When is a milk price a “good” milk price?
Dairy producers have difficulty determining whether a future milk price is a “good” milk price when forward pricing milk.
December 22, 2011 - Author: Craig Thomas, Michigan State University Extension
One of the most difficult decisions dairy producers face is whether or not current milk futures prices are “good” prices. The first problem is: What is a definition of “good.” Frankly, producers look at a “good” price as one that is “high.” So that naturally brings on another question: What is a “high” milk price? That usually brings on another question: Is the price “high” enough to be profitable? This is starting to get us closer to the essence of the question, but determining a price at which to forward price milk is obviously a dizzying process! However, by following a few simple principles I think it is relatively easy to determine if a future milk price is a “good” milk price. The dairy producer should take six items into consideration:
1) What is my cost of production? A dairy producer trying to price milk without knowing his/her cost of production is like a cross country traveler attempting their long trip blindfolded and without a map. Such a traveler would only successfully reach his destination by blind luck. The same is true for the dairy producer who does not know their cost of production. Every dairy producer should calculate their cost of producing milk at least quarterly. You cannot properly judge a future milk price until you know whether or not it is profitable. Many good tools are available for this purpose. I have a simple Microsoft Excel® cost of production spreadsheet that uses income tax Schedule F information. To obtain a copy, just contact me (firstname.lastname@example.org). By calculating your cost of production you will know your breakeven milk price which is always your starting point when making milk marketing decisions.
2) What are my marketing goals? Many dairy producers expect to hit a home run every time they forward price milk. That is not the goal of marketing! Is it possible to hit a home run once in a while? Yes! But, unfortunately, most home run hitters also strike out a lot. Remember, the goal of milk marketing is to control milk price risk. A good marketer may end up with the same average milk price as the producer who does not forward price milk. But, the good marketer will take some variation out of milk prices. For example, let’s say the average mailbox price for the year was $18/cwt. How would you prefer to receive that price? Look at the table below. Which would you rather receive: Scenario A or Scenario B? Both give you an average annual milk price of $18/cwt, but scenario B will result in some very tight cash flows in at least three months. Never forget that milk marketing’s primary goal is to reduce milk price risk and “smooth out” the milk price. Profit enhancement is, at best, a secondary goal. Practice moderation in your milk marketing by not trying to hit a home run each time you forward price milk. There are a precious few times when the market will offer an opportunity to hit a home run, but those times are the exception rather than the rule.
3) Be aware of price “anchoring.” Price “anchoring” is quite common among people who follow any market. Whether prices are low, high, or somewhere in the middle; people usually become psychologically anchored to the level of current prices. If prices are high, producers often wait to forward price milk and then when prices begin dropping they are still psychologically anchored to the higher prices and wait too long to forward price their milk. The same is true on the other end of the scale. When prices are low and begin rising, producers are psychologically anchored to the lower prices and wait too long before forward pricing milk and miss out on the higher prices. The result is that many producers become so wary they can never make a pricing decision. Make your first criteria be the relationship between what the current futures market is offering in comparison with your cost of production. Don’t be afraid of forward pricing a portion of your milk if it is profitable even if you believe the market is going higher. Remember, the goal is to control risk, remain profitable, and keep your business operating.
4) Know your historical milk prices. Current futures prices need to be put in the context of historical prices. The best way to accomplish this is by using a cumulative probability chart of historical Class III prices since most milk pricing tools (futures, options, forward contracts) are based on Class III prices. Figure 1 shows a cumulative probability chart for historical Class III prices. The horizontal axis is the price per hundredweight and the vertical axis is cumulative probability. The chart is easy to read. At any point along the red line draw a straight line down to the horizontal axis to determine the milk price and another straight line over to the vertical axis to determine the cumulative probability. For the current 2012 Chicago Mercantile Exchange Class III futures price average (12/19/11) of $17.10/cwt we find that $17.10 falls at the 88th percentile. This means that from 1995-present only 12% of the monthly settled Class III prices were above $17.10/cwt. Thus, from a historical perspective $17.10/cwt is an excellent price. Some have questioned including prices going all the way back to 1995. However, of the 17 annual average Class III prices from 1995-2011, of the ten lowest annual averages, six of those have occurred since 2000, and the second lowest was as recent as 2009.
Figure 1: Cumulative probability graph of USDA announced monthly BFP/Class III prices (1995-present) and current CME Class III futures averages.
5) Know your dairy market fundamentals. Dairy market fundamentals refer to knowing what is currently happening in the dairy industry as it concerns national milk production, cow numbers, cull rate, dairy product consumption and inventories, dairy product export and import markets, consumer confidence, feed costs, overall economic environment, etc. Every month I compile a Dairy Market Update that discusses these factors and ties them together to give a coherent outlook of the current market. Basically you are trying to make two simple assessments: 1) Do the current market fundamentals support stronger, weaker, or the same milk prices in the future? And, 2) How strong is this support? It is an imperfect science since it is impossible to predict the future. But it remains an important tool to give producers some level of confidence in making futures pricing decisions.
6) Develop a written marketing plan. Most producers have great difficulty in making a forward pricing decision because they don’t develop a written marketing plan. A written marketing plan takes several factors into consideration. First, a producer should know his/her “breakeven milk prices.” There are three important breakeven prices: 1) The milk price needed to cover variable cash costs. 2) The milk price needed to pay variable cash costs and debt payments. And, 3) The milk price needed to pay variable cash costs, debt payments, family living expenses and an acceptable profit. The first price will keep in business in the short term and the second will keep you in business in the long term. The third makes it worthwhile to go to the barn every morning. Second, a written plan should take into account your farm’s degree of financial risk. The more debt you have the greater your financial risk. As your financial risk increases it should be reflected by a more conservative marketing plan that is willing to forward price increased amounts of milk as long as doing so insures you meet your debt obligations. Third, a written plan should have various milk price levels at which you have determined you are willing to sell predetermined amount of milk. By making this roadmap ahead of time you can avoid a lot of the emotional problems associated with actually “pulling the trigger” and making a forward pricing decision. It is recommended that these pricing levels reflect a consensus of all the individuals on your farm that have a major financial stake in the business. Fourth, a written plan should be flexible. Even though you write down your plan, revisit it often and revise it as milk prices and market fundamentals change.
I don’t believe milk marketing using forward pricing tools is for everyone. To be a successful milk marketer you must make a commitment to follow these six factors. If you are not willing to make such a commitment then you will not be a successful marketer. That decision is yours to make and your decision to not market milk using forward pricing tools should not be judged by others. However, if you do make the commitment and follow these six factors it will be worth the effort.