ROANOKE, Va. — Introduced as being from the “great dairy state of Staten Island,” Katie Krupa discussed the basics of dairy risk management with producers and feed suppliers at the Virginia State Feed Association’s 67th annual Feed Convention and Cow College held in Roanoke, Va.
Producers who weathered the 2009 dairy markets understand the importance of risk management but may not be sure where to start. Krupa, who got her degrees in dairy science from Virginia Tech, started her career on the co-op side of the industry passing on information to farmers. Frustrated with not being able to give her opinion and watching dairy farmers “get stuck with their feet in the sand,” Krupa moved on to Rice Dairy, LLC, a boutique brokerage firm specializing in dairy where she serves as director of producer services.
Krupa emphasized the importance of designing a specific risk management program for individual farms.
“Risk management is for everyone. Futures and options trading is not for everyone,” Krupa said. “Every farm is different, every strategy is different. Farm financials are different, cows are different, people are different.”
For some farmers it may be enough to have a strong equity position or a good relationship with their financial institution. That is their risk management strategy.
“You actually have to put the math to it and know that you can do it,” cautioned Krupa.
For producers who either can’t or don’t want to simply take the chance, Krupa outlined three basic strategies: fixing the price, fixing the downside or setting a window. For all the options it’s essential to look at the margin between milk price and feed costs.
“I don’t look at milk price. It means nothing to me. A $10 milk price or $20 milk price doesn’t mean anything unless you put the feed cost to it. I look at a milk feed margin,” Krupa said.
For producers who want to set their price, futures and options may be a good strategy, but as with anything there are risks. Contract sizes are 200,000 pounds of milk per month so for many producers, it’s more attractive to work within a co-op. That allows producers to do as little as 20,000 to 30,000 pounds per month. Futures and options can be bought as far as 24 months in advance and as a single month or series of months.
“Futures — it’s fixing your price. It’s kind of like that old infomercial you set it and forget it,” said Krupa. “You’re fixing your price. You’re getting nothing less and nothing more.”
For farmers with a low equity position it can mean stability, but for other farmers losing out on the potential upside is a chance they are unwilling to take. There is also a cash outlay associated with futures. Accounts need to be funded at around $2,000 per contract per month for the initial margin. For a six-month contract that means $12,000 and if prices move up producers are required to add more money to the account.
The put option offers another choice for farmers who want more of a chance to recover the benefit of a higher market and who don’t want to have to put as much money in up front. The Put Option protects the price and functions like insurance. Producers pay a flat fee or premium in exchange for a level of protection. For example to protect the price at $17 producers might pay 40 cents per hundredweight. That would ensure them a price of $16.60 but would allow them to reap the benefits if the price goes to $19. But like insurance, producers pay the premium and don’t recover that money.
“You pay 40 cents up front and you never have to think about it,” said Krupa. “Do you want to use your car insurance, your health insurance, your life insurance — no. This is the same; you don’t want to use it.”
In order to offset the premium, a producer could choose to buy a put option and sell a call. If a producer buys a put at $17 for 40 cents, he is protected at $16.60. To recoup the 40 cent difference, he could choose to sell a Call at $20. That would set the floor of his milk price at $17 and the ceiling at $20. He would miss out on anything above $20 but it could theoretically cost him nothing for that window of stability. It does, however, require the producer to fund the account and if the market moves up, to add funds.
“If you’re hedging your milk you want to make sure you’re doing something about your feed,” warned Krupa. “Don’t do one without the other because if they start moving opposite from each other you’re not helping yourself. You’re putting yourself in a worse situation.”