The futures markets for dairy products indicate the prices for those commodities that are discovered through buying and selling at the exchange, representing the culmination of the forces of supply and demand.
Cash prices and futures prices tend to move up and down together, which is what makes the concept of hedging possible. But dairy producers and buyers are aware that the cash price in their own local area usually differs from the price that is quoted in the futures market; that difference is referred to as the basis.
The dairy basis is different from the basis for other agricultural commodities, such as grains, oilseeds and livestock. But, as with these other commodities, it is one of the most important factors impacting the result of a hedge strategy.
This lesson will discuss the dairy basis and its impact on dairy hedging strategies. An understanding of the basis is important because it can help you determine:
The foundation of the dairy basis is the Milk Check that every dairy producer receives at the end of each month. The Milk Check includes details that outline how the components of the milk the producer shipped for the month, butterfat, protein and other solids, compares to the standardized levels of these components for which the producer is paid.
The standardized levels are:
If the milk the producer shipped contained higher levels of these components, the producer’s Milk Check will reflect a premium; if his milk contains lower levels, then he will receive less.
The gross monthly price that the producer receives for his milk is known as the mailbox price. The Dairy basis is the difference between the producer’s mailbox price and the Class III Milk futures price.
Producers typically sell more than one class of milk, Classes I, II, III and IV. For the sake of simplicity, the Class III Milk futures price is used to calculate the basis.
Class III Milk futures are cash-settled to the value of the USDA’s announced Class III price each month; so, in a perfect world, there would be no dairy basis.
However, since dairy producers sell a blend of milk, which is reflected in their mailbox price, the basis is typically not zero. It reflects the correlation of the producer’s mailbox price to the Class III Milk futures price. The better the correlation, the more effective their hedging strategy will be.
The basis can be either positive or negative. A negative basis referred to as being under. In other words, the mailbox price is less than the Class III Milk futures price. A positive basis is referred to as being over, that is, the mailbox price is more than the Class III Milk futures price.
Negative basis = mailbox < futures
Positive basis = mailbox > futures
Suppose the Class III Milk futures price is $16 per hundredweight. If the mailbox price is $15.90 per hundredweight, the basis would be 10 cents under. If the mailbox price is $16.20 per hundredweight, the basis would be 20 cents over.
Since there are many futures contract months for each Dairy futures contract, the one you use will depend on whether you are calculating a current basis, or a deferred basis.
If calculating the current basis, you should use today’s cash market price minus the nearby futures price.
If calculating the deferred basis, you would use a forward cash market price minus the price of the futures contract month that is closest to, but not before, the time period when you plan to complete the cash transaction.
Any change in one market’s price relative to a change in the other will cause a change in the basis. One of the key considerations in evaluating the basis is its potential to strengthen or weaken. The more positive, or less negative, the basis becomes, the stronger it is. In contrast, the more negative, or less positive, the basis becomes, the weaker it is.
The basis will strengthen if the cash market price increases relative to the futures price. This will happen if the cash price increases by an amount greater than the futures price, or declines by an amount that is less than the decline in the futures price.
Suppose the cash market price for cheese is $1.55 per pound and the Cheese futures price is $1.75, This gives cheese a basis of 20 under: the cash price minus the futures price.
But if the cash price for cheese increases relative to the futures price, for instance, if the cash price increases to $1.65 and the futures price increases to $1.80, the cheese basis will strengthen to 15 under.
The cheese basis will also strengthen to 15 under if the cash price drops to $1.50 and the futures declines to $1.65.
A strengthening basis benefits a short hedger because it will increase the selling price. A basis that becomes weaker, or more negative, decreases the selling price. As you might expect, this means that long hedgers benefit from a weakening basis since it will give them lower expected purchase price.
As you can see, the behavior of the basis in the dairy markets can have a significant impact on the performance of a hedge. By hedging with futures, buyers and sellers are essentially reducing their price risk by assuming basis risk. Therefore, it is important that hedgers maintain historical basis records in order to compare the current basis with expected basis at the time of the ultimate purchase or sell.