15 January 2013

6 minute read

Prices are important. Prices can rise and fall to the alternating delight and disappointment of consumers and producers. However, you might be surprised to learn that economists do not always see price volatility as a bad thing. In fact it’s an essential signal to producers and consumers of goods that determines the amount that is produced and consumed. However, since 2007, EU and world dairy markets have been in a cycle of extreme price volatility. This extreme volatility has been mirrored at farm level where milk producers have seen monthly per litre milk prices in excess of 40 cent and as low as 20 cent over the last few years (see Figure 1). Extreme price volatility is a serious business problem affecting profitability, cashflow and investment decisions of farms and milk processors.

There is a growing desire to limit exposure to the extreme price volatility that the dairy industry faces. Reflecting this concern Teagasc, Cork Institute of Technology (CIT) and the Irish Cooperative Organisation Society (ICOS) recently organised a one-day conference for about 60 dairy executives and other interested parties from around Ireland. The event included contributions from researchers, risk industry professionals and the dairy industry. Some of the key issues discussed are summarised below.

Milk Price Volatility

There are particular reasons for the Irish dairy sector to be concerned about price volatility. The first is the planned expansion in milk production once milk quotas are removed and the second is high reliance of the Irish dairy industry on export markets. The seasonality of Irish milk production and the resulting commodity focus of the dairy processing industry means that much of Irish production is concentrated in four to five months of the year, making market returns, milk prices and dairy farm incomes vulnerable to even short term price fluctuations.

Milk Producers and Milk Processors

There are knock-on consequences of price volatility for farm incomes. But the negative effects of price volatility extend beyond farmers’ incomes, affecting cashflow, capacity to secure financing for investment and farmers’ ability to fund the repayment of financing. Price volatility also creates business problems for milk purchasers and processors and in a post-milk quota environment could create uncertainty in terms of the volume of milk supplied by farmers. Processors facing volatile farm gate milk prices also face challenges in correctly pricing dairy products during contract negotiations with their own dairy commodity customers. This uncertainty can have an impact on business profitability and the ability of processors to fund expansion plans.

Policy Tools to Address Risk

Policy tools may be able to counter extreme price volatility. In the context of the Common Agricultural Policy (CAP), the role of the Single Farm Payment as an income volatility buffer at farmlevel must be acknowledged. CAP reform could be used as an opportunity to introduce enhanced measures to address excessive price volatility. However, any new tools designed to manage price volatility through the CAP will need to be funded out of, at best, a fixed CAP budget and in all likelihood, such funding would have to be diverted from existing policy schemes.

In the USA, price volatility increased significantly in the late 1980s as a result of reduced price supports. So from an EU perspective, it is instructive to look at how the USA has dealt with extreme milk price volatility. For some years, the USA dairy industry has, with mixed success, been using a combination of public and private risk management tools to counter price volatility. The search for appropriate instruments for the USA market continues in the current USA Farm Bill deliberations, which are set to run into the first quarter of 2013.

Risk Management Through Financial Instruments

In the USA, dairy futures markets exist but, with the exception of USA class III milk contracts, these dairy futures are thinly traded. By contrast, the use of such financial products in the EU dairy sector is in its infancy. In the EU, in order to get others (in particular speculators who do not have a physical need to hedge) to share or assume some of the risk faced by farmers and milk processors, there will be a growing requirement for public access, on a timely basis, to accurate key dairy market price and quantity data. These data quality criteria are currently met in the USA but not in the EU.

Forward Milk and Input Pricing

There is a need to develop milk producers’ understanding of the concept of forward pricing of milk (and inputs). Some Irish dairy processors argue strongly that there are benefits to farmers from locking in a portion of their milk price, as well as, if possible, a portion of their input costs. However, while research has shown that there are tangible benefits to processors in locking in prices for milk, the USA experience indicates that the benefits to milk producers are not always as clear cut. In the context of volatile milk prices, farmers need more than just milk/input price certainty. Farmers also desire a price that returns a profit each year.

Given their position as price takers, farmers cannot use these tools to lock in a price that guarantees a profit every year. However, forward pricing can often provide peace of mind by reducing, though not eliminating, the likelihood of producers experiencing an income crisis in a given year.

Milk Pricing Index

Dairy industry commentators have observed that in recent years, Irish dairy processors have been forced to engage in a form of ineffective milk price smoothing. Cash reserves are used to hold prices at elevated levels when commodity markets begin to take a downturn, rather than using such reserves to boost prices when commodity markets are at their weakest. However, this entails making provisions for the inevitable rainy day when dairy product markets are buoyant.

There is merit in developing a transparent, objective and fair milk pricing tool, common to all Irish milk purchasers. Such an index would clearly identify to farmers and processors the commercial value of milk at all times in the price cycle. This would allow producers and purchasers to develop tools to stabilise incomes through, for example, a system of counter cyclical milk payments (payments that would be triggered in periods of low market prices). Such payments could be funded through deductions from price peaks, as well as via possible CAP Pillar II supports. Such a milk pricing tool would also facilitate the development of derivatives based tools, as such tools depend on objective pricing structures (like the Chicago Mercantile Exchange) to close out contracts.

The Role of Education

With the increased prevalence of volatile prices and the emergence of risk management as a business objective at both the processor and producer level, the relative novelty of risk management tools at the farm and processor levels means that there is a requirement for a programme of education for stakeholders across the dairy industry.

Volatile agricultural prices are a consequence of policy reform and the integration of European and global agricultural commodity markets. Irish farmers and the Irish agri-food industry will increasingly need to plan for an existence characterised by such volatility. Public policy and risk management instruments such as forward contracting, futures and derivatives contracts all have a potential role to play in enhancing the agri-food sector’s ability to mitigate the impact of risk.

Education in relation to the use of risk mitigation strategies as well as the development and dissemination of timely high quality market information, including transparent milk pricing indices, will be important to the future of the Irish dairy industry.

January 2013