Scenario 2--Corn hovers around the $4.25 mark.
c.       Scenario 3--China reduces buying combined with great harvest yield, and corn drops to $3.00.
2.      What is the net price of my feed inputs in each scenario, considering the following:
a.       What buying and/or hedging strategies and tools will I use in each scenario?
b.      In what time frame am I using these tools?
c.       For how much or what percent of my feed needs?
3.      What price development “signposts” will I use to trigger action? For example:
a.       If corn breaks through $4.50 December futures, then I know Scenario 1 is unfolding.
b.      If corn trades between $4.50 and $3.75, then Scenario 2 is unfolding.
c.       If corn trades below $3.75, then Scenario 3 is unfolding.
With a well-planned strategy and contingency plans, including specific action points as new information and price developments unfold, you are prepared and ready to act whether corn rallies or declines any amount. You’re less likely to lose precious time during a market move because you’re prepared with your strategies and tools. Good preparation avoids that uneasy feeling of what in the world just happened to prices today?
Take some time establish your strategy, and if you not sure where to start, consider talking over your ideas and more specific and detailed scenarios with a trusted professional. In today’s world, it’s worth your time.
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