United States

Department of

Agriculture

Rural BusinessCooperative

Service

RBS Research

Report 152

Dairy Cooperatives’

Role in Managing

Price Risks
Abstract Prices for milk and dairy products have become increasingly unstable as

the Government support safety net has been lowered. Dairy cooperatives’ traditional pricing system is delineated and their role in the new

market environment is discussed. Some of the risks involved in using

emerging hedging mechanisms such as futures, options, and forward

contracting for managing price risks are assessed. The traditional pricing system in regard to managing price risks is evaluated. Guidelines for

developing a cooperative’s hedging strategy are suggested.

Key words: Cooperatives, dairy, pricing, hedging, futures, options, forward contracting

Dairy Cooperatives’ Role in Managing Price Risks

K. Charles Ling and Carolyn Betts Liebrand

Rural Business-Cooperative Service

RBS Research Report 152

September 1996

Price: $5 domestic; $5.50 foreign
Preface The efforts by the Federal Government to reduce milk-producing capacity by lowering the price support safety net since the mid-1980s resulted

in wide and uncharacteristic milk price fluctuations beginning in 1988.

The drastic price changes since 1989-90 have served as a wakeup call

to the dairy industry that price volatility has become a fact of life as the

industry moves toward a market-oriented dairy economy.

Dairy cooperatives have adapted to the situation and hedged the price

risks by diversifying into multi-product and multi-plant operations, expediting inventory turnover, integrating and diversifying into consumerproduct and niche markets, forming marketing agencies in common to

share market information or coordinate dairy product marketing, and

entering joint ventures with other firms to shift away some of the risks.

New dairy price hedging mechanisms have been introduced by commodity exchanges. The Coffee, Sugar and Cocoa Exchange, New York,

began trading Cheddar cheese and nonfat dry milk futures contracts in

June 1993, and in December 1995, also started trading milk futures

contracts. The Chicago Mercantile Exchange launched trading of milk

futures contracts in January 1996. There has also been some experimenting with forward contracting, based on these futures contracts.

Futures, options, and forward contracting have been used extensively

for price hedging by some other commodities, but the dairy industry is

just beginning to learn to use them. This report attempts to add some

knowledge to the learning process for dairy farmers and their dairy

cooperatives. It is neither a trading guide nor an exhaustive exploration

of the subject matter.

This report focuses on dairy cooperatives’ role in managing price risks

for the benefit of member-producers who are also their owners and

patrons. This relationship is fundamentally different from the one

between proprietary milk handlers and their milk shippers. Therefore,

discussions in this report that are relevant to dairy cooperatives’ role in

managing price risks may not be applicable to proprietary handlers’ risk

management activities.
Contents Highlights

.*. III

Traditional Pricing Roles 1

Assured Markets 1

Cooperatives and Federal Milk Market Orders 2

Reblend 2

Patronage Refunds 2

Traditional Milk Pricing System 3

Government Programs 3

Pooling 3

Wide-area Market Coordination 3

Co-op Responses to Increasing Price Instability 4

increasing Price Instability 4

Cooperatives’ Responses 7

Emerging Hedging Mechanisms for Managing Price Risks 7

I. Futures Markets a

Milk Futures 9

A Cooperative’s Risks in Using Milk Futures 9

A Dairy Farmer’s Risks in Hedging 9

Futures Market for Nonfat Dry Milk and Cheese 10

A Cooperative’s Risks in Using Dairy Product Futures 10

II. Options 11

Ill. Forward Contracts 12

Evaluating the Traditional Pricing System in Terms

of Managing Price Risks 14

Conclusion 15

References 15
Highlights A fundamental role of dairy cooperatives is guaranteeing members a market for their milk. Dairy producers sign membership (marketing) agreements with their cooperatives, making them their exclusive marketing

agent. Members then ship all the milk they produce to the cooperative

which finds a market for that volume. Pay prices for most milk are based

on the pool blend price of Federal milk market orders. Cooperatives may

add operating earnings to and subtract operating expenses from pool

payment and pay producers a reblended price. A “13th check” at the end

of the fiscal year distributes part or all of the cooperative’s net savings

from operations to its members. Such is the essence of a dairy cooperative’s role in the traditional pricing system of milk.

This system has brought a degree of stability to the milk market. The

Government price support program provides a floor price for milk.

Government programs, marketwide pooling, and cooperative reblends

have created pricing uniformity among producers over a wide region and

dampen the fluctuation of milk prices they receive.

Prior to 1981, the milk support price level was mandated at between 75

and 90 percent of parity. In the mid-1970s support prices were frequently adjusted upward because of rapid inflation. High prices brought

on expanded milk production and milk prices hovered around the support price level. This served as a floor under milk prices and with the

surplus, in effect, a ceiling. To reduce the surplus, the price support level

was tied to the size of the Commodity Credit Corporation (CCC) purchases in the 1981 legislation. Legislation in 1982 froze the support

price level for 2 years and producers were assessed to help pay for the

program. Support prices were lowered in the 1983 and in the subsequent legislation. The whole-herd-buy-out program that ended in 1987

helped create a relative balance of supply and demand. With a lower

floor price, milk prices were more responsive to market forces and started to experience wide fluctuation beginning in 1988.

Dairy cooperatives have managed price risks by taking advantage of the

flexibility in the business system, by changing their business practices,

or by forming business alliances with other firms to shift the risk. In

many cases, cooperatives with multi-product, multi-plant operations

have the flexibility to shift production among products that would return

the highest margins. Other examples include faster inventory turnover to

avoid inventory writedowns, integrating into the consumer and niche

markets to avoid the volatilities in the commodity markets, forming marketing agencies in common to gain better market intelligence or coordinate product marketing, and forming joint ventures with other firms to

shift some risks to partners.

Hedging mechanisms are emerging for managing price risks.

Commodity exchanges saw the opportunities in the price volatility in the

dairy markets and offered futures and options for hedging price risks.

. . . 111
Highlights The Coffee, Sugar and Cocoa Exchange began trading Cheddar cheese

and nonfat dry milk futures contracts in 1993 and started trading milk

futures contracts in 1995. The Chicago Mercantile Exchange began

trading milk futures contracts early in 1996. Some cooperatives have

experimented with forward contracting for milk production, selling futures

contracts to offset fixed price agreements with members.

Milk and dairy products have some unique characteristics that may

affect the use of the emerging hedging mechanisms. Milk production is

a bovine biological process. It is produced day in and day out.

Therefore, milk is a flow product. By extension, dairy products such as

commodity cheese, butter, and nonfat dry milk are also flow products.

Under the pressure of accumulating products, inventory management is

usually for regulating dairy product flow to the market rather than for

storing for later sales at anticipated higher prices.

Milk production is limited by the number of cows in individual herds. Cow

numbers increase only gradually, so it is unlikely to have unforeseen

drastic increases in milk production. This limitation on milk production

undergirds the floor price of milk, although the price floor may not be

visible or rigid. On the other hand, consumption of milk and dairy products also changes gradually. Given a stable milk production level and a

stable consumption trend, shocks to the milk market usually translate

into upswings in milk prices.

Hedging by definition is a break-even proposition. By shifting away

undesirable price risks, a hedger actually takes on some new risks. (The

risk of basis changes inherent in all futures contracts is not discussed in

this report.)

For dairy cooperatives using the futures market to hedge price risks,

possibilities exist that actual milk volume delivered by members may be

lower than the short position taken by the cooperative on the futures

market. (Short position refers to the volume represented by the futures

contracts sold.) Part of the hedge may become speculation. For this reason, dairy cooperatives may have to limit the volume hedged to a certain

fraction of member production. Another possibility is that the futuresimplied cash price may be lower than the cash market milk price prevalent when the futures contracts expire, and the cooperative may be outpaid by competitors. This would create a potential problem for producer

relations. Still another possibility is that the futures market may not be

liquid enough for the cooperative to liquidate its futures position by the

settlement date. There may be some other possible unforeseen risks.

(Dairy farmers who use the futures market to hedge may encounter similar risks. In addition, they may need to hedge input costs to make sure

that the futures-implied milk price will yield profitable earnings.

iv
Highlights Furthermore, in the unlikely case of actual delivery on futures contract,

some complicating side effects may arise.)

There are many variations of forward contracts. In dairy, the marketing

agreement between producers and their cooperatives might be interpreted as one form of a forward contract that promises future deliveries

without specifying volumes or prices. The so-called new-generation

dairy cooperative would issue delivery rights to members based on their

equity subscription. The plan is similar to a conventional marketing

agreement, except that the delivery volume is specified.

Forward contracting usually refers to contracts that promise future delivery of a commodity of a fixed volume and at a fixed price. In essence,

they shift price risks from the contracting producers to the cooperative.

Because the cooperative is owned by the producers, shifting the risks

from the producers to the cooperative does not diminish producers’ collective risks. Contracted volume should constitute a separate pricing

pool so that producers who are not under forward contracts will not have

to share the contract risks and expenses. Studies of other commodities

show that forward contracting on average returns a price lower than

cash market price because producers have to bear the costs of this service-an analogy in the purchase of insurance.

Under the traditional pricing system, wide-area pooling of milk prices

and reblending by dairy cooperative are similar to mutual insurance of

milk prices by producers. Marketing agencies in common of dairy cooperatives that pool earnings and costs of marketing dairy products are

also akin to institutions of mutual insurance. Marketing agencies in common may be particularly useful for dairy cooperatives in the export markets where price fluctuation is potentially more volatile than in the

domestic market.

Because milk is produced continuously and priced regularly, theoretically the traditional pricing system is expected to pay producers an average

price in the long run that is even with the average milk price yielded by

“automatic hedging” (hedging all production all the time with futures contracts), without having to incur futures transaction costs.

Adapting to price instability by shifting or offsetting existing risks by

changing business practices may create new risks. A multi-product,

multi-plant cooperative may encounter chronic excess plant capacity.

Faster inventory turnover may result in foregoing profitable sale opportunities because the cooperative is short of inventory. Integrating into the

consumer-product or niche markets requires a new set of business

ingredients that the cooperative might be lacking. Joint ventures run the

risk that the joint venture partner may not perform its side of the contract. The cooperative may also find the contract restricts its own operational flexibility.

V
Highlights Risk management should not be an isolated business function, but

rather an integral part of the cooperative’s corporate strategy. The cooperative should assess the overall risks of its operations and determine

how the risks may impact on producer pay prices through the traditional

pricing system. If some of the risks are deemed to be best managed by

using the emerging hedging mechanisms, the board of directors should

spell out the policy and prepare guidelines for using them. The prerequisite for a sound hedging strategy is understanding what each hedge

mechanism is, how it works, what it is used for, and the risks involved in

using it.

vi
Dairy Cooperatives’ Role

in Managing Price Risks

D

airy cooperatives play a prominent role

in marketing milk. Based on farmers’

1994 cash receipts, an estimated 86 percent of milk at the first handler level was marketed by

the Nation’s 247 dairy cooperatives. Working in tandem with Government programs, dairy cooperatives

have promoted stability and orderliness in the marketplace.

The Federal Government has historically played

a significant role in milk marketing. For more than

one-half a century, the Government has provided a

dairy price support program and the Federal milk

market order program. The support program reduces

dairy farmers’ and their cooperatives’ price risks by

ensuring that they would receive at least the support

price for their milk. The market order system provides

for orderly marketing of milk by ensuring equal raw

product costs to handlers and equal blend pay prices

to producers. However, in the mid-1980s the

Government began successively lowering the level of

price supports for milk to reduce surplus production.

The Federal Agriculture Improvement and Reform Act

of 1996 (the 1996 farm bill) provides for further reductions in the milk support price through 1999 and complete elimination of the support program in 2000.

Beginning January 1,2000, a recourse loan program for

Cheddar cheese, butter, and powder will become effective. (The dairy price support program as authorized

by the Agricultural Act of 1949 will be effective on

January 1,2003, if no new legislation is enacted prior

to that date.)

The changes in the Government dairy price support program since the 1980s have resulted in

increased fluctuation in milk prices. Changes outlined

in the 1996 farm bill are expected to continue or

increase price volatility in a dairy sector that relies on

market forces. Because of this volatility, price risks

have become a growing concern of dairy farmers and

their cooperatives. This report examines the traditional

roles of dairy cooperatives in milk pricing and how

they address price risks, and assesses the implications

of the emerging mechanisms for managing price

volatility for dairy farmers and cooperatives.

Traditional Pricing Roles

As the dairy industry developed in the early

years of this country, producers faced marketing risks

due to undependable market outlets for milk, erratic

and chaotic milk pricing by dealers, seasonally fluctuating milk supplies, and the distance between farms

and cities (centers of consumption). In response, dairy

producers formed cooperatives that extended their

farm businesses beyond the farmgate. Through collective action, farmers were able to more effectiveIy bargain for milk prices, balance supply and demand, and

transport milk more economically, among other things.

Assured Markets

A fundamental role of dairy cooperatives is to

guarantee members a market for their milk. In fact,

surveys of dairy farmers have shown that the assurance of a market and guarantee of payment for their

milk are the primary reasons they belong to a cooperative. By negotiating terms of trade collectively, dairy

farmers reduce their exposure to loss of market or

unreasonable terms of trade.

Dairy producers sign membership (marketing)

agreements with their cooperative, making it their
exclusive marketing agent. Members then ship all their

milk to the cooperative which finds a market for the

milk. Cooperatives typically exert little or no influence

over the volume of milk produced by members.

Bargaining cooperatives carry out the obligation

to market their members’ milk solely by negotiating

milk prices with customers and rarely take title to the

milk. These cooperatives do not own manufacturing or

processing facilities. Other cooperatives negotiate milk

prices with customers and also own manufacturing

and /or processing facilities. These

manufacturing/processing cooperatives either use

their facilities to handle milk not needed by their customers or add value to members’ milk by making

higher value products, or both.

The ability of manufacturing/processing cooperatives to handle surplus milk by manufacturing it into

storable products, to a certain extent, reduces their

exposure to milk price risks. When milk supplies

increase, they can move surplus milk into manufacturing plants, thus, solidifying their bargaining position.

When supplies tighten they may be able to shift milk

from manufacturing to fulfill their customers’ needs

without having to purchase milk from spot markets at

elevated prices. However, operating their plants below

capacity increases operating costs.

For bargaining-only cooperatives, when supplies

are plentiful they may have to sell surplus milk at distressed prices, not having a means to handle the excess

volume. However, when milk supplies are tighter or in

balance with demand, they benefit from higher prices

without the burden of maintaining under-used manufacturing facilities.

Cooperatives and Federal Milk Market Orders

Cooperatives helped usher in the Federal milk

market order system to smooth fluctuations in individual producer prices and to reduce disruptive competition between producers. Market orders provide a system of Government-administered, producer-requested

regulation and rule-making that establishes minimum

prices for milk according to its end use, and pools the

price obligations of individual buyers across entire

marketing areas. Class I milk is used for fluid or beverage purposes; Class II milk is manufactured into soft

products like yogurt and ice cream; Class III milk is

used to produce “hard” products such as cheese; Class

IIIa milk is dried into powder. Buyers pay minimum

class prices according to how they use the milk, while

producers get paid a weighted average (by volume) of

the four class prices.

Classified pricing was intended to eliminate the

possibility that fluid processors would use distant milk

supplies to unduly lower nearby milk prices. It also

reduced the incentive for processors to add producers

when milk supplies were short and cut them off when

supplies were abundant. Likewise, pooling creates

pricing uniformity among producers and minimizes

the incentive of one farmer to undercut another to gain

access to higher value (fluid) markets.

Cooperatives principally have balanced the dayto-day milk needs of processors with the supply of

milk in a given market as facilitated by the market

order system. Cooperatives attempt to recover the

costs associated with market balancing by negotiating

“over-order” premiums (over and above the established market order minimum class prices) with milk

processor-customers. These premiums may reflect

additional transportation costs not covered by the market order price; the cost of providing fluid milk of

specified quality and/or butterfat content at specified

times and places; and/or the premium paid by fluid

milk processors to attract milk away from manufacturing operations (“give-up charges”). The amount of

over-order payments that cooperatives can demand

differ from actual costs incurred, depending upon the

relative market power of the cooperative and the

processor. The ability of cooperatives to recoup these

expenses from handlers in the market insulates members from shouldering the costs arising from market

balancing tasks.

Reblend

Cooperatives with members in more than one

Federal order market, or with some members not

delivering to a market order, are permitted to provide

for uniform distribution of milk payments to all members. Cooperatives may average (“rcblend”) the net

proceeds of all their operations over all members, and

are exempt from paying the blend price effective in

any particular market.

Patronage Refunds

Cooperatives that add value to members’ milk

through manufacturing and/or marketing return the

net savings to members through patronage refunds.

These are distributions of net income to members

(patrons) in proportion to the volume of milk they

marketed. Sometimes known as the “13th cheek,” net

savings from cooperative operations can provide

income for producers over and above the marketplace

raw milk price.
The Traditional Milk Pricing System

The traditional methods of pricing milk have

brought a degree of stability to the milk market.

Government programs, market-wide pooling, and

cooperative reblending have dampened the fluctuation

of milk prices received by farmers.

Government Programs

The dairy price support program undergirds the

farm milk price through Federal Government purchases of all butter, American cheese, and nonfat dry milk

that cannot be sold commercially at or above

announced prices. Federal purchase prices then become

a floor for wholesale product prices due to competition

among manufacturers across the Nation. Through competition for milk supplies by these manufacturers,

hopefully, U.S. dairy farmers will receive a farm milk

price that is at least the targeted support price.

The Federal market order system works in concert

with the dairy price support program so that farmers

who sell to handlers of nonsupported products will

receive at least the prices that manufacturers of supported products pay. Since the 196Os, every Federal

market order has used the Minnesota-Wisconsin (M-W)

price as a starting point for setting minimum class

prices. The M-W price is USDA’s estimate of prices

manufacturers in Wisconsin and Minnesota paid for

grade B (manufacturing) milk in a given month.

On June 1,1995, the M-W price was replaced by

the basic formula price as the base price for the Federal

market order system. This price also represents the

market price for manufacturing milk in Minnesota and

Wisconsin, but with adjustments reflecting month-tomonth changes in dairy product prices. Thus, the dairy

price support program effectively sets the minimum

price paid for manufacturing milk. This price is reflectcd in the basic formula price used to establish grade A

class prices in market orders, which currently price 74

percent of the Nation’s grade A milk.

Thus, the Federal dairy price support program

and the milk market order program have provided a

measure of long-term stability for the dairy industry.

Pooling

The pooling provisions in market orders and

reblend by cooperatives encourage stability in both

spatial and temporal price relationships. Marketwide

pooling under the orders and cooperative reblends

smooth out producer pay price variation throughout

the milkshcd.

Cows produce milk day in and day out and that

volume hits the market nearly every day throughout

the year. The daily delivered volume varies, depending on the fluctuation of individual cows’ production,

weather, road conditions, and other uncontrollable factors. Daily demand varies according to day of the

week in even greater magnitude due to factors such as

consumer buying habits. Pooling over time with

monthly pool prices minimizes the impact of the possible day-to-day fluctuation in milk prices in the spot

market.

In aggregate, milk production generally peaks in

the spring and bottoms out in the fall due to weatherrelated factors. Demand, on the other hand, peaks in

the fall when schools open and the ensuing holiday

season keeps demand strong. As a result, milk prices

tend to be higher in the fall and lower in spring.

Nevertheless, producers’ cash flow may be more even

than seasonal price fluctuations may indicate Because

producers market milk year-round, their volume sold

tends to be lower during the season when milk prices

are higher, while the reverse may be true in the flush

period. It evens out their month-to-month cash flow.

Wide-area Market Coordination

Many dairy cooperatives have members in a

wide geographical area and operate a complete procurement system, including assembling and managing

fluid milk supplies, routing raw milk to handlers as

needed, and managing the surplus. Many handlers

have entered into full supply arrangcmcnts with cooperatives to reduce the high cost of procuring and coordinating a fluctuating supply to meet a variable

demand. These handlers recognize that cooperatives

serving an entire market can better route milk to needed uses much more efficiently than if each handler

managed its own milk supplies independently.

Furthermore, marketwide coordination reduces

reserve storage requirements of milk, yielding significant savings for both farmers and plants.

Consequently, cooperatives’ ability to manage milk

supplies over a wide arca to a variety of handlers

reduces the need for individual handlers to use price

to attract the right amount of milk. This encourages

price stability.
Co-op Responses to Increasing

Price Instability

Increasing Price Instability

Prior to 1981, the milk support price level was

legislatively mandated between 75 and 90 percent of

parity. Commonly set at 80 percent of parity, this price

level evidently provided ample incentive for farmers

to produce abundant milk supplies. In the mid-1970s,

support prices were frequently increased because of

rapid inflation. This brought on expanded milk production. Large surpluses built up in the form of

Government purchases and holdings of butter, powder

and cheese. Market prices hovered around the support

price, which kept prices from falling further to marketclearing levels (figure 1). Therefore, the support price

served as a floor under milk prices and, with the surpluses, in effect, a ceiling. Price volatility was minimized.

The M-W Price, which reflects the market price

for raw milk, rises and falls according to market conditions. Sharp rises occur either when the basic supplydemand balance is very tight, or when the market

tightens unexpectedly. The M-W Price normally rises in

the short-supply season (typically October-November)

when milk production reaches a seasonal low point

and fluid product demand is seasonally high.

Conversely, the M-W Price is seasonally low in the

flush season (normally May-June) when milk production tends to peak and fluid milk product sales decline.

The very heavy surplus of the first half of the 1980s

obscured the seasonal deficit period, thus dampening

the seasonal rise and fall of the M-W Price. Even the

relatively large seasonal rise in 1984 was small compared to what was to come (refer again to figure 1).

The growing volume of butter, powder, and

cheese purchased by the Government through the

CCC required ever larger Government outlays to

finance the dairy price support program. As a result,

legislation passed in 1981 took steps to bring supplies

back into line with consumption by tying the minimum support level to the size of CCC purchases. This

was a major departure from traditional price support

policy under which price changes were tied directly to

parity. In 1982, the support price level was frozen legislatively for 2 years and a $1 per cwt assessment on

producers was instituted. The money collected was

used to partially offset rising Government costs.

Subsequently, the 1983 Dairy and Tobacco

Adjustment Act lowered the minimum price support

level and enacted a milk diversion program, the first of

two attempts at voluntary supply control. The second

supply control program, the whole herd buy-out, was

authorized by the Food Security Act of 1985. It called

for removing whole herds from dairy production for 5

years beginning between April 1986 and September

1987. In addition, the support price was ratcheted

downward in the following years. These actions contributed to a large decrease in the volume of product

(in the form of butter, powder, and cheese) removed

from the market by the CCC (figure 2).

Commercial stocks of commodity products also

play a crucial role in the dairy industry. American

cheese stocks were especially influential from the late

1980s on because cheese production was absorbing an

increasing share of the milk supply. Stocks help maintain smooth flows to consumers, stabilize seasonal price

swings, and offer a buffer against unexpected developments. During 1982-87, commercial American cheese

stocks declined fairly steadily, reflecting the profitability

of minimizing stocks when a surplus is constant. Under

these conditions, the role of stocks can be handled more

efficiently by varying the flow of cheese sold to the

Government. However, the low level of stocks in the

late 1980s contributed to wide price swings.

While changes in Federal dairy policy set the

stage, an ensuing combination of market factors led to

dramatically atypical fluctuations in milk prices in

1988 that continued well into the 1990s. On the

demand side, an unprecedented growth in foreign

demand and higher world prices for nonfat dry milk

allowed the United States to become a major player in

international dairy markets during 1988 and 1989.

Domestic use of skim milk products also accelerated in

1988 due to relatively large cuts in the support purchase price for nonfat dry milk. Commercial use of all

dairy products reached a record volume.

On the supply side, U.S. milk production reached

a record high in 1988 while the number of milk cows fell

to a 20th-century low. The record output occurred at the

same time that the price support was lowered by 50

cents, a summer drought substantially increased feed

costs, and milk-feed price relationships were the lowest

in more than 20 years. For the first time since 1982, the

M-W Price peaked in December instead of November,

reflecting a change in seasonal price patterns.

Falling milk output in 1989 accompanied by large

export commitments for nonfat dry milk, strong

domestic demand, and low commercial stocks of

cheese and nonfat dry milk led to uncharacteristically

sharp increases in wholesale, farm, and retail dairy

prices. Even though milk production was expanding

by early 1990, strong cheese sales tightened markets

4
Figure l- Support Price and Bask Formula Price,* by Month at 3.5 Percent Butterfat

Dollars per cwt.

15 I

BFP*

Support Price

8

6

5

1978 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96

Year and month

‘M-Wprice prior to June 1, 1995.

Sources: Dairy Yearbook. U.S. Department of Agriculture, Economic Research Service,

Statistical Bulletin Number 924, December 1995.

Dairy Market News. U.S. Department of Agriculture, Agricultural Marketing

Service, 1996, various issues.

5
Figure 2- Net Removals, Support Price and BFP*

Billion pounds; dollars per cwt @ 3.5% butterfat

25

20

Net Removals

15

10

5

0

7

1 I

vv

1 I I I I I I I I I I I

,,, \Pl

lrlllllhr

1970 72 74 76 78 80 82 84 86 88 90 92 94 96

Year

‘M-W price prior to June I, 1995.

Sources: Dairy Yearbook. U.S. Department of Agriculture, Economic Research Service,

Statistical Bulletin Number 924, December 1995.

Dairy Market News. U.S. Department of Agriculture, Agricultural Marketing

Service, 1996, various issues.

6
slightly more than expected and caused buyer concerns. Consequently, panicky stock building by buyers,

who feared a recurrence of late-1989 conditions, triggered counter-seasonal price rises even though milk

supplies for manufacturing were more readily available. In addition, commercial exports were negligible

because international prices for dairy products had

fallen dramatically. In 1990, milk prices reached nearrecord highs before declining precipitously. This

excluded the United States as a major trader. Thus,

milk prices plummeted as the collapse of supply concerns easily outweighed normal seasonal tightening.

Buyers very quickly shifted from attempting to

increase pipeline stocks to meeting current use partially from accumulated stocks. By late 1990, wholesale

prices of major dairy products settled near support

purchase prices following the mid-1990 collapse.

Notably, the annual average farm milk price in 1990

was the highest for the period 1981 through 1995,

dcspitc the wide price swings.

The level of support for milk price for the

remainder of the 1990s appears to be below marketclearing levels, such that market forces are relatively

free to influence milk prices as evidenced by the continued variability seen in figure 1.

Cooperatives’ Responses

Dairy cooperatives have adapted to the increased

price instability by using several strategies. Many

cooperatives claim to have stepped up their efforts to

turn over inventories and avoid being caught in a market downturn that would force them to write down the

inventory. This strategy may have worked to a certain

degree for nonfat dry milk, butter, and commodity

cheese. However, the strategy will not work for those

cooperatives that age cheese, because by the nature of

the aging process, they can not sell aged cheese before

its time. Furthermore, the aged cheese business

requires careful inventory management because both

shortage and surplus in supplying the consumer markct can bc costly.

Some cooperatives have diversified into processing value-added dairy products and integrated closer

to the consumer market. In such efforts, they hope to

capture a larger share of the consumer dollar. Other

cooperatives look toward nontraditional markets such

as fractionalizing milk components for industrial uses

or differentiating their products to fill market niches.

The operations in the consumer market and the nontraditional markets rely less on the commodity dairy

product markets where prices tend to be more volatile.

Another strategy is to form marketing agencies in

common that are permitted under the Capper-Volstead

Act of 1922. Dairy cooperatives have formed these

common agencies to share market information, especially regarding inventory levels and product movements of nonfat dry milk and whey powder. This valuable information enables the cooperatives to make

informed decisions on inventory management and

marketing operations. Examples of marketing agencies

in common that have been formed in recent years are

Dairy Marketing Cooperative Federation, Dairy

Marketing Information Association, and Western

Cooperative Marketing Association.

In 1995, three dairy cooperatives in California

joined forces to create DairyAmerica, Inc., a marketing

agency in common to market the powdered milk they

manufactured. Besides taking advantage of scale

economies in sales operations, the common agency can

better coordinate marketing of the product and spread

market risks over a very large volume.

Joint ventures have long been used by some dairy

cooperatives to shift the risks of manufacturing operations and inventory management to joint venture partners. The cooperative leases its manufacturing plant(s)

to the joint venture partner, which commits to purchasing milk from the cooperative, operating the

plant(s), and marketing the end products. In this

setup, the cooperative secures a market outlet for its

members’ milk without assuming the risks of further

processing, product marketing, and inventory management.

These responses by dairy cooperatives to reduce

exposures to price instability in the commodity market

falls in the broad definition of hedging. However,

hedging is usually narrowly defined to mean the use

of futures and options to manage price risks. Dairy

futures and options trading has been instituted in the

past 3 years. Another much discussed method for

managing price risks is forward contracting.

Emerging Hedging Mechanisms for

Managing Price Risks

Futures, options, and forward contracts, though

new to the dairy industry, have been used extensively

in some other commodities. There is a rich reservoir of

literature on the what’s and how’s of these pricing

mechanisms. This report summarizes only the very

basics of futures, options, and forward contracts as

applied to the dairy industry, mainly to set the stage

for delineating some of the risks associated with their

uses by dairy farmers and their cooperatives. It is not

7
intended as a trading guide. These risks are specific to

milk and dairy products and are in need of careful

assessment and examination. Not discussed in this

report is the risk of basis changes, which is inherent in

all futures contracts. (Basis is the difference between

the cash price at a specific location and the futures

price for a particular delivery period.)

Milk and dairy products have some unique characteristics, unlike other commodities. These unique

characteristics may affect the use of the emerging

hedging mechanisms:

l Milk is a flow product (much like water coming out of a spring). Cows produce milk every day.

Because of its perishability, once milk is produced, it

must be used and processed. On any given day, the

volume of milk supply going into the market is fixed

and reflects underlying cow numbers. It is difficult to

instantaneously change the volume of milk production

in response to changes in current market milk price.

This is very different from other storable commodities

such as grains, corn, soybeans, or cotton. At any point

in time, the volume of any one of these commodities

actually offered to the market is directly related to the

commodity price. Therefore, the market dynamics are

very different between milk and these commodities.

. Milk is processed into fluid and soft products

for current consumption or manufactured into “hard”

products, namely, cheese, butter, and nonfat dry milk.

Although these hard products are relatively storable,

they are also flow products because they are derived

from a flow product. Inventories of these hard products

are usually kept for the purpose of regulating product

flow to meet market demand. Storing them for price

speculation is not the usual practice of the industry.

l The capacity to produce milk is limited by the

underlying number of cows. Because of the biological

nature of the bovine animals, if there is an increase in

aggregate cow numbers, it tends to increase only gradually. Therefore, it is unlikely to have unforeseen drastic increases in milk production. This production capacity as limited by the cow numbers undergirds the floor

price of milk, although the floor may be neither visible

nor rigid. On the other hand, milk production could

drop instantaneously because cow numbers could be

reduced suddenly by diseases, natural disaster, or other

factors, or some cow herds could be liquidated in a

short period. Poor quality feeds or forage also could

reduce milk production drastically. Furthermore, in

terms of its components and usage, milk does not have

close substitutes and therefore overall demand for milk

does not change much. The exception would be a drastic decrease in demand due to food safety scare on

some rare occasions. Given a stable consumption trend,

shocks to the milk market usually translate into

upswings in milk prices. Subsequent price declines

should not drop below the price floor which is undergirded by the production capacity limit (or by the support price for milk if and when the support is effective).

Therefore, price volatility in the milk market may be

lopsided; price hikes do not have a upper limit while

there is a tacit floor on the down side. This lopsided

phenomenon also applies to dairy product markets. In

contrast, prospective and actual crop production can

change drastically in either direction because of favorable or adverse natural conditions such as weather or

pest infestation, and price swings are usually uninhibited in either direction, up or down.

I. Futures Markets

The major reason for the existence of futures markets is to provide a means for shifting the risk of price

changes in the cash market for the commodities

involved. A futures contract is a commitment to either

accept or make delivery of a specified quantity and

quality of a commodity at a specified time, and usually

at a specified place of delivery. Commitments are

enforced by requiring actual delivery and acceptance

of delivery of the underlying physical commodity, if a

contract is allowed to mature (come due). However, no

actual commodity changes hands unless and until the

contract matures. Most contracts are offset or “covered,” by making a transaction in the futures market

opposite to a previously taken position before they

come due. In fact, futures contracts are viewed as

financial instruments and the commodity is rarely

expected to physically change hands. For many of the

commodities traded, less than 2 percent of all futures

contracts result in actual delivery.

Buyers and sellers meet to trade futures contracts

at exchanges. The increase of price volatility in dairy

markets led the Coffee, Sugar and Cocoa Exchange

(CSCE), New York, to begin trading futures contracts

for milk and dairy products. In June 1993, the CSCE

introduced Cheddar cheese and nonfat dry milk

futures contracts. Next, the CSCE launched a milk

futures contract in December 1995. A second exchange

also developed dairy futures. The Chicago Mercantile

Exchange (CME) began trading milk futures in January

1996 and is planning to begin trading butter futures

later in 1996.

Those who use the futures market to shift price

risks are called hedgers. Hedging involves making

simultaneous and opposite transactions in the cash

and futures market, hoping that any loss in one market
will be offset by a gain in the other. Speculators

assume the price risks that hedgers are attempting to

avoid. Speculators aim to make a profit as a result of

buying and selling (trading) futures contracts. They

trade only futures contracts and do not deal in the

underlying commodity cash markets. Thus, they cannot offset losses in the futures market with gains in the

cash market. Speculators provide the futures market

with liquidity which increases the ease with which

hedgers are able to buy or sell contracts when they

want to offset their contracts, also known as settling or

lifting their hedges. Orders to buy and sell futures contracts go through brokers who charge commissions for

making the trades for hedgers and speculators.

A hedger buys or sells a commodity futures contract to lock in a desirable price and eliminate risk

exposure to price fluctuations during the time leading

to actual buying or selling of the cash commodity. The

hedger should evaluate whether the futures-implied

cash price is attractive relative to the forecasted future

cash price. A hedge should only be maintained if the

futures-implied cash price is deemed desirable; otherwise the hedge should be lifted. Hedging all production all the time (called automatic hedging) would

only exchange the futures-implied cash price for the

subsequent actual cash price. Over the long run, automatic hedging may not gain any advantage over relying on current cash transactions and may even be a

disadvantage because of the transaction costs incurred

in trading futures. (See Jack D. Schwager book for discussion on hedging, pp. 9-11.)

Milk Futures

The milk futures contract offered by the CSCE

calls for f.o.b. delivery of one tanker load (50,000

pounds) of Grade A raw milk with 3.5 percent butterfat to Interstate Milk Shippers (IMS) certified plants,

receiving stations, or transfer stations in the Madison,

WI, district. The buyer picks up the milk from the seller’s plant. Delivery months are February, April, June,

August, October, and December. Starting on July 1,

1996, CSCE calls these 6 months the “regular delivery

months.” The other 6 months of the year are called

“additional delivery months.” (Trading in an additional delivery month is limited. It is initiated at the opening of trading on the first CSCE business day of the

second calendar month preceding such additional

delivery month.)

The milk futures contract traded on the CME is

similar. It also calls for 50,000 pounds of Grade A

cow’s milk delivered to approved facilities in

Minnesota, Wisconsin, and portions of surrounding

States within designated Federal milk market order

areas. The contract months are February, April, June,

July, September, and November.

A Cooperative’s Risks in Using Milk Futures

Hedging by trading futures may help shift price

risks. However, trading futures also creates other risks

for dairy cooperatives and dairy farmers. Some generally observable risks are discussed here. However,

both dairy cooperatives and individual producers may

have specific risks due to particular situations in addition to what are addressed in this report.

Dairy cooperatives do not produce milk. Under

their marketing agreements with members, dairy cooperatives receive whatever milk volume is produced by

members’ farms, but cooperatives have no control over

the actual volume. When hedging on futures, there is a

risk that actual milk volume may be lower than the

short position taken by the cooperative. (Short position

refers to the volume represented by futures contracts

sold.) A part of the hedge may become speculation; but

the degree depends on the extent of the production

shortfall. Then, possible losses in the futures market

could not be offset by gains in the cash market for the

volume of milk the cooperative hedged, but did not

receive deliveries from members. For this reason, dairy

cooperatives may have to limit the volume hedged to a

fraction of member production.

Cooperatives that hedge in the milk futures market have the ability to pay their members the futuresimplied cash price. However, if the eventual cash market milk price turns out to be higher than the

futures-implied cash price, the cooperatives may be

out-paid by competitors-a potential problem for producer relations. In this situation, the cooperative cannot pay the going cash price because it must cover its

losses in the futures market through paying its producers the hedged price rather than the current cash market price.

Cooperatives typically handle large volumes of

milk. If a large proportion of their milk is hedged in the

futures market, there is a risk that the futures market

may not have enough liquidity for the cooperative to

lift its hedges in time. In that situation the cooperative

would likely pay a high price to liquidate its position,

or would have to deliver to fulfill the futures contracts.

A Dairy Farmer’s Risks in Hedging

Under normal market conditions, when feed cost

rises, the milk/feed price ratio falls. That leads farmers

to feed less concentrate rations to dairy cows, resulting

in lower milk production. Higher milk price would

9
likely ensue and help offset at least some of the

impacts of the rising production cost. Thus, if a producer hedges milk price in the futures market, the producer would also need to hedge farm supply costs,

especially feed. Otherwise, the producer’s profit margin may be squeezed by the unexpectedly high feed

cost and a hedged milk price that is fixed. A loss could

result depending on how high feed cost rises.

Milk production is a bovine biological process.

Many variables can affect a cow’s performance. Factors

such as diseases, adverse weather conditions, and high

feed cost can cut the milk volume produced by the

cow. If there is a shortfall in milk production, part of

the producer’s hedge in the futures market may

become speculative, increasing instead of minimizing

exposures to possible loss. Therefore, it is important to

determine what proportion of a producer’s milk is to

be hedged. Hedging a high proportion may cause

some portion of the hedge to be speculative, while

hedging too small a volume would not provide adequate protection from price risks.

Producers receive cash market prices for their

milk on a monthly basis. Milk prices in the futures

market are also quoted on a monthly basis. However,

as stated earlier, milk is a flow product that is produced day in and day out all year round. Choosing

the right time period to hedge milk production is an

important consideration. Automatic hedging (hedging

all production all the time) would only substitute the

futures-implied cash price for cash milk price as the

producer’s pay price for milk. Over the long run, such

substitution may just be a break-even exercise or even

a losing proposition because of the futures’ transaction costs.

Producers who hedge selectively to lock in a

price need to have market insight. They run the risk of

foregoing higher prices if the market does not act as

predicted.

As mentioned earlier, volatility in the milk market may be lopsided; price hikes do not have an upper

limit while falling prices may be mitigated by a tacit

floor (or an explicit floor when the Government support price is effective). In other words, price protection

by hedging is rather limited on the down side, but

hedging prevents the producer from benefitting from

rising cash market prices, which have no limits. In this

connection, the worst case scenario for the producer

who locks in a fixed milk price through hedging is

when the rising cash market milk price is due to

reduced milk production caused by unexpectedly high

feed cost.

Another risk in hedging is that the producer may

be squeezed if there is low liquidity in the futures market and the producer is not able to lift the hedge at the

right moment or would have to pay a high price to buy

settlement contracts. The alternative is to make delivery on the futures contracts, the logistics of which may

be troublesome for an individual dairy farmer. Also,

making delivery to a buyer other than the producer’s

own cooperative may constitute a breach of the membership agreement.

Futures Market for Nonfat Dry Milk and Cheese

The CSCE nonfat dry milk futures contract calls

for delivery of 11,000 pounds of USDA Extra Grade or

better nonfat dry milk in 25 kg bags FOB Western

region. Delivery unit is 4 contracts (44,000 pounds) and

delivery months are the same as in milk futures. The

nonfat dry milk must be certified Kosher, have moisture content of 4 percent or less, have been manufactured using low heat, and be less than 180 days old on

date of delivery. The seller is responsible for shipping

the nonfat dry milk from its manufacturing plant or

storage center according to the buyer’s shipping

instructions to any location within the continental

United States. Nonfat dry milk delivered from points

outside the Western Region are subject to a .5

cent/pound location differential for the Central Region,

and a 1.5 cents/pound for the Eastern Region. If the

final settlement price is below the CCC support price,

differentials will be reduced by an equivalent amount.

The CSCE Cheddar cheese futures contract calls

for FOB delivery of 10,500 pounds of USDA Grade A

or better Cheddar cheese in 40-pound blocks at any

point within the continental United States (640-pound

blocks are deliverable at a discount of 300 points). The

delivery unit is 4 contracts (42,000 pounds), and the

delivery months are the same as in milk futures. The

cheese will be manufactured from pasteurized milk,

colored, have a moisture basis of 36.5 percent to 39

percent, and must be less than 30 days old on the first

Exchange business day following the first Thursday of

the delivery month. On the day cheese is actually

delivered it must be more than 4 days old. The seller

will ship the cheese from its manufacturing plant or

storage center according to the buyers’ shipping

instructions. Cheese may be delivered at any point

within the continental United States.

A Cooperative’s Risks in Using Dairy Product Futures

Dairy cooperatives manufacture members’ milk

into storable products such as cheese, butter, and nonfat dry milk either as their main lines of business or as

10
last-resort processing. Conventional wisdom would

have it that dairy cooperatives are in the position to

use nonfat dry milk and cheese futures for hedging to

protect inventory values. As with the case of milk

futures, while hedging helps cooperatives manage

price risks, it also creates some new risks. These risks

should be considered when contemplating hedging.

Nonfat dry milk and cheese are products derived

from members’ milk. Dairy cooperatives generally do

not have control over milk production . They take

whatever actual volume members produce and manufacture some or all of it into various products. A cooperative that hedges on nonfat dry milk and/or cheese

futures markets may encounter the risk that actual

milk volume it receives may not be enough to cover

the short position it takes selling futures contracts. Part

of the hedge will become speculative transaction; how

speculative depends on the size of the production

shortfall. For this reason, dairy cooperatives may have

to limit the volume hedged to a fraction of production.

Milk is a flow product as are hard products

derived from it. Flow products must be moved to the

market as soon as possible before excessive inventories

accumulate. Unlike other commodities, nonfat dry milk

and commodity cheese as flow products may not be

suitably stored for later price increases. (Aged cheese is

different, as explained later.) Our estimate is that dairy

cooperatives on average keep manufactured products

inventory for no more than a month. In 1994, the year

the most recent data is available, the Nation’s top 27

dairy cooperatives with processing/manufacturing

operations had an inventory turnover rate (sales to

inventory ratio ) of 41.4. Assuming 60 percent of their

sales was for raw milk and the rest was processed/manufactured products (the actual volume processed/manufactured by cooperatives was 38 percent of member

milk deliveries in 19921, and assuming all of their inventories were processed/manufactured products, the

inventory turnover rate for these products was 16.5.

Allowing for some estimation error, the actual inventory turnover rate may be higher than this number, but in

all likelihood will be less than 30--the inventory level

on average was less than a month’s supply.

Aged cheese may be the exception because it is

sold to the consumer market. Price movements in the

consumer market are very different from price changes

in the commodity market. Consumer psychology is

such that retail marketers and their suppliers usually

do not like to change prices frequently. They change

prices only when they are certain that the changes will

be for a prolonged period of time, or permanent, and

the price adjustments are usually made in a racheting

fashion. In other words, prices in the consumer market

are usually quite stable and do not experience the

same kind of volatility as in the commodity cheese

market.

The futures-implied cash price is the one a cooperative that hedges in the futures market can afford to

pay its members for milk. If, by the contract expiration

date, the cash market price turns out to be higher than

the futures-implied cash price, the cooperatives may

not be able to pay its producers a price as high as its

competitors. This could potentially create a producer

relations problem for the cooperative.

II. Options

There are two type of options: calls and puts. A

call option confers to the buyer the right, but not the

obligation, to purchase a designated futures contract at

a specified price, known as the strike price or exercise

price, at any time prior to the expiration of the futures

contract. On the other hand, a put option confers to the

buyer the right, but not the obligation, to sell a designated futures contract at the strike price, at any time

prior to the expiration of the futures contract. As the

futures market moves, options for additional strike

prices on each futures contract may be available for

trading. Therefore, the total number of different

options may far exceed the number

of futures contracts. The cost of an option (i.e.,

the price the buyer of an option pays) is called the premium.

A put option protects a milk seller against falling

prices. During the effective time period of the put

option, if the current price of the underlying futures

contract is lower than the strike price by at least the

premium, the option holder would come out ahead

(provided that the transaction cost is covered). On the

other hand, if the futures price is not lower than the

strike price by at least the amount of the premium by

the time the underlying futures contract expires, the

option holder would incur a loss. The maximum

amount the holder could lose is limited to the premium (and the transaction cost). While the loss is limited,

the protection the put option provides is potentially

large. The tradeoff is that the probability of the potentially small loss may be high, while the probability of

the potentially large gain may be low.

A holder of the call option profits from rising

prices or is protected against rising milk prices if the

holder is a milk buyer. A call option is profitable when

the current price of the underlying futures contract is

higher than the strike price by at least the premium

(provided that the transaction cost is covered). The

11
holder of the option could buy the futures contract and

settle it for a profit. However, if the current price of the

futures contract is not higher than the strike price by at

least the premium by the time the underlying futures

contract expires, the call option holder would incur a

loss. The maximum amount the holder could lose is

the premium (and the transaction cost). While the

potential loss to the option holder is limited, the potential gain is unlimited. Again, the tradeoff is that the

probability of the potentially large gain may be low,

while the probability of the limited loss may be high.

The observation by Schwager provides a good

summary of options trading:

Roughly speaking, the option buyer accepts a

large probability of a small loss in return for a small

probability of a large gain, whereas the option seller

accepts a small probability of a large loss in exchange

for a large probability of a small gain. In an efficient

market, neither the consistent option buyer nor the

consistent option seller should have any advantage

over the long run.

An option allows the hedger to sell or buy a

futures contract at a time closer to the contract expiration date than outright futures trading. Presumably by

the time the option is executed, more market information would be available to make hedging less risky.

However, for dairy producers or cooperatives, using

options requires more investment in information gathering to determine if the price protection is worth the

premium, and how likely a large price increase may

be. Using options is a more costly method of hedging

when price movements are relatively small.

III. Forward Contracts

There are many variations of forward contracts

that have been used by commodities other than dairy.

In dairy, current market transactions are most prevalent. Forward contracts are rarely used, although the

marketing agreements between dairy farmers and

their cooperatives might be interpreted as one form of

forward contracts that promise future deliveries without specifying volumes or prices. Some cooperatives,

however, provide price guarantees to some new or

highly leveraged farmers to enable them to obtain

bank financing.

There have been recent discussions about “newgeneration” dairy cooperatives that would issue delivery rights to members based on their equity subscription. The plan is similar to a conventional marketing

agreement, except in this case, the delivery volume is

specified. Only the milk volume that is within the

delivery rights is entitled to receive a favorable price

and to share in the earnings of the cooperative and

enjoy certain other privileges. The delivery rights may

be transferrable at the discretion of the cooperative’s

board of directors. This plan is workable if the coopcrative consistently generates positive earnings to make

purchasing the delivery rights worthwhile. For a milk

producer whose production surpasses the delivcryright contract volume, the excess milk is likely to be

priced lower. Overall, whether the producer would be

better off under the new-generation delivery rights

arrangement depends on the relative proportion of

contract versus non-contract volumes and on the price

difference between the two types of delivery.

Another form of forward contract being discussed is a fixed-volume, fixed-price contract. (This is

the common form used by other commodities, but

rarely used by dairy cooperatives.) Producers would

forward contract with the cooperative. The contract

would specify a predetermined fixed price for a given

volume of milk delivery for a given time period (most

likely for a particular month).

In essence, this type of forward contracts shift

price risks from the contracting producers to the cooperative. The shift in risks reveals some interesting

aspects of forward contracts:

l A cooperative is owned by its membcr-producers. Shifting the risks from the producers to the cooperative does not diminish producers’ risks. Rather, the

risks remain the same, except that they are collectively

assumed by the cooperative. Shifting the risks assumes

that the cooperative could manage the risks better than

the individual producers could do themselves.

l Some member-producers probably would not

use the forward contracts. Therefore, they probably

would not cover all milk volume produced by mcmber-producers. Because of the costs of managing the

risks, shifting price risks to the cooperative through

forward contracts would disadvantage those producers whose production is not under forward contracts

or the milk volume that is not covered by forward contracts. A separate pricing pool may have to be maintained by the cooperative to pool the proceeds and

share expenses from forward contracting.

l Fixed-price forward contracts would compel

the cooperative to hedge the contracted volume to protect the cooperative from price risks. The cooperative

may make advanced sales of, say, cheese to buyers at a

certain price, to be delivered later when the contracted

milk volume is available. Thus, price risks arc shifted

to the cheese buyers. Alternatively, the cooperative

may hedge the contracted volume in the futures market. Over the long run, forward contracts may not

12
return more than current market milk prices to producers. As a matter of fact, forward contracts can be

expected to return lower milk prices because of the

costs of transacting forward contracts and trading

futures.

l The cooperative should be aware of the risks

associated with futures trading, if it decides to hedge

the contract volume on the futures market.

There have been many empirical studies of forward contracts in commodities other than dairy.

Brorsen, et al., in their analysis of the data of Texas

Gulf forward basis bids for Hard Red Winter wheat

from 1975 to 1991, concluded that a farmer would

average about $0.02 to $0.04 per bushel less forward

contracting on April 15 (before harvest begins) each

year than by selling during the last half of June (when

harvest is near completion). They concluded that farmers were paying a premium for the service of forward

contracting, which was consistent with earlier studies

on live cattle, grain, and soybeans.

In a recent extensive study of the red meat packing industry organized by USDA Grain Inspection,

Packers and Stockyards Administration, a team of

researchers found that cattle purchased by packers

under forward contracts brought $1.74 per cwt. (liveweight) less than delivered prices for similar cattle

obtained on the spot market, while marketing agreement cattle brought prices about 54 cents above spot

market prices. (In livestock procurement, a forward

contract is a contract between a packer and a seller to

purchase a specific lot of cattle at a future date, with

the contract established at any time from placement of

cattle on feed up to 2 weeks prior to kill date; a marketing agreement is a long-term arrangement between

a packer and a seller in which the packer agrees to

purchase a specified number of cattle per specified

time period such as a week, month, or year.) Using a

different data-set, another team of researchers for the

same study found that prices paid for cattle delivered

under forward contracts on any given day were about

$3.00 per cwt. lower (dressed-weight basis) than prices

for similar cattle on the cash market, while prices for

cattle obtained through marketing agreements were

about 10 cents per cwt. higher than prices for cashmarket cattle.

These studies show that forward contracting is

certainly not free. Producers pay a price for shifting

market risks to other parties. As a result, forward contracting prices tend to be lower than spot market

prices. It is also interesting to note that cattle sales

under marketing agreements received higher prices

than the spot market.

Dairy cooperatives have only limited experience

with fixed-volume and fixed-price forward contracts.

Alto Dairy Cooperative at Waupun, WI, is believed to

be the first one to pioneer such contracts for dairy. In

1994, the cooperative conducted a pilot program for

members to forward-contract a portion of their milk

production. The pilot project used cheese futures contracts because 90 percent of the change in the basic formula price can be explained by changes in Cheddar

cheese prices. In addition, the milk futures contracts

had not been developed at the time of the project

which was conducted between August 1,1994 and

August 31,1995. (Alto’s pilot program was evaluated

in a report by Cropp.)

Seventy-eight producers signed up for the project, where 43 actually executed one or more cash forward price contracts during the 13-month trial period.

Alto Dairy would bid to buy milk delivered into the

future. The bid price was based on the previous business day’s prices for Cheddar cheese futures contracts

on CSCE. Producers could phone Alto Dairy each

morning and get the offered bid prices. Quoted bid

prices were base prices; producers who contracted

received all premiums and price adjustments otherwise paid by Alto Dairy on all member milk delivered

to the cooperative. If a bid price was acceptable, the

producer could contract a specified quantity of future

milk production at that price. Producers had the

option of forward contracting 5,000 pounds or more of

a given month’s milk production, up to a maximum of

50 percent of their monthly milk production. The producer could contract various milk volumes at more

than one price per month as long as the total quantity

contracted for the month was less than 50 percent of

monthly milk production. Some producers accepted

more than one contract price for a given month. If the

bid prices were unacceptable, producers were not

obligated to contract future milk production.

Alto Dairy was able to guarantee producers the

contract price by selling Cheddar cheese futures to

hedge the producer contracted volume and then buying offsetting Cheddar cheese futures when the milk

was delivered. If the price of cheese declined in the

time between the two transactions, Alto Dairy would

make a profit on the futures market and add this profit

to the now lower cash price to pay the contract price

for milk. If the price of cheese increased, Alto Dairy

would experience a loss on the futures market but pay

producers the contract price, which was lower than the

cash price. Thus, the net effect to Alto Dairy was to

come out the same (except for the transaction cost) as

if paying producers the going cash price, while pro13
ducers receive a guaranteed price for future milk production, regardless of cash market price changes.

Alto Dairy assumed some risks in offering the

forward contracts to members and viewed the associated costs as the cost of providing the member service.

One of the risks is basis change. (Basis is the relationship between the cash and futures market prices.) If

the basis changes between the time of setting and lifting of a hedge, the price objective will not be met. By

assuming this risk, Alto Dairy would gain or lose by

the amount and direction of basis change.

Furthermore, Alto Dairy’s bids were offered based on

the previous business day’s settling price for Cheddar

cheese futures. Alto Dairy may not always have been

able to set a hedge at the exact bid price. This difference between contract price and hedged price is

known as slippage.

At the end of the 13 months, Alto Dairy showed a

net gain from all forward contracts combined, even

after paying brokerage commission. Alto’s objective is

to adjust the basis used in forward contract price quotations so that the gain/loss is near zero.

Although 256 total individual forward price contracts were made by producers, Alto Dairy made only

201 short hedges to cover them. Alternatively, the

unhedged cash forward contracts were protected with

corresponding cash cheese sales.

By the end of the pilot project (August 31,1995),

136 contracts resulted in the producer getting a $03 to

$.73 per cwt higher price than Alto Dairy’s actual producer pay price, 119 received a $.Ol to $76 per cwt

lower price as a result of their forward contract(s), and

one contract was equal in price. On average, the cash

forward contract price was $.003 per cwt higher than

Alto Dairy’s actual pay price for milk.

Evaluating the Traditional Pricing

System in Terms of Managing Price

Risks

In light of the assessment of the emerging mechanisms for hedging price risks, it is also useful to evaluate the traditional milk pricing system in regard to

price risk management.

Most dairy cooperatives coordinate milk marketing over a wide geographical area, and pool and

reblend their proceeds monthly to pay producers.

These practices ensure that pay price for producers in

the same pool is equalized regardless of location and

regardless of milk price movements during the month.

Individual member-producers share price risks together-much like mutual insurance.

Marketing agencies in common of dairy cooperatives that pool earnings and costs of marketing dairy

products are also akin to institutions of mutual insurance. Marketing agencies in common may be particularly useful for dairy cooperatives in the export markets where price fluctuation is potentially more

volatile than in the domestic market.

There is a pronounced seasonality of milk production, and price movements tend to run counter to

the seasonal production pattern. Therefore, producer

cash flow may be more even than seasonal movements

in price or production alone would suggest. Also,

because milk is a flow product, in the long run the

average cash market milk price, in theory, can be

expected to be even with the average futures-implied

cash price received by a producer who hedges all production all the time on the futures market-what is

called automatic hedging.

Dairy cooperatives concerned with product price

fluctuation usually have the ability to manage risks

through changes in business practices without having

to follow an explicit hedging plan. Because they usually have multi-product, multi-plant operations, they

have the flexibility to shift production to products that

would return the highest margins. Other examples

include faster inventory turnover to avoid inventory

write-downs, integrating into the consumer and niche

markets to avoid the volatilitics in the commodity

markets, forming marketing agencies in common to

gain better market intelligence or coordinate product

marketing, and joint ventures with other firms to shift

some risks to partners.

But, by shifting or offsetting existing risks, these

cooperatives arc certain to take on new ones. A multiproduct, multi-plant cooperative may cncountcr

chronic excess plant capacity. Faster inventory

turnover may result in not having enough inventory to

take advantage of rising prices or sales opportunities.

Integrating into the consumer-product or niche markets requires a new set of business ingredients such as

ample capital, a forward-looking board of directors

and capable management, among many other things.

Having all the right ingredients does not guarantee

success, but lacking any one can doom the business

enterprise. For a cooperative that is in a joint venture

with another firm, the risk is that the joint venture

partner may not successfully perform its side of the

contract. The cooperative may also find its own opcrational flexibility being rcstrictcd by the joint venture

contract.

14
Conclusion References

The traditional pricing system has served dairy

cooperatives and their members well. In the gradually

deregulated dairy market environment where the

awareness of price instability is heightened, the challenge for the board of directors and management is to

assess the overall risks of the cooperative’s operations

and determine how the risks may impact on producer

pay prices through their traditional pricing system,

and if and how the risks should be managed. They

may want to manage the risks by taking advantages of

the flexibility in the business system, by changing their

business practices, or by forming alliance with other

firms to shift the risks.

If they decide that some of the risks should be

managed by using the emerging hedging mechanisms,

it is imperative that they should understand what each

hedging mechanism is, how it works, what it is used

for, and the risks involved in using it. (This and the

next paragraphs benefitted from the insights presented

in The Economist.)

Because the opportunities for using the hedging

mechanisms and the risks involved in using them tend

not to be fully comprehended, they are susceptible to

misuses. What is intended as hedging sometime turns

out unexpectedly to be speculating and wreaks havoc

on the cooperative. This has been the experience in

some commodities other than dairy. Therefore, careful

management and prudent precautions are required in

using them. If the board of directors decides some of

the risks should be managed with the emerging hedging mechanisms, it should determine a hedging strategy for the cooperative that should at least include the

following:

l Treat risk management as an integral part of

the cooperative’s overall corporate business strategy,

not as an isolated business function.

l Adopt an explicit policy for the use of the

hedging mechanisms and spell it out to the membership.

l Set up a process to monitor the cooperative’s

uses of the hedging mechanisms.

l Have safeguard to ensure that controls are in

place to protect against misuse and fraud.

l Require that risk exposures by using the hedging mechanisms be properly accounted for in the

financial statements to inform members, creditors, and

other interested parties.

Brorsen, B. Wade, J. Cooms, and K. Anderson. The

Cost of Forward Contracting Wheat.

Agribusiness, Vol. 11, No. 4,349-354 (1995).

Coffee, Sugar & Cocoa Exchange, Inc. Trading Milk

Futures and Options. Coffee, Sugar & Cocoa

Exchange, Inc., New York. 1995.

Cropp, Robert A. Forward Milk Contracting Pilot

Program, Alto Dairy Cooperative: Summary

September 1994-August 1995. University of

Wisconsin Center for Cooperatives, Madison, WI.

February 1996.

Cropp, Robert A. and M. Stephenson. Introduction to

Cheese and Nonfat Dry Milk Futures. Dairy

Markets and Policy Issues and Options, Cornell

University, M-12, February 1995.

The Economist. Too Hot to Handle? A Survey of

Corporate Risk Management. The Economist.

February lOth, 1996.

Fortenberry, Randall T., R. Cropp, and H. Zapata.

Analysis of Expected Price Dynamics Between

the Proposed Fluid Milk Futures Contract and

Cash Prices for Fluid Milk. A report to the Coffee,

Sugar, and Cocoa Exchange, Inc. September 1995.

Liebrand, Carolyn B. Security, Price or Service? Farmer

Cooperatives. U. S. Department of Agriculture,

Rural Development Administration, Cooperative

Services Programs. Washington, DC. September

1994.

Ling, K. Charles and Carolyn Betts Liebrand.

Marketing Operations of Dairy Cooperatives. U.

S. Department of Agriculture, Agricultural

Cooperative Services. ACS Research Report 133.

Washington, DC. April 1994.

Ling, K. Charles and Carolyn Betts Liebrand. Vertical

Integration Patterns of Dairy Co-ops Reflect

Changing Market. Farmer Cooperatives. U. S.

Department of Agriculture, Rural Business and

Cooperative Development Service, Cooperative

Services Programs, Washington, DC. September

1995.

Manchester, Alden C. The Public Role in the Dairy

Economy-Why and How Government Intervene

in the Milk Business. Westview Press, Boulder,

co. 1983.

Schwager, Jack D. A Complete Guide to the Futures

Markets: Fundamental Analysis, Technical

Analysis, Trading, Spreads, and Options. John

Wiley & Sons, Inc., New York. 1984.

15
U. S. Department of Agriculture. Concentration in the

Red Meat Packing Industry. U. S. Department of

Agriculture, Grain Inspection, Packers and

Stockyards Administration, Washington, DC.

February 1996.

U. S. Department of Agriculture. Farmer Cooperative

Statistics, 1994. U. S. Department of Agriculture,

Rural Business-Cooperative Service, RBS Service

Report 49. November 1995.

The information about Coffee, Sugar & Cocoa

Exchange, Inc. and Chicago Mercantile Exchange

is based on the postings by the two exchanges on

the World Wide Web as of June 25,1996.

16
U.S. Department of Agriculture

Rural Business/Cooperative Service

Stop 3250

Washington, D.C. 20250-3250

Rural Business/Cooperative Service (FIBS) provides research, management, and

educational assistance to cooperatives to strengthen the economic position of farmers and

other rural residents. It works directly with cooperative leaders and Federal and State

agencies to improve organization, leadership, and operation of cooperatives and to give

guidance to further development.

The cooperative segment of RBS (1) helps farmers and other rural residents develop

cooperatives to obtain supplies and services at lower cost and to get better prices for

products they sell; (2) advises rural residents on developing existing resources through

cooperative action to enhance rural living; (3) helps cooperatives improve services and

operating efficiency; (4) informs members, directors, employees, and the public on how

cooperatives work and benefit their members and their communities; and (5) encourages

international cooperative programs. RBS also publishes research and educational

materials and issues Rural Cooperatives magazine.

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programs on the basis of race, color, national origin, sex, religion, age, disability, political

beliefs and marital or familial status. (Not all prohibited bases apply to all programs.)

Persons with disabilities who require alternative means for communication of program

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To file a complaint, write the Secretary of Agriculture, U.S. Department of Agriculture,

Washington, D.C. 20250, or call (202) 720-7327 (voice) or (202) 720-l 127 (TDD). USDA is

an equal employment opportunity employer.