Margot Rudstrom, Extension Economist

November 25, 2005

This is the third and final article on “Milk Marketing.” Part I was on establishing your target price. Part II asked the question, “What is a good price for the Market?” The next step in implementing your marketing plan is taking action (Part III).

There are a number of pricing tools available to help you take action. Pricing tools can be grouped by how they function. In a nutshell, one group of tools, cash forward contracts offered by milk processors and futures contracts or hedging, will fix the price you will receive. Whereas, put options and minimum price contracts offered by milk processors are tools that allow you to set a floor for your Class III milk price.

Hedging with Class III Futures Contracts

Hedging dairy futures involves producing milk and selling a Class III futures contract. When you sell a futures contract you agree to sell a specified volume of milk, 200,000 pounds, at a specified price at a date in the future. There are three things to remember when hedging: 1) It is very important that you have enough milk volume, at least 200,000 pounds, when you hedge; 2) you will need to work with a broker who is licensed to buy and sell futures contracts on the Chicago Mercantile Exchange (CME); therefore, there will be a broker fee; 3) you will need to establish a margin account with your broker. A percentage of the value of the futures contract needs to be kept in your margin account. If the value of the futures contract increases, you will be required to put more money into your margin account. This is called a “margin call.” If the value of your futures contract declines, you will have excess money in your margin account.

Cash Forward Contracts with a Processor

Many milk processors offer fixed price cash forward contracts. Before you can forward contract with a processor you will need to sign a participation agreement or master agreement. The participation agreement outlines the terms and conditions of cash forward contracts including the details on the pricing mechanism the processor uses, termination mechanisms, penalties for undelivered milk contracted, minimum contract size, maximum amount you can contract in any given month, and other relevant details. It is important to “READ” the participation agreement and ask questions. READ stands for Really Examine All Details.

Signing a participation agreement does not mean you need to forward contract. However, if you do not have a signed participation agreement you will not be able to forward contract with your processor.

The processor contracts are based on the CME Class III futures contracts. In a sense, the processor is hedging for you. They are able to pool milk from a number of producers to cover the 200,000 pound volume of a futures contract. The processor deducts an administrative fee off the Class III price to cover the margin account.

Most processors allow you the opportunity to forward contract milk month by month. For example, you might choose to contract milk for January, April and July. Some processors offer the opportunity to contract for 12 consecutive months.

Put Options

Put options are pricing tools that let you set a minimum price for your milk by selling a futures contract at a pre-specified price. That price is called the “strike price.” You can buy a put option for any month for which a Class III futures contract is trading. There are a range of strike prices in $0.25 increments above and below the Class III futures contract value. You pay a premium when you buy a put. Like hedging, you will need a broker to purchase your put. Two general rules apply when it comes to the premium. First, the higher the strike price, the higher the premium. Second, the further into the future you buy a put, the higher the premium.

Minimum Price Contracts with Processors

These contracts work like put options. As with fixed price contracts, the cost to a producer for a minimum price contract is the cost of the put option plus an administrative fee. If the Class III price is announced above the minimum price in the contract, you receive the announced price. If the announced Class III price is below the minimum price, you receive the minimum price specified in your contract.

It is important that you track your marketing decisions. I keep a 12-month tracking sheet that I update every time I take a marketing action or when the Class III price is announced. I track the volume of milk I have protected, the marketing tool(s) I used to protect it and the milk price I will receive on my protected milk. The most difficult thing in milk marketing is taking an action. Even when you know you are locking in a profit, it is often difficult to take the action. When you are marketing, you will miss opportunities. But remember, the purpose of milk marketing is to meet your target prices. If the market provides you that opportunity, are you ready and able to take it? Having a marketing plan tells you what action you will take if the market offers your target prices.