Those involved in selling milk and dairy products are aware of the risks they face from a potential decline in prices. Market participants such as producers, cooperatives, and dairy food manufacturers, are concerned about the impact that a fall in the price could have on their business, and are constantly seeking ways to mitigate this risk and protect their bottom line.
Fortunately, due to the availability of CME Group Dairy futures and options, there are many strategies that sellers can employ. This module will discuss selling futures as a hedge against falling dairy prices. For the sake of simplicity, the examples will not consider the dairy basis or futures transaction costs.
Assume that it is May, and a dairy farmer is concerned about the potential for milk prices to decline when he sells his milk in November. He wants to hedge a portion of his monthly milk production. The November Class 3 Milk futures price is currently $17 per hundredweight.
The dairy farmer compares November futures price to his expected mailbox price. The mailbox price is the net price received by dairy farmers for milk in a particular month, including all payments received for milk sold, minus the costs associated with marketing the milk.
The farmer reviews the mailbox prices he has received in November over the past five years and decides that $17 per hundredweight will allow his dairy operations to be profitable. He decides to lock in this price by selling, or going short, November Class 3 Milk futures.
Look at what happens to his short futures hedge if Class 3 Milk prices actually do decline.
Assume that in November the dairy farmer’s mailbox check is $15 per hundredweight. This is $2 per hundredweight lower than the farmer was anticipating in May.
However, the $2 gain he makes when he offsets his short futures position by buying November Class 3 Milk futures at $15 will give him a net purchase price of $17.00 per hundredweight, which is the mailbox price of $15 plus the $2 gain on his short futures position.
If the farmer’s mailbox price increases instead, the dairy farmer will still receive a net price of $17 per hundredweight for his milk.
For example, suppose the farmer’s mailbox price increases to $19 per hundredweight in November. This is $2 higher than the farmer anticipated back in May.
However, he offsets his short futures position by buying November Class 3 Milk futures at $19 per hundredweight, for a $2 loss. So even though he could sell his milk at a higher price, the farmer still receives a net sell price of $17 per hundredweight.
Under this scenario—where hedging with futures provided protection against falling milk prices, but did not allow him to take advantage of a higher price—it may appear on the surface that hedging was a losing proposition for the dairy farmer.
However, remember his original goal at the beginning of this process: to lock in a price of $17 per hundredweight for his milk. By hedging with futures, he could accomplish what he intended when making the decision to hedge. Relinquishing the chance at a higher price in exchange for securing price protection, knowing that the price could just as easily have declined, is a trade-off that a futures hedger is willing to make.
No one can predict the future, but hedgers can take steps to manage it. Selling dairy futures allows those who need protection against falling prices to acquire the peace of mind of knowing that they took steps to manage the risk involved in selling milk and dairy products for their business.