May 21, 2018

Will History Repeat Itself?

 |  By: Robin Schmahl

Class III futures have shown nearly steady price increases since mid-March with most contracts about $1.00 higher. This certainly has improved the outlook for milk prices for the year, but for some it is too little, too late. Dairy farms have been going out of business at an increased pace. For some, poor finances make difficult to continue. For some, it is a matter of having nowhere to go with their milk due to a plant dropping them as a patron. For others, it is a matter of just becoming sick of working hard and dealing with the challenges associated with the business.

The Margin Protection Program (MPP) will provide some benefit for those who can take advantage of it. We already know there are payments for February of $1.12 per cwt and March at $1.23 per cwt if the $8.00 level is chosen. However, this may pencil out well for smaller farms producing 5 million pounds of milk or less during the year, but for those large dairies that produce significantly more than that level, it does not pencil out due to the minimum amount that must be covered and the cost of the program at the $8.00 level over the 5 million pound level.

Certainly, MPP will provide some much needed income for some and the steadily increasing milk prices as shown by futures contracts does provide a brighter future. However, caution must always be exercised.

Buyers of cheese and butter have been purchasing earlier in the attempt to gain ownership of supply ahead of the usual time in case milk production will decrease due to declining farm numbers. This has increased buyer aggressiveness since mid-March and continues through spring flush. Strengthening milk prices during the highest volume time of the year does increase the potential for stronger milk prices as we move through the summer.

However, this is not an unusual phenomenon. This same pattern took place last year only at a slightly different time. Milk futures in 2017 began increasing in price around mid-April and increased around $1.50 by the end of May. Once buyers felt they had forward purchased sufficient supply, they moved to purchasing on an as-needed basis which resulted in prices falling around $1.80 depending on the contract. Due to the similar pattern of buying and the similar price pattern, one must be cautious as prices generally decline faster than they increase.

There are differences this year that can keep a similar pattern from taking place and we certainly hope this will be the case. The month of March showed record exports of dairy products. Milk production is slowing as reported on the April Milk Production report with production increasing 0.6%, the lowest so far this year. Cow numbers have declined from the previous month for two consecutive months and domestic demand remains strong. This may prevent a similar pattern as last year from unfolding. However, most milk plants are running at capacity and then some with the Northeast Federal Order have been granted the permission to dump milk through July 1st due to an oversupply of milk.

I am recommending to initiate three-way option spreads at current prices to provide downside protection as well as level the upside open to some extent. Establish theses spreads by purchasing put options near where the market is trading. Selling puts options $1.50 below that level and then sell call options $2.00 above that level. This allows for the ability to protect price up to $1.50 lower and to take advantage of price $2.00 higher if the market were to increase. The recommending cost of this spread position is 40 cents. Do not be one who watches the market go up waiting for a higher price to hedge and then ends up watching it go back down again without having anything hedged. Even though milk prices were not very good last year, each contract had two opportunities to protect milk prices nearly $2.00 above where they ended when looking at the historical price charts. This may be one of those opportunities this year.

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