Hedging Dairy Prices to Lower Risk

ANALYSIS - Dairy farmers could reduce the risk of volatile markets by using hedging contracts for a portion of their production, writes Chris Harris.
calendar icon 20 September 2012
clock icon 3 minute read

Hedging has been used to reduce the risk in other volatile areas such as equities, foreign exchange and energy that are all subject to price spikes and dips.

And hedging is also used in other commodity products that are also subject to the volatility of the market.

However, commodities risk manager John Lancaster from the Dublin based FC Stone Commodity Services said the use of hedging tools by milk cooperatives and processors in the UK and Europe could ease the burden of the highs and lows of the market and help fix prices.

Speaking at the recent Dairy UK conference in Birmingham, Mr Lancaster said that hedging has already been used elsewhere around the world by Dairy Farmers of America and Fonterra.

But he said the option was not just something for the big players. It is now becoming more and more relevant since the UK and EU market became more volatile.

Up to 2007, the dairy markets had been relatively stable with movements of just plus or minus two per cent.

But since that time, they had become more volatile and price spikes - both positive and negative - of up to 40 per cent have been seen in both SMP and butter.

Part of the reason for the spikes and the volatility was not down to speculators, but simply supply, demand and policy.

Prices have been affected by the removal of export refunds and support allowing milk to find its own level on the open market.

He said: "Volatility is a factor of the market now and the industry was not prepared for it."

Other factors that have made the dairy markets so volatile over the last five years have been the prices of cereals and grain.

Soy has been showing spikes of 20, 30 and 40 per cent on the Chicago Board of Trade and the Paris Maize contract has been showing fluctuations of 30 per cent while London Feed Wheat showed spikes of 60 to 70 per cent in 2010.

"All these impact on the dairy sector," said Mr Lancaster.

Extreme volatility hits cash flow and planning, investment, research and development he said.

However, Mr Lancaster said that from examples in the US have shown that by tracking at a hedged rate, farmers may have missed the highs in the prices, but they also missed the deep lows.

He added that retailers and ingredients buyers prefer to do business with suppliers who are able to provide a stable price and for farmers hedging contracts offer the opportunity for some degree of certainty on margins and in the US they have helped farmers to develop their businesses.

He said that typically a farmer would hedge between 40 and 60 per cent of production, allowing the rest to be subject to market forces.

He said that by fixing a rate and hedging the farmer has certainty as to price of future production or percentage of production and the co-op secures future supply of milk. The co-op also does not have the risk of fixing its price. And it can then offer fixed pricing to customers and ensure margin.

While processors have been slower than farmers to take up the concept in Europe to date the EU has seen 15,000 tonnes of better, 5,000 tonnes of SMP and 1,000 tonnes of cheese hedged.

Mr Lancaster concluded: "Dairy is in competition with other products that have these tools and high price volatility here to stay.

"The industry needs a full range of tools to be competitive on world markets."

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