With dairies' feed expenses reaching 70% of milk's cost structure, learn how other industries have long dealt with these input dynamics.
By Will Babler, Principal, Atten Babler Commodities, LLC
Milk Cost Structure
The value or price of milk can be considered to be equal to the sum of fixed costs, labor, feed costs and other non-commodity variable costs. In good years for dairy producers, a profit margin can also be included in the sum. In the past feed costs usually ranged from 25% to 50% of the price of milk. During that time, the cost of producing milk was dominated by fixed costs and, to a lesser extent, non-commodity variable costs and profits.
Source: USDA, Atten Babler Commodities
In recent years, the dominant portion of the cost structure has shifted dramatically away from fixed costs toward feed costs, which are now more than 70% of the price of milk. This shift has occurred as increases in feed costs have not been equally met with a corresponding increase in milk price. This change suggests that many dairy producers, particularly those without vertical integration on feed, now have economics similar to other traditional commodity processors.
Commodity Processor Examples
With over 70% of milk price made up of commodity feed costs, the dairy industry is entering the territory of other commodity processors. Consider the following examples from the ethanol and petroleum industries. These simplified calculations use primary commodities and representative conversion ratios and ignore cash market basis. In each case, the input commodities represent around 80% of the final product value.
Input Commodity Value Divided by Output Commodity Value
(Calculated using the average of nearby futures June 2011 through June 2012)
• Ethanol Producer: (Corn + Natural Gas) / (Ethanol + DDGS) = 83%
• Crude Oil Refiner: Crude Oil / (Heating Oil + Gasoline) = 80%
Considering the recent trend of dairy production moving toward processing economics, it is worth examining the risks faced by processors and the hedging practices they utilize.
Commodity Processor Risks
Commodity processors are heavily exposed to market risks, since commodity prices dictate such a large portion of total costs and all of the final product value. Often processors operate in narrow margin environment where price volatility can quickly eat into profits. If inputs and output pricing become un-correlated, this risk can be amplified.
Commodity Processor Hedging Strategies
Processors utilize two primary hedging strategies in tandem to mitigate their commodity price risk. For the purpose of this article, we will define these strategies as merchandising and crush hedging.
Merchandising is simply managing the physical inflows and outflows of commodities, such that inventory is maintained at a floating price. Consider the example of a dairy that buys all of its corn needs at one point during the year. This creates an inventory position which, since it is a long fixed-price position, protects against higher prices. At the same time, this inventory position also presents a significant opportunity cost if prices fall. A merchandiser mitigates this risk by holding a short hedge position, either short futures or long puts, to financially offset the declining value of inventory in a falling market.
Once the processor has ensured that it has mitigated the risk of inventory values being exposed to market price swings, it next looks to manage its crush margins. The crush margin is the spread between the output commodities and input commodities. As price volatility unfolds for each individual input and output commodity, the crush margin, or profit margin, can vary significantly. When crush margins move to favorable levels, the processor will utilize futures or options to lock in both input and output prices to secure the favorable profit margin.
Lessons for the Dairy Industry
One important characteristic of traditional commodity processing industries is a relatively high level of correlation between input and output prices. While feed costs as a proportion of milk price have become very high, the correlation between feed and milk has been very unstable and is not as high as in most processing industries. While this presents a measure of additional risk for dairies, many aspects of the processor hedging approach should still be considered.
In the current environment, dairies would be well served by cautiously managing inventory risk on feed. They should also be disciplined in simultaneously covering feed each time milk is sold at a fixed priced or hedged with a strategy that includes a short call. Producers should also seek to opportunistically lock in favorable crush margins if and when volatility presents a profitable opportunity.
Given the nuances of the dairy market, it is recommended that producers consider the general themes laid out here for commodity processors and modify the approach by utilizing option hedging tools in order to increase flexibility. While there is no guarantee that the current trend toward a processing environment will persist, it certainly points to a need for an increased focus on risk management and the value of learning from other industries that have dealt with these dynamics for many years.
Will Babler is a principal at Atten Babler Commodities LLC. Contact him at (815) 777-1129 or Wbabler@attenbabler.com. Learn more about Atten Babler Risk Management.
Risk in purchasing options is the option premium paid plus commissions and fees. Selling futures and/or options leaves you vulnerable to unlimited risk. Transaction cost used throughout this report includes both commissions and fees. Atten Babler Commodities LLC uses sources that they believe to be reliable, but they cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. Unless otherwise stated the information contained herein is meant for educational purposes only and is not a solicitation to buy futures or options.