In a presentation to the NZX Dairy Derivatives seminar in Singapore, Fletcher, a broker and research analyst for Rice Dairy, examined the products dairy farmers had available for managing milk price risk in the three largest dairy exporting regions, NZ, the European Union and the United States.
Risk could be managed in many different ways. Forward contracting was one form of risk management where the processor and the farmer had an agreement on volume and price.
Another way risk could be managed was to physically store product and buy/sell at a time when the price was attractive.
“Obviously this can’t be done for milk as it is a perishable product but farmers can buy feed in advance to reduce the risk of having to buy product when prices are high,” Fletcher said.
Other ways risk could be managed were by using derivatives products such as futures or options or insurance products.
The US led the way in terms of the selection of risk management tools available to farmers. US farmers could insure they received a minimum margin between the milk and feed prices.
Many US dairy companies also offered a range of milk prices including fixed milk prices and collars – where the farmer would receive a milk price within a predetermined price range. Farmers could also use the milk price futures and options products available on the CME (the US equivalent of the NZX).
Fletcher estimated between 5% and 20% of US dairy farmers hedged their milk price risk to provide certainty over margin.
“Some farmers actively hedge both their milk price and feed price risk all of the time, providing their business with known operating margins but some other farmers only hedge some of the time – they are more opportunist hedgers” Fletcher said.
Dairy farmers in the US could manage their milk price risk through a variety of schemes dairy companies offered their clients, such as fixed milk prices, therefore didn’t necessarily need to trade directly with the exchange.
“It is difficult to accurately assess how much of the milk supply in the US is hedged due to the hedging that is done through products offered by dairy companies.
“The smaller farmers often find it easier to use the milk price products offered by their dairy company as they don’t need to find the cash required to fund margin calls.”
But it was the milk price derivatives traded on the CME that often enabled dairy companies to provide products like fixed milk prices to their clients.
“The dairy company can use the CME to manage underlying milk price risk then package up a simpler product for their suppliers such as a fixed milk price.”
The NZ market could also develop in a similar way to the US market.
“In time we may see dairy companies developing their own milk price risk management tools which would allow farmers to manage their risk without having to trade directly on the exchange.”
The NZX milk price futures and options market had developed rapidly.
NZX derivatives senior Nick Morris said early trading in NZ Milk Price Futures exceeded expectations, with more than 18 million kilograms of milksolids traded since the product launched in May.
The NZX rapidly developed the risk management tools, which were primarily designed for farmers and milk processors to reduce the risk associated with movement in the farmgate milk price.
“NZX is very nimble, having developed these farmer tools much quicker than many other exchanges would,” Fletcher said.
“To be successful, derivatives markets require transparency in the underlying physical market.”
Global Dairy Trade had helped the NZX Derivatives Market to develop because it provided that transparency.
“One of the challenges NZ has is that it doesn’t have a long history of risk management but mentality is changing with many farmers now embracing price risk management.”
European farmers lacked risk management tools.
In that market the EEX had futures for skim milk powder, butter and whey powder but they were not very helpful for farmers because most of the milk in the market was sold to consumers in either liquid form or made into cheese.
If European farmers were to try to hedge using the dairy commodity futures products available on the EEX it was likely they would face considerable basis risk.
“This means they may actually be taking on risk rather than reducing risk.”
In Europe there was not even a transparent price for cheese. In that market it would be much more difficult to develop a tool for farmers to hedge milk price risk because dairy companies tended to have different price structures and uses for milk.
Fletcher suggested the first step for Europe was to develop a transparent cheese price.
“There is no simple answer for Europe but I think the first step should be cheese futures.”
Rice Dairy provided brokerage and advice to dairy farmers across the globe – primarily in the US but also in NZ and Europe.
