United StatesDepartment ofAgriculture

Rural Business-CooperativeService

RBS ResearchReport 152

Dairy Cooperatives’Role in ManagingPrice Risks

Abstract Prices for milk and dairy products have become increasingly unstable asthe Government support safety net has been lowered. Dairy coopera-tives’ traditional pricing system is delineated and their role in the newmarket environment is discussed. Some of the risks involved in usingemerging hedging mechanisms such as futures, options, and forwardcontracting for managing price risks are assessed. The traditional pric-ing system in regard to managing price risks is evaluated. Guidelines fordeveloping a cooperative’s hedging strategy are suggested.

Key words: Cooperatives, dairy, pricing, hedging, futures, options, for-ward 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 capaci-ty by lowering the price support safety net since the mid-1980s resultedin wide and uncharacteristic milk price fluctuations beginning in 1988.The drastic price changes since 1989-90 have served as a wakeup callto the dairy industry that price volatility has become a fact of life as theindustry moves toward a market-oriented dairy economy.

Dairy cooperatives have adapted to the situation and hedged the pricerisks by diversifying into multi-product and multi-plant operations, expe-diting inventory turnover, integrating and diversifying into consumer-product and niche markets, forming marketing agencies in common toshare market information or coordinate dairy product marketing, andentering joint ventures with other firms to shift away some of the risks.

New dairy price hedging mechanisms have been introduced by com-modity exchanges. The Coffee, Sugar and Cocoa Exchange, New York,began trading Cheddar cheese and nonfat dry milk futures contracts inJune 1993, and in December 1995, also started trading milk futurescontracts. The Chicago Mercantile Exchange launched trading of milkfutures contracts in January 1996. There has also been some experi-menting with forward contracting, based on these futures contracts.

Futures, options, and forward contracting have been used extensivelyfor price hedging by some other commodities, but the dairy industry isjust beginning to learn to use them. This report attempts to add someknowledge to the learning process for dairy farmers and their dairycooperatives. It is neither a trading guide nor an exhaustive explorationof the subject matter.

This report focuses on dairy cooperatives’ role in managing price risksfor the benefit of member-producers who are also their owners andpatrons. This relationship is fundamentally different from the onebetween proprietary milk handlers and their milk shippers. Therefore,discussions in this report that are relevant to dairy cooperatives’ role inmanaging price risks may not be applicable to proprietary handlers’ riskmanagement 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 aMilk 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 mar-ket for their milk. Dairy producers sign membership (marketing) agree-ments with their cooperatives, making them their exclusive marketingagent. Members then ship all the milk they produce to the cooperativewhich finds a market for that volume. Pay prices for most milk are basedon the pool blend price of Federal milk market orders. Cooperatives mayadd operating earnings to and subtract operating expenses from poolpayment and pay producers a reblended price. A “13th check” at the endof the fiscal year distributes part or all of the cooperative’s net savingsfrom operations to its members. Such is the essence of a dairy coopera-tive’s role in the traditional pricing system of milk.

This system has brought a degree of stability to the milk market. TheGovernment price support program provides a floor price for milk.Government programs, marketwide pooling, and cooperative reblendshave created pricing uniformity among producers over a wide region anddampen the fluctuation of milk prices they receive.

Prior to 1981, the milk support price level was mandated at between 75and 90 percent of parity. In the mid-1970s support prices were fre-quently adjusted upward because of rapid inflation. High prices broughton expanded milk production and milk prices hovered around the sup-port price level. This served as a floor under milk prices and with thesurplus, in effect, a ceiling. To reduce the surplus, the price support levelwas tied to the size of the Commodity Credit Corporation (CCC) pur-chases in the 1981 legislation. Legislation in 1982 froze the supportprice level for 2 years and producers were assessed to help pay for theprogram. Support prices were lowered in the 1983 and in the subse-quent legislation. The whole-herd-buy-out program that ended in 1987helped create a relative balance of supply and demand. With a lowerfloor price, milk prices were more responsive to market forces and start-ed to experience wide fluctuation beginning in 1988.

Dairy cooperatives have managed price risks by taking advantage of theflexibility in the business system, by changing their business practices,or by forming business alliances with other firms to shift the risk. Inmany cases, cooperatives with multi-product, multi-plant operationshave the flexibility to shift production among products that would returnthe highest margins. Other examples include faster inventory turnover toavoid inventory writedowns, integrating into the consumer and nichemarkets to avoid the volatilities in the commodity markets, forming mar-keting agencies in common to gain better market intelligence or coordi-nate product marketing, and forming joint ventures with other firms toshift some risks to partners.

Hedging mechanisms are emerging for managing price risks.Commodity exchanges saw the opportunities in the price volatility in thedairy markets and offered futures and options for hedging price risks.

. . .111

Highlights The Coffee, Sugar and Cocoa Exchange began trading Cheddar cheeseand nonfat dry milk futures contracts in 1993 and started trading milkfutures contracts in 1995. The Chicago Mercantile Exchange begantrading milk futures contracts early in 1996. Some cooperatives haveexperimented with forward contracting for milk production, selling futurescontracts to offset fixed price agreements with members.

Milk and dairy products have some unique characteristics that mayaffect the use of the emerging hedging mechanisms. Milk production isa bovine biological process. It is produced day in and day out.Therefore, milk is a flow product. By extension, dairy products such ascommodity cheese, butter, and nonfat dry milk are also flow products.Under the pressure of accumulating products, inventory management isusually for regulating dairy product flow to the market rather than forstoring for later sales at anticipated higher prices.

Milk production is limited by the number of cows in individual herds. Cownumbers increase only gradually, so it is unlikely to have unforeseendrastic increases in milk production. This limitation on milk productionundergirds the floor price of milk, although the price floor may not bevisible or rigid. On the other hand, consumption of milk and dairy prod-ucts also changes gradually. Given a stable milk production level and astable consumption trend, shocks to the milk market usually translateinto upswings in milk prices.

Hedging by definition is a break-even proposition. By shifting awayundesirable price risks, a hedger actually takes on some new risks. (Therisk of basis changes inherent in all futures contracts is not discussed inthis report.)

For dairy cooperatives using the futures market to hedge price risks,possibilities exist that actual milk volume delivered by members may belower than the short position taken by the cooperative on the futuresmarket. (Short position refers to the volume represented by the futurescontracts sold.) Part of the hedge may become speculation. For this rea-son, dairy cooperatives may have to limit the volume hedged to a certainfraction of member production. Another possibility is that the futures-implied cash price may be lower than the cash market milk price preva-lent when the futures contracts expire, and the cooperative may be out-paid by competitors. This would create a potential problem for producerrelations. Still another possibility is that the futures market may not beliquid enough for the cooperative to liquidate its futures position by thesettlement date. There may be some other possible unforeseen risks.

(Dairy farmers who use the futures market to hedge may encounter sim-ilar risks. In addition, they may need to hedge input costs to make surethat the futures-implied milk price will yield profitable earnings.

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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 marketingagreement between producers and their cooperatives might be inter-preted as one form of a forward contract that promises future deliverieswithout specifying volumes or prices. The so-called new-generationdairy cooperative would issue delivery rights to members based on theirequity subscription. The plan is similar to a conventional marketingagreement, except that the delivery volume is specified.

Forward contracting usually refers to contracts that promise future deliv-ery 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 risksfrom the producers to the cooperative does not diminish producers’ col-lective risks. Contracted volume should constitute a separate pricingpool so that producers who are not under forward contracts will not haveto share the contract risks and expenses. Studies of other commoditiesshow that forward contracting on average returns a price lower thancash market price because producers have to bear the costs of this ser-vice-an analogy in the purchase of insurance.

Under the traditional pricing system, wide-area pooling of milk pricesand reblending by dairy cooperative are similar to mutual insurance ofmilk prices by producers. Marketing agencies in common of dairy coop-eratives that pool earnings and costs of marketing dairy products arealso akin to institutions of mutual insurance. Marketing agencies in com-mon may be particularly useful for dairy cooperatives in the export mar-kets where price fluctuation is potentially more volatile than in thedomestic market.

Because milk is produced continuously and priced regularly, theoretical-ly the traditional pricing system is expected to pay producers an averageprice in the long run that is even with the average milk price yielded by“automatic hedging” (hedging all production all the time with futures con-tracts), without having to incur futures transaction costs.

Adapting to price instability by shifting or offsetting existing risks bychanging 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 opportu-nities because the cooperative is short of inventory. Integrating into theconsumer-product or niche markets requires a new set of businessingredients that the cooperative might be lacking. Joint ventures run therisk that the joint venture partner may not perform its side of the con-tract. The cooperative may also find the contract restricts its own opera-tional flexibility.

V

Highlights Risk management should not be an isolated business function, butrather an integral part of the cooperative’s corporate strategy. The coop-erative should assess the overall risks of its operations and determinehow the risks may impact on producer pay prices through the traditionalpricing system. If some of the risks are deemed to be best managed byusing the emerging hedging mechanisms, the board of directors shouldspell out the policy and prepare guidelines for using them. The prerequi-site for a sound hedging strategy is understanding what each hedgemechanism is, how it works, what it is used for, and the risks involved inusing it.

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Dairy Cooperatives’ Rolein Managing Price Risks

D airy cooperatives play a prominent rolein marketing milk. Based on farmers’1994 cash receipts, an estimated 86 per-

cent of milk at the first handler level was marketed bythe Nation’s 247 dairy cooperatives. Working in tan-dem with Government programs, dairy cooperativeshave promoted stability and orderliness in the mar-ketplace.

The Federal Government has historically playeda significant role in milk marketing. For more thanone-half a century, the Government has provided adairy price support program and the Federal milkmarket order program. The support program reducesdairy farmers’ and their cooperatives’ price risks byensuring that they would receive at least the supportprice for their milk. The market order system providesfor orderly marketing of milk by ensuring equal rawproduct costs to handlers and equal blend pay pricesto producers. However, in the mid-1980s theGovernment began successively lowering the level ofprice supports for milk to reduce surplus production.The Federal Agriculture Improvement and Reform Actof 1996 (the 1996 farm bill) provides for further reduc-tions in the milk support price through 1999 and com-plete elimination of the support program in 2000.Beginning January 1,2000, a recourse loan program forCheddar cheese, butter, and powder will become effec-tive. (The dairy price support program as authorizedby the Agricultural Act of 1949 will be effective onJanuary 1,2003, if no new legislation is enacted priorto that date.)

The changes in the Government dairy price sup-port program since the 1980s have resulted inincreased fluctuation in milk prices. Changes outlinedin the 1996 farm bill are expected to continue or

increase price volatility in a dairy sector that relies onmarket forces. Because of this volatility, price riskshave become a growing concern of dairy farmers andtheir cooperatives. This report examines the traditionalroles of dairy cooperatives in milk pricing and howthey address price risks, and assesses the implicationsof the emerging mechanisms for managing pricevolatility for dairy farmers and cooperatives.

Traditional Pricing Roles

As the dairy industry developed in the earlyyears of this country, producers faced marketing risksdue to undependable market outlets for milk, erraticand chaotic milk pricing by dealers, seasonally fluctu-ating milk supplies, and the distance between farmsand cities (centers of consumption). In response, dairyproducers formed cooperatives that extended theirfarm businesses beyond the farmgate. Through collec-tive action, farmers were able to more effectiveIy bar-gain for milk prices, balance supply and demand, andtransport milk more economically, among other things.

Assured MarketsA fundamental role of dairy cooperatives is to

guarantee members a market for their milk. In fact,surveys of dairy farmers have shown that the assur-ance of a market and guarantee of payment for theirmilk are the primary reasons they belong to a coopera-tive. By negotiating terms of trade collectively, dairyfarmers reduce their exposure to loss of market orunreasonable terms of trade.

Dairy producers sign membership (marketing)agreements with their cooperative, making it their

exclusive marketing agent. Members then ship all theirmilk to the cooperative which finds a market for themilk. Cooperatives typically exert little or no influenceover the volume of milk produced by members.

Bargaining cooperatives carry out the obligationto market their members’ milk solely by negotiatingmilk prices with customers and rarely take title to themilk. These cooperatives do not own manufacturing orprocessing facilities. Other cooperatives negotiate milkprices with customers and also own manufacturingand /or processing facilities. Thesemanufacturing/processing cooperatives either usetheir facilities to handle milk not needed by their cus-tomers or add value to members’ milk by makinghigher value products, or both.

The ability of manufacturing/processing cooper-atives to handle surplus milk by manufacturing it intostorable products, to a certain extent, reduces theirexposure to milk price risks. When milk suppliesincrease, they can move surplus milk into manufactur-ing plants, thus, solidifying their bargaining position.When supplies tighten they may be able to shift milkfrom manufacturing to fulfill their customers’ needswithout having to purchase milk from spot markets atelevated prices. However, operating their plants belowcapacity increases operating costs.

For bargaining-only cooperatives, when suppliesare plentiful they may have to sell surplus milk at dis-tressed prices, not having a means to handle the excessvolume. However, when milk supplies are tighter or inbalance with demand, they benefit from higher priceswithout the burden of maintaining under-used manu-facturing facilities.

Cooperatives and Federal Milk Market OrdersCooperatives helped usher in the Federal milk

market order system to smooth fluctuations in individ-ual producer prices and to reduce disruptive competi-tion between producers. Market orders provide a sys-tem of Government-administered, producer-requestedregulation and rule-making that establishes minimumprices for milk according to its end use, and pools theprice obligations of individual buyers across entiremarketing areas. Class I milk is used for fluid or bever-age purposes; Class II milk is manufactured into softproducts like yogurt and ice cream; Class III milk isused to produce “hard” products such as cheese; ClassIIIa milk is dried into powder. Buyers pay minimumclass prices according to how they use the milk, whileproducers get paid a weighted average (by volume) ofthe four class prices.

Classified pricing was intended to eliminate thepossibility that fluid processors would use distant milksupplies to unduly lower nearby milk prices. It alsoreduced the incentive for processors to add producerswhen milk supplies were short and cut them off whensupplies were abundant. Likewise, pooling createspricing uniformity among producers and minimizesthe incentive of one farmer to undercut another to gainaccess to higher value (fluid) markets.

Cooperatives principally have balanced the day-to-day milk needs of processors with the supply ofmilk in a given market as facilitated by the marketorder system. Cooperatives attempt to recover thecosts associated with market balancing by negotiating“over-order” premiums (over and above the estab-lished market order minimum class prices) with milkprocessor-customers. These premiums may reflectadditional transportation costs not covered by the mar-ket order price; the cost of providing fluid milk ofspecified quality and/or butterfat content at specifiedtimes and places; and/or the premium paid by fluidmilk processors to attract milk away from manufactur-ing operations (“give-up charges”). The amount ofover-order payments that cooperatives can demanddiffer from actual costs incurred, depending upon therelative market power of the cooperative and theprocessor. The ability of cooperatives to recoup theseexpenses from handlers in the market insulates mem-bers from shouldering the costs arising from marketbalancing tasks.

ReblendCooperatives with members in more than one

Federal order market, or with some members notdelivering to a market order, are permitted to providefor uniform distribution of milk payments to all mem-bers. Cooperatives may average (“rcblend”) the netproceeds of all their operations over all members, andare exempt from paying the blend price effective inany particular market.

Patronage RefundsCooperatives that add value to members’ milk

through manufacturing and/or marketing return thenet savings to members through patronage refunds.These are distributions of net income to members(patrons) in proportion to the volume of milk theymarketed. Sometimes known as the “13th cheek,” netsavings from cooperative operations can provideincome for producers over and above the marketplaceraw milk price.

The Traditional Milk Pricing System

The traditional methods of pricing milk havebrought a degree of stability to the milk market.Government programs, market-wide pooling, andcooperative reblending have dampened the fluctuationof milk prices received by farmers.

Government ProgramsThe dairy price support program undergirds the

farm milk price through Federal Government purchas-es of all butter, American cheese, and nonfat dry milkthat cannot be sold commercially at or aboveannounced prices. Federal purchase prices then becomea floor for wholesale product prices due to competitionamong manufacturers across the Nation. Through com-petition for milk supplies by these manufacturers,hopefully, U.S. dairy farmers will receive a farm milkprice that is at least the targeted support price.

The Federal market order system works in concertwith the dairy price support program so that farmerswho sell to handlers of nonsupported products willreceive at least the prices that manufacturers of sup-ported products pay. Since the 196Os, every Federalmarket order has used the Minnesota-Wisconsin (M-W)price as a starting point for setting minimum classprices. The M-W price is USDA’s estimate of pricesmanufacturers in Wisconsin and Minnesota paid forgrade B (manufacturing) milk in a given month.

On June 1,1995, the M-W price was replaced bythe basic formula price as the base price for the Federalmarket order system. This price also represents themarket price for manufacturing milk in Minnesota andWisconsin, but with adjustments reflecting month-to-month changes in dairy product prices. Thus, the dairyprice support program effectively sets the minimumprice paid for manufacturing milk. This price is reflect-cd in the basic formula price used to establish grade Aclass prices in market orders, which currently price 74percent of the Nation’s grade A milk.

Thus, the Federal dairy price support programand the milk market order program have provided ameasure of long-term stability for the dairy industry.

PoolingThe pooling provisions in market orders and

reblend by cooperatives encourage stability in bothspatial and temporal price relationships. Marketwidepooling under the orders and cooperative reblendssmooth out producer pay price variation throughoutthe milkshcd.

Cows produce milk day in and day out and thatvolume hits the market nearly every day throughoutthe year. The daily delivered volume varies, depend-ing on the fluctuation of individual cows’ production,weather, road conditions, and other uncontrollable fac-tors. Daily demand varies according to day of theweek in even greater magnitude due to factors such asconsumer buying habits. Pooling over time withmonthly pool prices minimizes the impact of the possi-ble day-to-day fluctuation in milk prices in the spotmarket.

In aggregate, milk production generally peaks inthe spring and bottoms out in the fall due to weather-related factors. Demand, on the other hand, peaks inthe fall when schools open and the ensuing holidayseason keeps demand strong. As a result, milk pricestend to be higher in the fall and lower in spring.Nevertheless, producers’ cash flow may be more eventhan seasonal price fluctuations may indicate Becauseproducers market milk year-round, their volume soldtends to be lower during the season when milk pricesare higher, while the reverse may be true in the flushperiod. It evens out their month-to-month cash flow.

Wide-area Market CoordinationMany dairy cooperatives have members in a

wide geographical area and operate a complete pro-curement system, including assembling and managingfluid milk supplies, routing raw milk to handlers asneeded, and managing the surplus. Many handlershave entered into full supply arrangcmcnts with coop-eratives to reduce the high cost of procuring and coor-dinating a fluctuating supply to meet a variabledemand. These handlers recognize that cooperativesserving an entire market can better route milk to need-ed uses much more efficiently than if each handlermanaged its own milk supplies independently.Furthermore, marketwide coordination reducesreserve storage requirements of milk, yielding signifi-cant savings for both farmers and plants.Consequently, cooperatives’ ability to manage milksupplies over a wide arca to a variety of handlersreduces the need for individual handlers to use priceto attract the right amount of milk. This encouragesprice stability.

Co-op Responses to IncreasingPrice Instability

Increasing Price InstabilityPrior to 1981, the milk support price level was

legislatively mandated between 75 and 90 percent ofparity. Commonly set at 80 percent of parity, this pricelevel evidently provided ample incentive for farmersto produce abundant milk supplies. In the mid-1970s,support prices were frequently increased because ofrapid inflation. This brought on expanded milk pro-duction. Large surpluses built up in the form ofGovernment purchases and holdings of butter, powderand cheese. Market prices hovered around the supportprice, which kept prices from falling further to market-clearing levels (figure 1). Therefore, the support priceserved as a floor under milk prices and, with the sur-pluses, in effect, a ceiling. Price volatility was mini-mized.

The M-W Price, which reflects the market pricefor raw milk, rises and falls according to market condi-tions. Sharp rises occur either when the basic supply-demand balance is very tight, or when the markettightens unexpectedly. The M-W Price normally rises inthe short-supply season (typically October-November)when milk production reaches a seasonal low pointand fluid product demand is seasonally high.Conversely, the M-W Price is seasonally low in theflush season (normally May-June) when milk produc-tion tends to peak and fluid milk product sales decline.The very heavy surplus of the first half of the 1980sobscured the seasonal deficit period, thus dampeningthe seasonal rise and fall of the M-W Price. Even therelatively large seasonal rise in 1984 was small com-pared to what was to come (refer again to figure 1).

The growing volume of butter, powder, andcheese purchased by the Government through theCCC required ever larger Government outlays tofinance the dairy price support program. As a result,legislation passed in 1981 took steps to bring suppliesback into line with consumption by tying the mini-mum support level to the size of CCC purchases. Thiswas a major departure from traditional price supportpolicy under which price changes were tied directly toparity. In 1982, the support price level was frozen leg-islatively for 2 years and a $1 per cwt assessment onproducers was instituted. The money collected wasused to partially offset rising Government costs.

Subsequently, the 1983 Dairy and TobaccoAdjustment Act lowered the minimum price supportlevel and enacted a milk diversion program, the first of

two attempts at voluntary supply control. The secondsupply control program, the whole herd buy-out, wasauthorized by the Food Security Act of 1985. It calledfor removing whole herds from dairy production for 5years beginning between April 1986 and September1987. In addition, the support price was ratcheteddownward in the following years. These actions con-tributed to a large decrease in the volume of product(in the form of butter, powder, and cheese) removedfrom the market by the CCC (figure 2).

Commercial stocks of commodity products alsoplay a crucial role in the dairy industry. Americancheese stocks were especially influential from the late1980s on because cheese production was absorbing anincreasing share of the milk supply. Stocks help main-tain smooth flows to consumers, stabilize seasonal priceswings, and offer a buffer against unexpected develop-ments. During 1982-87, commercial American cheesestocks declined fairly steadily, reflecting the profitabilityof minimizing stocks when a surplus is constant. Underthese conditions, the role of stocks can be handled moreefficiently by varying the flow of cheese sold to theGovernment. However, the low level of stocks in thelate 1980s contributed to wide price swings.

While changes in Federal dairy policy set thestage, an ensuing combination of market factors led todramatically atypical fluctuations in milk prices in1988 that continued well into the 1990s. On thedemand side, an unprecedented growth in foreigndemand and higher world prices for nonfat dry milkallowed the United States to become a major player ininternational dairy markets during 1988 and 1989.Domestic use of skim milk products also accelerated in1988 due to relatively large cuts in the support pur-chase price for nonfat dry milk. Commercial use of alldairy products reached a record volume.

On the supply side, U.S. milk production reacheda record high in 1988 while the number of milk cows fellto a 20th-century low. The record output occurred at thesame time that the price support was lowered by 50cents, a summer drought substantially increased feedcosts, and milk-feed price relationships were the lowestin more than 20 years. For the first time since 1982, theM-W Price peaked in December instead of November,reflecting a change in seasonal price patterns.

Falling milk output in 1989 accompanied by largeexport commitments for nonfat dry milk, strongdomestic demand, and low commercial stocks ofcheese and nonfat dry milk led to uncharacteristicallysharp increases in wholesale, farm, and retail dairyprices. Even though milk production was expandingby 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 IBFP*

Support Price

8

6

51978 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 MarketingService, 1996, various issues.

5

Figure 2- Net Removals, Support Price and BFP*

Billion pounds; dollars per cwt @ 3.5% butterfat25

20

Net Removals

15

10

5

0

7

1 I

vv1 I I I I I I I I I I I

,,, \Pllrlllllhr

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 MarketingService, 1996, various issues.

6

slightly more than expected and caused buyer con-cerns. Consequently, panicky stock building by buyers,who feared a recurrence of late-1989 conditions, trig-gered counter-seasonal price rises even though milksupplies for manufacturing were more readily avail-able. In addition, commercial exports were negligiblebecause international prices for dairy products hadfallen dramatically. In 1990, milk prices reached near-record highs before declining precipitously. Thisexcluded the United States as a major trader. Thus,milk prices plummeted as the collapse of supply con-cerns easily outweighed normal seasonal tightening.Buyers very quickly shifted from attempting toincrease pipeline stocks to meeting current use partial-ly from accumulated stocks. By late 1990, wholesaleprices of major dairy products settled near supportpurchase prices following the mid-1990 collapse.Notably, the annual average farm milk price in 1990was the highest for the period 1981 through 1995,dcspitc the wide price swings.

The level of support for milk price for theremainder of the 1990s appears to be below market-clearing levels, such that market forces are relativelyfree to influence milk prices as evidenced by the con-tinued variability seen in figure 1.

Cooperatives’ ResponsesDairy cooperatives have adapted to the increased

price instability by using several strategies. Manycooperatives claim to have stepped up their efforts toturn over inventories and avoid being caught in a mar-ket downturn that would force them to write down theinventory. This strategy may have worked to a certaindegree for nonfat dry milk, butter, and commoditycheese. However, the strategy will not work for thosecooperatives that age cheese, because by the nature ofthe aging process, they can not sell aged cheese beforeits time. Furthermore, the aged cheese businessrequires careful inventory management because bothshortage and surplus in supplying the consumer mar-kct can bc costly.

Some cooperatives have diversified into process-ing value-added dairy products and integrated closerto the consumer market. In such efforts, they hope tocapture a larger share of the consumer dollar. Othercooperatives look toward nontraditional markets suchas fractionalizing milk components for industrial usesor differentiating their products to fill market niches.The operations in the consumer market and the non-traditional markets rely less on the commodity dairyproduct markets where prices tend to be more volatile.

Another strategy is to form marketing agencies incommon that are permitted under the Capper-VolsteadAct of 1922. Dairy cooperatives have formed thesecommon agencies to share market information, espe-cially regarding inventory levels and product move-ments of nonfat dry milk and whey powder. This valu-able information enables the cooperatives to makeinformed decisions on inventory management andmarketing operations. Examples of marketing agenciesin common that have been formed in recent years areDairy Marketing Cooperative Federation, DairyMarketing Information Association, and WesternCooperative Marketing Association.

In 1995, three dairy cooperatives in Californiajoined forces to create DairyAmerica, Inc., a marketingagency in common to market the powdered milk theymanufactured. Besides taking advantage of scaleeconomies in sales operations, the common agency canbetter coordinate marketing of the product and spreadmarket risks over a very large volume.

Joint ventures have long been used by some dairycooperatives to shift the risks of manufacturing opera-tions and inventory management to joint venture part-ners. The cooperative leases its manufacturing plant(s)to the joint venture partner, which commits to pur-chasing milk from the cooperative, operating theplant(s), and marketing the end products. In thissetup, the cooperative secures a market outlet for itsmembers’ milk without assuming the risks of furtherprocessing, product marketing, and inventory man-agement.

These responses by dairy cooperatives to reduceexposures to price instability in the commodity marketfalls in the broad definition of hedging. However,hedging is usually narrowly defined to mean the useof futures and options to manage price risks. Dairyfutures and options trading has been instituted in thepast 3 years. Another much discussed method formanaging price risks is forward contracting.

Emerging Hedging Mechanisms forManaging Price Risks

Futures, options, and forward contracts, thoughnew to the dairy industry, have been used extensivelyin some other commodities. There is a rich reservoir ofliterature on the what’s and how’s of these pricingmechanisms. This report summarizes only the verybasics of futures, options, and forward contracts asapplied to the dairy industry, mainly to set the stagefor delineating some of the risks associated with theiruses by dairy farmers and their cooperatives. It is not

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intended as a trading guide. These risks are specific tomilk and dairy products and are in need of carefulassessment and examination. Not discussed in thisreport is the risk of basis changes, which is inherent inall futures contracts. (Basis is the difference betweenthe cash price at a specific location and the futuresprice for a particular delivery period.)

Milk and dairy products have some unique char-acteristics, unlike other commodities. These uniquecharacteristics may affect the use of the emerginghedging mechanisms:

l Milk is a flow product (much like water com-ing out of a spring). Cows produce milk every day.Because of its perishability, once milk is produced, itmust be used and processed. On any given day, thevolume of milk supply going into the market is fixedand reflects underlying cow numbers. It is difficult toinstantaneously change the volume of milk productionin response to changes in current market milk price.This is very different from other storable commoditiessuch as grains, corn, soybeans, or cotton. At any pointin time, the volume of any one of these commoditiesactually offered to the market is directly related to thecommodity price. Therefore, the market dynamics arevery different between milk and these commodities.

. Milk is processed into fluid and soft productsfor 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 derivedfrom a flow product. Inventories of these hard productsare usually kept for the purpose of regulating productflow to meet market demand. Storing them for pricespeculation is not the usual practice of the industry.

l The capacity to produce milk is limited by theunderlying number of cows. Because of the biologicalnature of the bovine animals, if there is an increase inaggregate cow numbers, it tends to increase only grad-ually. Therefore, it is unlikely to have unforeseen dras-tic increases in milk production. This production capac-ity as limited by the cow numbers undergirds the floorprice of milk, although the floor may be neither visiblenor rigid. On the other hand, milk production coulddrop instantaneously because cow numbers could bereduced suddenly by diseases, natural disaster, or otherfactors, or some cow herds could be liquidated in ashort period. Poor quality feeds or forage also couldreduce milk production drastically. Furthermore, interms of its components and usage, milk does not haveclose substitutes and therefore overall demand for milkdoes not change much. The exception would be a dras-tic decrease in demand due to food safety scare on

some rare occasions. Given a stable consumption trend,shocks to the milk market usually translate intoupswings in milk prices. Subsequent price declinesshould not drop below the price floor which is under-girded by the production capacity limit (or by the sup-port price for milk if and when the support is effective).Therefore, price volatility in the milk market may belopsided; price hikes do not have a upper limit whilethere is a tacit floor on the down side. This lopsidedphenomenon also applies to dairy product markets. Incontrast, prospective and actual crop production canchange drastically in either direction because of favor-able or adverse natural conditions such as weather orpest infestation, and price swings are usually uninhibit-ed in either direction, up or down.

I. Futures MarketsThe major reason for the existence of futures mar-

kets is to provide a means for shifting the risk of pricechanges in the cash market for the commoditiesinvolved. A futures contract is a commitment to eitheraccept or make delivery of a specified quantity andquality of a commodity at a specified time, and usuallyat a specified place of delivery. Commitments areenforced by requiring actual delivery and acceptanceof delivery of the underlying physical commodity, if acontract is allowed to mature (come due). However, noactual commodity changes hands unless and until thecontract matures. Most contracts are offset or “cov-ered,” by making a transaction in the futures marketopposite to a previously taken position before theycome due. In fact, futures contracts are viewed asfinancial instruments and the commodity is rarelyexpected to physically change hands. For many of thecommodities traded, less than 2 percent of all futurescontracts result in actual delivery.

Buyers and sellers meet to trade futures contractsat exchanges. The increase of price volatility in dairymarkets led the Coffee, Sugar and Cocoa Exchange(CSCE), New York, to begin trading futures contractsfor milk and dairy products. In June 1993, the CSCEintroduced Cheddar cheese and nonfat dry milkfutures contracts. Next, the CSCE launched a milkfutures contract in December 1995. A second exchangealso developed dairy futures. The Chicago MercantileExchange (CME) began trading milk futures in January1996 and is planning to begin trading butter futureslater in 1996.

Those who use the futures market to shift pricerisks are called hedgers. Hedging involves makingsimultaneous and opposite transactions in the cashand futures market, hoping that any loss in one market

will be offset by a gain in the other. Speculatorsassume the price risks that hedgers are attempting toavoid. Speculators aim to make a profit as a result ofbuying and selling (trading) futures contracts. Theytrade only futures contracts and do not deal in theunderlying commodity cash markets. Thus, they can-not offset losses in the futures market with gains in thecash market. Speculators provide the futures marketwith liquidity which increases the ease with whichhedgers are able to buy or sell contracts when theywant to offset their contracts, also known as settling orlifting their hedges. Orders to buy and sell futures con-tracts go through brokers who charge commissions formaking the trades for hedgers and speculators.

A hedger buys or sells a commodity futures con-tract to lock in a desirable price and eliminate riskexposure to price fluctuations during the time leadingto actual buying or selling of the cash commodity. Thehedger should evaluate whether the futures-impliedcash price is attractive relative to the forecasted futurecash price. A hedge should only be maintained if thefutures-implied cash price is deemed desirable; other-wise the hedge should be lifted. Hedging all produc-tion all the time (called automatic hedging) wouldonly exchange the futures-implied cash price for thesubsequent actual cash price. Over the long run, auto-matic hedging may not gain any advantage over rely-ing on current cash transactions and may even be adisadvantage because of the transaction costs incurredin trading futures. (See Jack D. Schwager book for dis-cussion on hedging, pp. 9-11.)

Milk FuturesThe milk futures contract offered by the CSCE

calls for f.o.b. delivery of one tanker load (50,000pounds) of Grade A raw milk with 3.5 percent butter-fat 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 sell-er’s plant. Delivery months are February, April, June,August, October, and December. Starting on July 1,1996, CSCE calls these 6 months the “regular deliverymonths.” The other 6 months of the year are called“additional delivery months.” (Trading in an addition-al delivery month is limited. It is initiated at the open-ing of trading on the first CSCE business day of thesecond calendar month preceding such additionaldelivery month.)

The milk futures contract traded on the CME issimilar. It also calls for 50,000 pounds of Grade Acow’s milk delivered to approved facilities inMinnesota, Wisconsin, and portions of surrounding

States within designated Federal milk market orderareas. The contract months are February, April, June,July, September, and November.

A Cooperative’s Risks in Using Milk FuturesHedging by trading futures may help shift price

risks. However, trading futures also creates other risksfor dairy cooperatives and dairy farmers. Some gener-ally observable risks are discussed here. However,both dairy cooperatives and individual producers mayhave specific risks due to particular situations in addi-tion to what are addressed in this report.

Dairy cooperatives do not produce milk. Undertheir marketing agreements with members, dairy coop-eratives receive whatever milk volume is produced bymembers’ farms, but cooperatives have no control overthe actual volume. When hedging on futures, there is arisk that actual milk volume may be lower than theshort position taken by the cooperative. (Short positionrefers to the volume represented by futures contractssold.) A part of the hedge may become speculation; butthe degree depends on the extent of the productionshortfall. Then, possible losses in the futures marketcould not be offset by gains in the cash market for thevolume of milk the cooperative hedged, but did notreceive deliveries from members. For this reason, dairycooperatives may have to limit the volume hedged to afraction of member production.

Cooperatives that hedge in the milk futures mar-ket have the ability to pay their members the futures-implied cash price. However, if the eventual cash mar-ket milk price turns out to be higher than thefutures-implied cash price, the cooperatives may beout-paid by competitors-a potential problem for pro-ducer relations. In this situation, the cooperative can-not pay the going cash price because it must cover itslosses in the futures market through paying its produc-ers the hedged price rather than the current cash mar-ket price.

Cooperatives typically handle large volumes ofmilk. If a large proportion of their milk is hedged in thefutures market, there is a risk that the futures marketmay not have enough liquidity for the cooperative tolift its hedges in time. In that situation the cooperativewould 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 HedgingUnder normal market conditions, when feed cost

rises, the milk/feed price ratio falls. That leads farmersto feed less concentrate rations to dairy cows, resultingin lower milk production. Higher milk price would

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likely ensue and help offset at least some of theimpacts of the rising production cost. Thus, if a pro-ducer hedges milk price in the futures market, the pro-ducer would also need to hedge farm supply costs,especially feed. Otherwise, the producer’s profit mar-gin may be squeezed by the unexpectedly high feedcost and a hedged milk price that is fixed. A loss couldresult depending on how high feed cost rises.

Milk production is a bovine biological process.Many variables can affect a cow’s performance. Factorssuch as diseases, adverse weather conditions, and highfeed cost can cut the milk volume produced by thecow. If there is a shortfall in milk production, part ofthe producer’s hedge in the futures market maybecome speculative, increasing instead of minimizingexposures to possible loss. Therefore, it is important todetermine what proportion of a producer’s milk is tobe hedged. Hedging a high proportion may causesome portion of the hedge to be speculative, whilehedging too small a volume would not provide ade-quate protection from price risks.

Producers receive cash market prices for theirmilk on a monthly basis. Milk prices in the futuresmarket are also quoted on a monthly basis. However,as stated earlier, milk is a flow product that is pro-duced day in and day out all year round. Choosingthe right time period to hedge milk production is animportant consideration. Automatic hedging (hedgingall production all the time) would only substitute thefutures-implied cash price for cash milk price as theproducer’s pay price for milk. Over the long run, suchsubstitution may just be a break-even exercise or evena losing proposition because of the futures’ transac-tion costs.

Producers who hedge selectively to lock in aprice need to have market insight. They run the risk offoregoing higher prices if the market does not act aspredicted.

As mentioned earlier, volatility in the milk mar-ket may be lopsided; price hikes do not have an upperlimit while falling prices may be mitigated by a tacitfloor (or an explicit floor when the Government sup-port price is effective). In other words, price protectionby hedging is rather limited on the down side, buthedging prevents the producer from benefitting fromrising cash market prices, which have no limits. In thisconnection, the worst case scenario for the producerwho locks in a fixed milk price through hedging iswhen the rising cash market milk price is due toreduced milk production caused by unexpectedly highfeed cost.

Another risk in hedging is that the producer maybe squeezed if there is low liquidity in the futures mar-ket and the producer is not able to lift the hedge at theright moment or would have to pay a high price to buysettlement contracts. The alternative is to make deliv-ery on the futures contracts, the logistics of which maybe troublesome for an individual dairy farmer. Also,making delivery to a buyer other than the producer’sown cooperative may constitute a breach of the mem-bership agreement.

Futures Market for Nonfat Dry Milk and CheeseThe CSCE nonfat dry milk futures contract calls

for delivery of 11,000 pounds of USDA Extra Grade orbetter nonfat dry milk in 25 kg bags FOB Westernregion. Delivery unit is 4 contracts (44,000 pounds) anddelivery months are the same as in milk futures. Thenonfat dry milk must be certified Kosher, have mois-ture content of 4 percent or less, have been manufac-tured using low heat, and be less than 180 days old ondate of delivery. The seller is responsible for shippingthe nonfat dry milk from its manufacturing plant orstorage center according to the buyer’s shippinginstructions to any location within the continentalUnited States. Nonfat dry milk delivered from pointsoutside the Western Region are subject to a .5cent/pound location differential for the Central Region,and a 1.5 cents/pound for the Eastern Region. If thefinal settlement price is below the CCC support price,differentials will be reduced by an equivalent amount.

The CSCE Cheddar cheese futures contract callsfor FOB delivery of 10,500 pounds of USDA Grade Aor better Cheddar cheese in 40-pound blocks at anypoint within the continental United States (640-poundblocks are deliverable at a discount of 300 points). Thedelivery unit is 4 contracts (42,000 pounds), and thedelivery months are the same as in milk futures. Thecheese will be manufactured from pasteurized milk,colored, have a moisture basis of 36.5 percent to 39percent, and must be less than 30 days old on the firstExchange business day following the first Thursday ofthe delivery month. On the day cheese is actuallydelivered it must be more than 4 days old. The sellerwill ship the cheese from its manufacturing plant orstorage center according to the buyers’ shippinginstructions. Cheese may be delivered at any pointwithin the continental United States.

A Cooperative’s Risks in Using Dairy Product FuturesDairy cooperatives manufacture members’ milk

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

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last-resort processing. Conventional wisdom wouldhave it that dairy cooperatives are in the position touse nonfat dry milk and cheese futures for hedging toprotect inventory values. As with the case of milkfutures, while hedging helps cooperatives manageprice risks, it also creates some new risks. These risksshould be considered when contemplating hedging.

Nonfat dry milk and cheese are products derivedfrom members’ milk. Dairy cooperatives generally donot have control over milk production . They takewhatever actual volume members produce and manu-facture some or all of it into various products. A coop-erative that hedges on nonfat dry milk and/or cheesefutures markets may encounter the risk that actualmilk volume it receives may not be enough to coverthe short position it takes selling futures contracts. Partof the hedge will become speculative transaction; howspeculative depends on the size of the productionshortfall. For this reason, dairy cooperatives may haveto limit the volume hedged to a fraction of production.

Milk is a flow product as are hard productsderived from it. Flow products must be moved to themarket as soon as possible before excessive inventoriesaccumulate. Unlike other commodities, nonfat dry milkand commodity cheese as flow products may not besuitably stored for later price increases. (Aged cheese isdifferent, as explained later.) Our estimate is that dairycooperatives on average keep manufactured productsinventory for no more than a month. In 1994, the yearthe most recent data is available, the Nation’s top 27dairy cooperatives with processing/manufacturingoperations had an inventory turnover rate (sales toinventory ratio ) of 41.4. Assuming 60 percent of theirsales was for raw milk and the rest was processed/man-ufactured products (the actual volume processed/man-ufactured by cooperatives was 38 percent of membermilk deliveries in 19921, and assuming all of their inven-tories were processed/manufactured products, theinventory turnover rate for these products was 16.5.Allowing for some estimation error, the actual invento-ry turnover rate may be higher than this number, but inall likelihood will be less than 30--the inventory levelon average was less than a month’s supply.

Aged cheese may be the exception because it issold to the consumer market. Price movements in theconsumer market are very different from price changesin the commodity market. Consumer psychology issuch that retail marketers and their suppliers usuallydo not like to change prices frequently. They changeprices only when they are certain that the changes willbe for a prolonged period of time, or permanent, andthe price adjustments are usually made in a racheting

fashion. In other words, prices in the consumer marketare usually quite stable and do not experience thesame kind of volatility as in the commodity cheesemarket.

The futures-implied cash price is the one a coop-erative that hedges in the futures market can afford topay its members for milk. If, by the contract expirationdate, the cash market price turns out to be higher thanthe futures-implied cash price, the cooperatives maynot be able to pay its producers a price as high as itscompetitors. This could potentially create a producerrelations problem for the cooperative.

II. OptionsThere are two type of options: calls and puts. A

call option confers to the buyer the right, but not theobligation, to purchase a designated futures contract ata specified price, known as the strike price or exerciseprice, at any time prior to the expiration of the futurescontract. On the other hand, a put option confers to thebuyer the right, but not the obligation, to sell a desig-nated futures contract at the strike price, at any timeprior to the expiration of the futures contract. As thefutures market moves, options for additional strikeprices on each futures contract may be available fortrading. Therefore, the total number of differentoptions 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 pre-mium.

A put option protects a milk seller against fallingprices. During the effective time period of the putoption, if the current price of the underlying futurescontract is lower than the strike price by at least thepremium, the option holder would come out ahead(provided that the transaction cost is covered). On theother hand, if the futures price is not lower than thestrike price by at least the amount of the premium bythe time the underlying futures contract expires, theoption holder would incur a loss. The maximumamount the holder could lose is limited to the premi-um (and the transaction cost). While the loss is limited,the protection the put option provides is potentiallylarge. The tradeoff is that the probability of the poten-tially small loss may be high, while the probability ofthe potentially large gain may be low.

A holder of the call option profits from risingprices or is protected against rising milk prices if theholder is a milk buyer. A call option is profitable whenthe current price of the underlying futures contract ishigher than the strike price by at least the premium(provided that the transaction cost is covered). The

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holder of the option could buy the futures contract andsettle it for a profit. However, if the current price of thefutures contract is not higher than the strike price by atleast the premium by the time the underlying futurescontract expires, the call option holder would incur aloss. The maximum amount the holder could lose isthe premium (and the transaction cost). While thepotential loss to the option holder is limited, the poten-tial gain is unlimited. Again, the tradeoff is that theprobability of the potentially large gain may be low,while the probability of the limited loss may be high.

The observation by Schwager provides a goodsummary of options trading:

Roughly speaking, the option buyer accepts alarge probability of a small loss in return for a smallprobability of a large gain, whereas the option selleraccepts a small probability of a large loss in exchangefor a large probability of a small gain. In an efficientmarket, neither the consistent option buyer nor theconsistent option seller should have any advantageover the long run.

An option allows the hedger to sell or buy afutures contract at a time closer to the contract expira-tion date than outright futures trading. Presumably bythe time the option is executed, more market informa-tion would be available to make hedging less risky.However, for dairy producers or cooperatives, usingoptions requires more investment in information gath-ering to determine if the price protection is worth thepremium, and how likely a large price increase maybe. Using options is a more costly method of hedgingwhen price movements are relatively small.

III. Forward ContractsThere are many variations of forward contracts

that have been used by commodities other than dairy.In dairy, current market transactions are most preva-lent. Forward contracts are rarely used, although themarketing agreements between dairy farmers andtheir cooperatives might be interpreted as one form offorward contracts that promise future deliveries with-out specifying volumes or prices. Some cooperatives,however, provide price guarantees to some new orhighly leveraged farmers to enable them to obtainbank financing.

There have been recent discussions about “new-generation” dairy cooperatives that would issue deliv-ery rights to members based on their equity subscrip-tion. The plan is similar to a conventional marketingagreement, except in this case, the delivery volume isspecified. Only the milk volume that is within thedelivery rights is entitled to receive a favorable price

and to share in the earnings of the cooperative andenjoy certain other privileges. The delivery rights maybe transferrable at the discretion of the cooperative’sboard of directors. This plan is workable if the coopcr-ative consistently generates positive earnings to makepurchasing the delivery rights worthwhile. For a milkproducer whose production surpasses the delivcry-right contract volume, the excess milk is likely to bepriced lower. Overall, whether the producer would bebetter off under the new-generation delivery rightsarrangement depends on the relative proportion ofcontract versus non-contract volumes and on the pricedifference between the two types of delivery.

Another form of forward contract being dis-cussed is a fixed-volume, fixed-price contract. (This isthe common form used by other commodities, butrarely used by dairy cooperatives.) Producers wouldforward contract with the cooperative. The contractwould specify a predetermined fixed price for a givenvolume of milk delivery for a given time period (mostlikely for a particular month).

In essence, this type of forward contracts shiftprice risks from the contracting producers to the coop-erative. The shift in risks reveals some interestingaspects of forward contracts:

l A cooperative is owned by its membcr-produc-ers. Shifting the risks from the producers to the coop-erative does not diminish producers’ risks. Rather, therisks remain the same, except that they are collectivelyassumed by the cooperative. Shifting the risks assumesthat the cooperative could manage the risks better thanthe individual producers could do themselves.

l Some member-producers probably would notuse the forward contracts. Therefore, they probablywould not cover all milk volume produced by mcm-ber-producers. Because of the costs of managing therisks, shifting price risks to the cooperative throughforward contracts would disadvantage those produc-ers whose production is not under forward contractsor the milk volume that is not covered by forward con-tracts. A separate pricing pool may have to be main-tained by the cooperative to pool the proceeds andshare expenses from forward contracting.

l Fixed-price forward contracts would compelthe cooperative to hedge the contracted volume to pro-tect the cooperative from price risks. The cooperativemay make advanced sales of, say, cheese to buyers at acertain price, to be delivered later when the contractedmilk volume is available. Thus, price risks arc shiftedto the cheese buyers. Alternatively, the cooperativemay hedge the contracted volume in the futures mar-ket. Over the long run, forward contracts may not

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return more than current market milk prices to pro-ducers. As a matter of fact, forward contracts can beexpected to return lower milk prices because of thecosts of transacting forward contracts and tradingfutures.

l The cooperative should be aware of the risksassociated with futures trading, if it decides to hedgethe contract volume on the futures market.

There have been many empirical studies of for-ward contracts in commodities other than dairy.Brorsen, et al., in their analysis of the data of TexasGulf forward basis bids for Hard Red Winter wheatfrom 1975 to 1991, concluded that a farmer wouldaverage about $0.02 to $0.04 per bushel less forwardcontracting on April 15 (before harvest begins) eachyear than by selling during the last half of June (whenharvest is near completion). They concluded that farm-ers were paying a premium for the service of forwardcontracting, which was consistent with earlier studieson live cattle, grain, and soybeans.

In a recent extensive study of the red meat pack-ing industry organized by USDA Grain Inspection,Packers and Stockyards Administration, a team ofresearchers found that cattle purchased by packersunder forward contracts brought $1.74 per cwt. (live-weight) less than delivered prices for similar cattleobtained on the spot market, while marketing agree-ment cattle brought prices about 54 cents above spotmarket prices. (In livestock procurement, a forwardcontract is a contract between a packer and a seller topurchase a specific lot of cattle at a future date, withthe contract established at any time from placement ofcattle on feed up to 2 weeks prior to kill date; a mar-keting agreement is a long-term arrangement betweena packer and a seller in which the packer agrees topurchase a specified number of cattle per specifiedtime period such as a week, month, or year.) Using adifferent data-set, another team of researchers for thesame study found that prices paid for cattle deliveredunder forward contracts on any given day were about$3.00 per cwt. lower (dressed-weight basis) than pricesfor similar cattle on the cash market, while prices forcattle obtained through marketing agreements wereabout 10 cents per cwt. higher than prices for cash-market cattle.

These studies show that forward contracting iscertainly not free. Producers pay a price for shiftingmarket risks to other parties. As a result, forward con-tracting prices tend to be lower than spot marketprices. It is also interesting to note that cattle salesunder marketing agreements received higher pricesthan the spot market.

Dairy cooperatives have only limited experiencewith fixed-volume and fixed-price forward contracts.Alto Dairy Cooperative at Waupun, WI, is believed tobe the first one to pioneer such contracts for dairy. In1994, the cooperative conducted a pilot program formembers to forward-contract a portion of their milkproduction. The pilot project used cheese futures con-tracts because 90 percent of the change in the basic for-mula price can be explained by changes in Cheddarcheese prices. In addition, the milk futures contractshad not been developed at the time of the projectwhich was conducted between August 1,1994 andAugust 31,1995. (Alto’s pilot program was evaluatedin a report by Cropp.)

Seventy-eight producers signed up for the pro-ject, where 43 actually executed one or more cash for-ward price contracts during the 13-month trial period.Alto Dairy would bid to buy milk delivered into thefuture. The bid price was based on the previous busi-ness day’s prices for Cheddar cheese futures contractson CSCE. Producers could phone Alto Dairy eachmorning and get the offered bid prices. Quoted bidprices were base prices; producers who contractedreceived all premiums and price adjustments other-wise paid by Alto Dairy on all member milk deliveredto the cooperative. If a bid price was acceptable, theproducer could contract a specified quantity of futuremilk production at that price. Producers had theoption of forward contracting 5,000 pounds or more ofa given month’s milk production, up to a maximum of50 percent of their monthly milk production. The pro-ducer could contract various milk volumes at morethan one price per month as long as the total quantitycontracted for the month was less than 50 percent ofmonthly milk production. Some producers acceptedmore than one contract price for a given month. If thebid prices were unacceptable, producers were notobligated to contract future milk production.

Alto Dairy was able to guarantee producers thecontract price by selling Cheddar cheese futures tohedge the producer contracted volume and then buy-ing offsetting Cheddar cheese futures when the milkwas delivered. If the price of cheese declined in thetime between the two transactions, Alto Dairy wouldmake a profit on the futures market and add this profitto the now lower cash price to pay the contract pricefor milk. If the price of cheese increased, Alto Dairywould experience a loss on the futures market but payproducers the contract price, which was lower than thecash price. Thus, the net effect to Alto Dairy was tocome out the same (except for the transaction cost) asif paying producers the going cash price, while pro-

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ducers receive a guaranteed price for future milk pro-duction, regardless of cash market price changes.

Alto Dairy assumed some risks in offering theforward contracts to members and viewed the associ-ated costs as the cost of providing the member service.One of the risks is basis change. (Basis is the relation-ship between the cash and futures market prices.) Ifthe basis changes between the time of setting and lift-ing of a hedge, the price objective will not be met. Byassuming this risk, Alto Dairy would gain or lose bythe amount and direction of basis change.Furthermore, Alto Dairy’s bids were offered based onthe previous business day’s settling price for Cheddarcheese futures. Alto Dairy may not always have beenable to set a hedge at the exact bid price. This differ-ence between contract price and hedged price isknown as slippage.

At the end of the 13 months, Alto Dairy showed anet gain from all forward contracts combined, evenafter paying brokerage commission. Alto’s objective isto adjust the basis used in forward contract price quo-tations so that the gain/loss is near zero.

Although 256 total individual forward price con-tracts were made by producers, Alto Dairy made only201 short hedges to cover them. Alternatively, theunhedged cash forward contracts were protected withcorresponding 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 pro-ducer pay price, 119 received a $.Ol to $76 per cwtlower price as a result of their forward contract(s), andone contract was equal in price. On average, the cashforward contract price was $.003 per cwt higher thanAlto Dairy’s actual pay price for milk.

Evaluating the Traditional PricingSystem in Terms of Managing PriceRisks

In light of the assessment of the emerging mecha-nisms for hedging price risks, it is also useful to evalu-ate the traditional milk pricing system in regard toprice risk management.

Most dairy cooperatives coordinate milk market-ing over a wide geographical area, and pool andreblend their proceeds monthly to pay producers.These practices ensure that pay price for producers inthe same pool is equalized regardless of location andregardless of milk price movements during the month.Individual member-producers share price risks togeth-er-much like mutual insurance.

Marketing agencies in common of dairy coopera-tives that pool earnings and costs of marketing dairyproducts are also akin to institutions of mutual insur-ance. Marketing agencies in common may be particu-larly useful for dairy cooperatives in the export mar-kets where price fluctuation is potentially morevolatile than in the domestic market.

There is a pronounced seasonality of milk pro-duction, and price movements tend to run counter tothe seasonal production pattern. Therefore, producercash flow may be more even than seasonal movementsin price or production alone would suggest. Also,because milk is a flow product, in the long run theaverage cash market milk price, in theory, can beexpected to be even with the average futures-impliedcash price received by a producer who hedges all pro-duction all the time on the futures market-what iscalled automatic hedging.

Dairy cooperatives concerned with product pricefluctuation usually have the ability to manage risksthrough changes in business practices without havingto follow an explicit hedging plan. Because they usual-ly have multi-product, multi-plant operations, theyhave the flexibility to shift production to products thatwould return the highest margins. Other examplesinclude faster inventory turnover to avoid inventorywrite-downs, integrating into the consumer and nichemarkets to avoid the volatilitics in the commoditymarkets, forming marketing agencies in common togain better market intelligence or coordinate productmarketing, and joint ventures with other firms to shiftsome risks to partners.

But, by shifting or offsetting existing risks, thesecooperatives arc certain to take on new ones. A multi-product, multi-plant cooperative may cncountcrchronic excess plant capacity. Faster inventoryturnover may result in not having enough inventory totake advantage of rising prices or sales opportunities.Integrating into the consumer-product or niche mar-kets requires a new set of business ingredients such asample capital, a forward-looking board of directorsand capable management, among many other things.Having all the right ingredients does not guaranteesuccess, but lacking any one can doom the businessenterprise. For a cooperative that is in a joint venturewith another firm, the risk is that the joint venturepartner may not successfully perform its side of thecontract. The cooperative may also find its own opcra-tional flexibility being rcstrictcd by the joint venturecontract.

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Conclusion References

The traditional pricing system has served dairycooperatives and their members well. In the graduallyderegulated dairy market environment where theawareness of price instability is heightened, the chal-lenge for the board of directors and management is toassess the overall risks of the cooperative’s operationsand determine how the risks may impact on producerpay prices through their traditional pricing system,and if and how the risks should be managed. Theymay want to manage the risks by taking advantages ofthe flexibility in the business system, by changing theirbusiness practices, or by forming alliance with otherfirms to shift the risks.

If they decide that some of the risks should bemanaged by using the emerging hedging mechanisms,it is imperative that they should understand what eachhedging mechanism is, how it works, what it is usedfor, and the risks involved in using it. (This and thenext paragraphs benefitted from the insights presentedin The Economist.)

Because the opportunities for using the hedgingmechanisms and the risks involved in using them tendnot to be fully comprehended, they are susceptible tomisuses. What is intended as hedging sometime turnsout unexpectedly to be speculating and wreaks havocon the cooperative. This has been the experience insome commodities other than dairy. Therefore, carefulmanagement and prudent precautions are required inusing them. If the board of directors decides some ofthe risks should be managed with the emerging hedg-ing mechanisms, it should determine a hedging strate-gy for the cooperative that should at least include thefollowing:

l Treat risk management as an integral part ofthe cooperative’s overall corporate business strategy,not as an isolated business function.

l Adopt an explicit policy for the use of thehedging mechanisms and spell it out to the member-ship.

l Set up a process to monitor the cooperative’suses of the hedging mechanisms.

l Have safeguard to ensure that controls are inplace to protect against misuse and fraud.

l Require that risk exposures by using the hedg-ing mechanisms be properly accounted for in thefinancial statements to inform members, creditors, andother interested parties.

Brorsen, B. Wade, J. Cooms, and K. Anderson. TheCost of Forward Contracting Wheat.Agribusiness, Vol. 11, No. 4,349-354 (1995).

Coffee, Sugar & Cocoa Exchange, Inc. Trading MilkFutures and Options. Coffee, Sugar & CocoaExchange, Inc., New York. 1995.

Cropp, Robert A. Forward Milk Contracting PilotProgram, Alto Dairy Cooperative: SummarySeptember 1994-August 1995. University ofWisconsin Center for Cooperatives, Madison, WI.February 1996.

Cropp, Robert A. and M. Stephenson. Introduction toCheese and Nonfat Dry Milk Futures. DairyMarkets and Policy Issues and Options, CornellUniversity, M-12, February 1995.

The Economist. Too Hot to Handle? A Survey ofCorporate Risk Management. The Economist.February lOth, 1996.

Fortenberry, Randall T., R. Cropp, and H. Zapata.Analysis of Expected Price Dynamics Betweenthe Proposed Fluid Milk Futures Contract andCash Prices for Fluid Milk. A report to the Coffee,Sugar, and Cocoa Exchange, Inc. September 1995.

Liebrand, Carolyn B. Security, Price or Service? FarmerCooperatives. U. S. Department of Agriculture,Rural Development Administration, CooperativeServices Programs. Washington, DC. September1994.

Ling, K. Charles and Carolyn Betts Liebrand.Marketing Operations of Dairy Cooperatives. U.S. Department of Agriculture, AgriculturalCooperative Services. ACS Research Report 133.Washington, DC. April 1994.

Ling, K. Charles and Carolyn Betts Liebrand. VerticalIntegration Patterns of Dairy Co-ops ReflectChanging Market. Farmer Cooperatives. U. S.Department of Agriculture, Rural Business andCooperative Development Service, CooperativeServices Programs, Washington, DC. September1995.

Manchester, Alden C. The Public Role in the DairyEconomy-Why and How Government Intervenein the Milk Business. Westview Press, Boulder,co. 1983.

Schwager, Jack D. A Complete Guide to the FuturesMarkets: Fundamental Analysis, TechnicalAnalysis, Trading, Spreads, and Options. JohnWiley & Sons, Inc., New York. 1984.

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U. S. Department of Agriculture. Concentration in theRed Meat Packing Industry. U. S. Department ofAgriculture, Grain Inspection, Packers andStockyards Administration, Washington, DC.February 1996.

U. S. Department of Agriculture. Farmer CooperativeStatistics, 1994. U. S. Department of Agriculture,Rural Business-Cooperative Service, RBS ServiceReport 49. November 1995.

The information about Coffee, Sugar & CocoaExchange, Inc. and Chicago Mercantile Exchangeis based on the postings by the two exchanges onthe World Wide Web as of June 25,1996.

16

U.S. Department of AgricultureRural Business/Cooperative Service

Stop 3250Washington, 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.

The United States Department of Agriculture (USDA) prohibits discrimination in its

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

information (Braille, large print, audiotape, etc.) should contact the USDA Office of

Communications at (202) 720-2791.

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.