Fluid Milk: A Better Hedge

  • 26 Aug 2019
  • By Matthew Gould and Marin Bozic
  • Topics: Agriculture

Most of the packaged milk manufactured in the USA is under the jurisdiction of federally regulated milk marketing orders which dictate minimum prices paid by fluid milk manufacturers each month for raw milk including the minimum price of milkfat and skim milk. There are 11 Federal Milk Market Orders in the USA which cover approximately 92% of total fluid milk sales.1

On 20 December 2018, the Agriculture Improvement Act of 2018 (Farm Bill) was enacted which included changes to the pricing formula for the skim milk portion of milk costs regulated by Federal Milk Marketing Orders.

Before this amendment, the base Class I skim milk price was calculated each month as the higher of the advanced pricing factors for Class III and Class IV skim milk.

Under the newly amended pricing formula, the base class I skim milk is the simple average of the monthly advanced pricing factors for Class III and Class IV skim milk, plus $0.74 per cwt.2

The first Class I milk price calculated by the new formula was the May 2019 advanced skim milk price which was announced on 17 April 2019.3

Prior to May 2019: Advanced Skim Milk Price = MAX(Advanced Class III Skim Milk Price, Advanced Class IV Skim Milk Price)

NEW: Base Advanced Skim Milk Price = Average(Advanced Class III Skim Milk Price, Advanced Class IV Skim Milk Price) + $0.74

Prior to May 2019: Base Class I Milk Price =0.965 *MAX(Class III Skim Milk Pricing Factor, Class IV Skim Milk Pricing Factor) + 3.5 * Advanced Butterfat Pricing Factor

NEW: Base Class I Milk Price = 0.965 * ((Advanced Class III Skim Milk Price + Advanced Class IV Skim Milk Price)/2 + $0.74) + 3.5 * Advanced Butterfat Pricing Factor

Why change the Class I milk pricing formula?

The industry desired to more effectively, and simply, manage Class I milk price risk using existing futures contracts. The stated industry objectives for the price change were as follows:4

  • Balance processor desire for better price risk hedging with cooperative and dairy producer desire to maintain the integrity of Federal Milk Marketing Orders.
  • Eliminate the uncertain basis that occurs when the Class I mover shifts between Class III and Class IV.
  • Facilitate the use of existing Class III and Class IV futures and options to manage Class I price risk with minimal changes to the Federal Milk Marketing Order system.
  • Provide several benefits that can result from the ability to hedge longer-term costs for fluid milk products.
  • Help processors to manage price risk for dairy beverage ingredients, as they currently can for non-dairy ingredients.
  • Help dairy producers to effectively hedge the Class I portion of their producer milk payments, as they currently can for the other portion of their payments.
  • Encourage and promote the use of dairy ingredients in new fluid milk and dairy-based beverages that meet Class I specifications.

Hedging the previous Class I skim milk pricing formula proved too unwieldly for many Class I manufacturers5

Under the previous formula, the “higher of” factor meant either of the two advanced milk prices —Class III or Class IV— could end up driving the Class I skim milk price each month.

A minority of organizations with Class I price exposure chose to hedge by using the highest-priced futures contract –Class III or Class IV – and accepted the basis risk. By the time USDA announced the Class I price, the driver of milk costs may have changed. If so, the hedge under-performed. For many Class I hedgers, the strategy of using futures failed to adequately reduce price risk.

Another small number of hedgers chose to hedge Class I milk exposure by utilizing futures and options. These participants would hedge with the higher-priced futures contract and also pay the premium for an option on the other futures contract. While the strategy was effective at reducing price risk, for many fluid milk buyers it was also cost-prohibitive.

Lastly, a few manufacturers and end-users utilized the OTC markets to hedge Class I price risk. But risk premiums in these markets tended to be prohibitively expensive. In 2018, just 26 million lbs of the 44 billion lbs (0.0006%) of packaged milk produced were hedged using OTC Class I milk contracts.6

In summary, with the previous Class I formula in place, basis risk was often too high or too expensive to mitigate.

The newly reformed Class I skim milk formula dramatically improves the effectiveness of hedging Class I price risk with already available futures contracts.

The newly reformed skim milk pricing formula is the average of the advanced Class III and Class IV skim milk pricing factors plus $0.74/cwt. That means that each of the advanced Class III and Class IV skim milk prices have equal, and stable, contributions to the updated pricing formula.

Under the newly reformed pricing system, basis is greatly reduced, but not eliminated.

Basis risk remains because the Class I milk price is calculated from two weeks of price surveys while CME futures contracts settle to announced prices that include data from those same two weeks but also data from another two or three weeks for a total of four or five weeks of survey pricing data.

The basis between advanced and announced-equivalent Class I milk prices averaged $0.01/cwt over the last 15 years; 61% of the time the difference has been $0.03/cwt or less; 80% of the time, $0.11/cwt or less.8

Will the new formula raise the price of Class I milk?

The new pricing formula was designed to produce similar historical values as the previous “higher of” formula.10 Industry lobbyists first proposed the new pricing formula in October 2017. At that time, the “higher of” advanced skim milk pricing formula had exceeded the simple average of advanced Class III and Class IV prices by between $0.73/cwt and $0.75/cwt over 5-year, 10-year and 15-year timeframes. This was the rationale behind the formula being the average of the advanced Class III and IV skim milk prices plus $0.74/cwt.



Will more farmers hedge their Class I milk exposure?

Dairy farmers in regions of the USA with high Class I utilizations are believed to have used CME futures and options at lower rates compared to parts of the country with the lowest levels of Class I utilization.13

This is partially because of the basis risk and complexity involved with hedging Class I milk pricing under the previous formula.14 The previous formula made forecasting hedging error difficult. For farmers located in high Class I utilization states like Florida, Class I milk prices represent more than 70% of milk check values for most months and, up until now, the price risk was too challenging to manage.15

With the new formula in place, more dairy farmers are likely to better understand and hedge their milk revenue risk associated with Class I prices, especially in the Southeastern United States.

Mechanics of hedging Class I milk price risk under the new pricing formula

Choosing the right contract month

Class I milk prices are announced during the prior month. For example, the May 2019 base Class I milk price was announced in April 2019. The futures contract month with the lowest amount of basis risk will be the one settling in the same month as the date of the Class I price announcement. In other words, a hedger would use April futures to hedge May milk.

Choosing the right futures contracts

The CME offers six different futures contracts which can be used to hedge price risk for Class I milkfat and Class I skim milk: Announced Class III, Class IV, Cheese, Dry Whey, Nonfat Dry Milk and Butter futures.

For hedging base Class I milk with components equal to 3.5% milkfat and 96.5% skim milk, the hedging strategy with the lowest amount of basis risk will utilize 50% Class III futures contracts and 50% Class IV futures contracts. Both futures contracts are for milk with the same components, 3.5% fat and 96.5% skim milk.

The Class III and Class IV futures contracts are for 200,000 lbs of milk meaning Class I milk would be fully hedged in increments of 400,000 lbs.

For Class I price exposures that are markedly different from increments of 400,000 lbs of milk, or with different components than 3.5% milkfat and 96.5% skim milk, hedgers may consider two different hedging strategies:

Strategy 1: Hedging skim milk price exposure with equal amounts of Class III and Class IV futures; hedging remaining net milkfat exposure with appropriate number of butter futures.

Below is an example for hedging 10 million lbs of milk with 2.0% milkfat (200,000 lbs) and 98% skim milk (9,800,000) using Class III, Class IV, and Butter futures.

Class III and Class IV futures contract sizes are 200,000 lbs of milk with components equal to 3.5% milkfat and 96.5% skim milk. Therefore, each futures contract covers 193,000 lbs of skim milk and 7,000 lbs of milkfat.

Out of 9,800,000 lbs of skim milk, 50% (4,900,000 lbs) would be hedged using Class III futures, and the same amount would be hedged with Class IV. It will take about 25 contracts of Class III futures and 25 contracts of Class IV futures to fully hedge the Class I skim milk price exposure.  

The original milkfat exposure totaled 200,000 lbs. However, each Class III and IV contract hedge 7,000 lbs of milkfat – the total of 50 contracts hedges 350,000 lbs of milkfat. The hedger originally had 200,00 lbs of milkfat exposure and has over-hedged and will need to offset that price risk with an opposite position in butter futures.

The original milkfat exposure of 200,000 lbs was over-hedged by 150,000 lbs. Each butter futures contract covers about 16,515.28 lbs of milkfat. which means to offset the exposure, the hedger will need to enter into a short position of about 9 butter futures contracts.16

Strategy 2:  Hedge 10 million lbs of Class I with components equal to 2% milkfat and 98% skim milk by utilizing futures contracts for cheese, butter, nonfat dry milk and dry whey.

Below is an example for 10 million lbs of milk with 2.0% milkfat (200,000 lbs) and 98% skim milk (9,800,000).

Out of 9,800,000 lbs of skim milk, 4,900,000 lbs would be hedged using Class III commodities (Cheese, Dry Whey and Butter), and the same amount would be hedged with Nonfat Dry Milk, which drives the advanced Class IV milk pricing factor.

Per Federal Milk Marketing Order pricing formulas, there are nine pounds of nonfat solids in 100 lbs of skim milk. Thus, in 4,900,000 million lbs of skim milk there are 441,000 lbs of nonfat solids.

Per FMMO pricing formulas, manufacturing yield for nonfat dry milk is 0.99, i.e. 100 lbs of nonfat solids yields 99 lbs of nonfat dry milk. Multiplying 441,000 lbs by 0.99 we get 436,590.00 lbs of nonfat dry milk.17

Since the NFDM futures contract size is 44,000 lbs, it takes about 10 contracts to fully cover the price exposure to the Class IV skim milk pricing factor. In similar fashion, using FMMO pricing formulas, we find the following hedging profile:

Execution of trades & legging risk.

Each hedge for Class I products will require the utilization of multiple futures contracts. In the simplest example of using just Class III and Class IV futures contracts, a hedger will need to execute trades for two separate contracts at the same time.

However, dairy markets can, at times, be illiquid. This is especially relevant for Class IV futures contracts which currently trade less frequently and at wider bid-ask spreads than Class III futures contracts. There is a very real risk that one side of a two-part hedge is filled or that the hedge occurs at worse-than-expected prices. This is called legging risk.

To minimize legging risk, hedgers will need to work closely with their brokers to identify appropriate strategies. For example, at times it may make sense to work orders for Class IV futures contracts and as those orders trade, the broker will then trade the second leg of the hedge in the more-liquid Class III futures.

For product-based hedges that utilize cheese, butter, nonfat dry milk, and dry whey contracts, the legging risk is higher given the complexity of four separate commodities that need to trade simultaneously.

Beginning in June 2019, CME began offering the ability to simultaneously buy or sell Class III and IV options electronically, which reduces the legging risk for options-based strategies.

Hedging Horizons

Dairy processors who desire to stabilize their expenses should consider hedging using more distant contracts.

The chart below compares the standard deviation of unhedged Class I milk prices to the net price of milk hedged in 30-day intervals from 30 to 360 days.

For milk prices hedged 270 days in advance of expiration, the standard deviation equaled $1.82/cwt under the old formula and $1.42/cwt under the new formula. In other words, hedging 270 days in advance reduced price risk by 36% (old formula) and 48% (new formula), respectively.

The reason distant horizons work better for reducing Class I price oscillations is because price shocks in the dairy sector tend to last 5-9 months.19 Having a short hedging horizon will expose milk buyers to higher prices as futures prices will have already increased by the time they attempt to open the hedging position.

References

  1. Based on fluid milk sales in Federal Milk Marketing Orders and USDA estimated fluid milk sales November 2018 – April 2019
  2. https://www.federalregister.gov/documents/2019/03/11/2019-04347/federal-milk-marketing-orders-amending-the-class-i-skim-milk-price-formula
  3. https://www.federalregister.gov/documents/2019/03/11/2019-04347/federal-milk-marketing-orders-amending-the-class-i-skim-milk-price-formula
  4. https://www.idfa.org/docs/default-source/d-news/nmpf-idfa-dairy-risk-management-agreement.pdf
  5. Newton, J. and C. Thraen. 2012. “Road Block to Risk Management – How Federal Milk Pricing Provisions Complicate Class 1 Cross-Hedging Incentives.” Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management. St. Louis, MO.
  6. USDA Fluid Milk Sales Estimates, OTC data from Rice Dairy, LLC
  7. Comparison between USDA Announced Prices which CME Futures Settle To and USDA Advanced Prices
  8. Analysis of USDA data in period beginning January 2000 and ending April 2019
  9. Analysis of USDA data February 2000 through April 2019
  10. https://www.idfa.org/docs/default-source/d-news/nmpf-idfa-dairy-risk-management-agreement.pdf
  11. Analysis of USDA Announced vs. Advanced Class I Skim Milk Prices under previous and reformed formula
  12. Analysis of USDA data February 2000 to April 2019
  13. Based on conversations with CME futures brokers
  14. Newton, J. and C. Thraen. 2012. “Road Block to Risk Management – How Federal Milk Pricing Provisions Complicate Class 1 Cross-Hedging Incentives.” Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management. St. Louis, MO.
  15. 2018 Receipts from Federal Milk Marketing Order 06
  16. BOZIC, M.; FORTENBERY, T. R. 2012. Creating Synthetic Cheese Futures: A Method for Matching Cash and Futures Prices in Dairy. Journal of Agribusiness, vol. 30, no. 2, 185–199.
  17. BOZIC, M.; FORTENBERY, T. R. 2012. Creating Synthetic Cheese Futures: A Method for Matching Cash and Futures Prices in Dairy. Journal of Agribusiness, vol. 30, no. 2, 185–199.
  18. BOZIC, M.; FORTENBERY, T. R. 2012. Creating Synthetic Cheese Futures: A Method for Matching Cash and Futures Prices in Dairy. Journal of Agribusiness, vol. 30, no. 2, 185–199.
  19. Bozic, M., J. Newton, C.S. Thraen, and B.W. Gould. 2012. “Mean-reversion in Income over Feed Cost Margins: Evidence and Implications for Managing Margin Risk by U.S. Dairy Producers.” Journal of Dairy Science 95(12): 7417-7428
  20. The Net Milk Price equals the Base Class I Milk Price calculated using the old and new Class I formulas plus any gains or losses from hedging. Gains and losses from hedging are the difference between CME futures settlement prices on the day of hedging and USDA announced prices at futures contract expiration. The reduction in volatility is measured as the percentage difference between the standard deviation of unhedged Class I Milk Prices between January 2010 and April 2019 and the standard deviation of Net Milk Prices which include estimated cash flows from hedging activities. The standard deviation of unhedged milk prices was $2.83/cwt as calculated by the old formula and $2.75/cwt as calculated with the new formula.