USA: Forward Milk: Alto Dairy Cooperatives

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This paper brought to you in electronic format by the 
University of Wisconsin Center for Cooperatives.
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University of Wisconsin Center for Cooperatives and 
Department of Agricultural Economics
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January 1996

FORWARD MILK: Alto Dairy Cooperatives
Summary, September 1994 - August 1995

By Bob Cropp

Introduction

In June 1993, the New York Coffee, Sugar and Cocoa
Exchange (CSCE) introduced futures and options contracts
for cheddar cheese and nonfat dry milk. These contracts
provided the opportunity for dairy industry participants,
dairy farmers, dairy manufacturers, distributors, and
others-- to manage price risk in an era of increasingly
volatile dairy markets.

While both buyers and sellers of cheese and nonfat dry
milk can use these futures and options contracts to reduce
the risk of price change of these products, these same
contracts can be used to reduce the risk of a change in
farm level milk prices. This is because the base price and
mover of grade A milk prices under all federal milk
marketing orders is the Basic Formula Price (BFP).

The BFP is the grade B price paid to dairy producers by
butter, milk powder and cheese plants located in Minnesota
and Wisconsin adjusted by a product price formula for the
same three products. Since about 85 percent of the grade B
milk in Wisconsin and 65 percent in Minnesota is used to
make cheese, cheese is the major determinant of the BFP.
About 90 percent of the change in the BFP may be explained
by changes in cheddar cheese prices.  With such a strong
relationship, dairy producers and buyers of farm level
milk can use cheese futures and options contracts to reduce
the risks from changing milk prices.

Roger Blimling of Blimling and Associates received an
Agricultural Development and Diversification Grant from the
Wisconsin State Department of Agriculture, Trade and
Consumer Protection to conduct a pilot project with Alto
Dairy Cooperative, Waupan, Wisconsin. Alto Dairy would use
the cheese futures contracts as a means of offering cash
forward milk price contracts to their member dairy
producers. The pilot project began August 1, 1994 and
expired August 31, 1995. This paper summarizes the cash
forward contracting experience. Data and results during
this 12 month period were provided by Don Desjarlais, Vice
President of Finance, Alto Dairy. 

The Pilot Program

Description of Program:

During July 1994, Alto Dairy met with member-producers to
explain the cash forward milk price program. Interested
producers were asked to sign-up for the pilot program.
Seventy-eight producers signed. The initial phase of the
pilot program was restricted to the 78 producers.

Producers could forward contract no less than 5,000 pounds
of a given month's milk production at any one offered
contract price and were restricted to a maximum of 50
percent of a given month's production contracted. Some
producer's accepted one or more contract prices for a given
month.

Alto Dairy would bid to buy milk delivered into the
future. Accepted bid prices were hedged by Alto Dairy
selling (taking a short position) cheese future contracts
on the futures market.

The bid price was based upon the previous business day's
prices for cheddar cheese futures contracts. Participating
member-producers could phone Alto Dairy each morning and
get these bid prices. If a bid price for one or more months
was acceptable, the producer could contract a specified
quantity of future milk production at that price. Alto
Dairy would pool the milk volume from among those
member-producers who had contracted for a given futures
contract month and then sell the number of cheddar cheese
futures contracts on the CSCE equivalent to this milk
volume. One cheese contract is 10,500 pounds of cheese or
an equivalent of about 105,000 pounds of milk. A producer
could accept bid prices for a specified quantity of a
month's milk production once, twice or more times as long
as the total quantity contracted did not exceed 50 percent
of the given month's total production. 

Thus, a producer could have several different contract
prices for specified quantities of a given month's milk
production. For example, a producer might have accepted a
bid of $12.25 per hundredweight for 5,000 pounds of
November milk, another bid at $12.40 per hundredweight for
10,000 pounds of November milk and left unprotected 20,000
pounds of November milk. When November milk is delivered
the producer would receive the $12.25 price for 5,000
pounds, $12.40 for 10,000 pounds and for the 20,000 pounds
Alto Dairy's November pay price for milk not contracted. It
should be noted that these bid prices were base prices.
Producers who contracted received all premiums and other
price adjustments. 

As the contracted milk is delivered, Alto Dairy would buy
(take a long position) cheddar cheese futures contracts. If
the price of cheese had declined, Alto Dairy would make a
profit on the futures market to be used to pay the contract
price for milk. If the price of cheese had increased, Alto
Dairy would experience a loss on the futures market but
producers would still receive the contract price.

The cheddar cheese futures contract delivery months are
February, May, July, September and November. The contract
month expires the last trading day which is the first
Thursday of the delivery month. Therefore, Alto Dairy's bid
prices for March and April milk production would be based
on the prices for May cheddar cheese futures. Bids for May
and June milk production would be based on July cheddar
cheese futures and so forth. 

A simple example will illustrate how this cash forward
milk price contract works. On January 7, May cheddar cheese
futures are trading at $1.30 per pound. Cheese at $1.30 per
pound is equivalent to about $13.00 per hundredweight of
milk. Let's say Alto Dairy assumes a basis of $1.00 per
hundredweight and provides a bid price of $12.00 per
hundredweight on January 8 for March and April milk
production. Mr. Smith, a member-producer accepts that bid
for 10,000 pounds of March milk production. Alto Dairy, on
January 8, sells May cheddar cheese futures at $1.30 per
pound. Later when March milk is delivered Alto Dairy buys
May cheddar cheese futures. 

In this illustration, cheddar cheese futures had declined
10 cents to $1.20 per pound. Since cheese prices drive farm
level milk prices, the farm level milk price for milk would
not be $12.00 per hundredweight, but rather $11.00 per
hundredweight. But Alto Dairy can take the 10 cent per
pound of cheese profit on the futures market ($1.00 per
hundredweight on milk) to meet its contract obligation of
$12.00 per hundredweight.

If cheese prices had increased, farm level milk prices
would also be higher. But Alto Dairy would only be able to
pay the $12.00 contract price because it would have
experienced a loss rather than a profit on the futures
market. 

 ILLUSTRATION OF CASH FORWARD
 CONTRACT, PRICES DECLINE

1.  January 8: 

Cash Market :  Mr. Smith accepts Alto's bid
of $12.00/cwt. for March milk.   

Futures Market : Alto sells May cheese futures at $1.30
per lb.

Basis :   $1.00

2.  March 31:
Cash Market :  Mr. Smith delivered to Alto March
production.  The market price for March milk is $11.00/cwt.  

Futures Market :        Alto buys May cheese futures at 
$1.20 per lb.

Basis :   $1.00

--------------------------------------------------------------
Cash Market :  Loss: $1.00/cwt. 
Futures Market :   Gain: 10 cents      
Cash market price $11.00 plus $1.00 futures gain = $12.00
contract price.

The above example assumed that the estimated basis of
$1.00 at the time the hedge was set did not change.
However, if the basis had changed, Alto Dairy would have
gained or lost by the amount of basis change. This is the
basis risk that Alto Dairy assumes.

In addition to basis risk, Alto Dairy assumed another
risk, slippage. Alto Dairy's bids are based on the previous
business day settle price for cheddar cheese futures. Alto
Dairy may or may not be able to set a hedge (sell a futures
contract at that exact bid price). If the cheese futures
price declines, Alto Dairy suffers some slippage. But if
cheese futures price increases, Alto Dairy gains. With a
volume of trades the slippages and gains should about
offset each other.

Cash Forward Contract Results

Number and Volume of Contracts:

Of the 78 member-producers who signed up for the pilot
program, 43 executed one or more cash forward price
contracts. A total of 256 cash forward contracts were
executed. These contracts represented a total of 8,035,000
pounds of milk for the period of September 1994 through
August 1995.  Individual contracts ranged from 10,000
pounds of milk to 250,000 pounds of milk. Pounds contracted
for an individual farm for a given month ranged from 25,000
pounds to 250,000 pounds. The percent of an individual
farm's milk production contracted for a given month ranged
from 5.38 percent to 81.77 percent.

Bid prices and contract prices:

Because cheddar cheese futures contract prices for a given
delivery month changed 6 cents to almost 15 cents per
pound, Alto's bid prices for each of the delivery months
also had a large range. Bid prices ranged as little as $.73
per hundredweight ($10.96 to $11.69) for milk delivered May
1995 to as high as $1.39 per hundredweight ($11.02 to
$12.41) for milk delivered in August 1995 (Table 1).

No producer accepted any of the lowest bids for a delivery
month. However, for 9 of the 12 months there were bids
accepted at the highest bid price.  But of the 256 total
contracts only 18, 7.0 percent, were accepted at the
highest price. The range in bids accepted for a delivery
month were as little as $.14 per hundredweight ($11.51 to
$11.65) for May 1995 to as much as $.75 per hundredweight
($11.66 to $12.41) for August 1995. There was just one bid
accepted for November 1994.

The range in bids illustrate the opportunities for
producers to lock in favorable milk prices. Significant
differences in profit result if low bids rather than high
bids are accepted for a given delivery month. But the
objective of the futures market and cash forward contracts
is not to get the highest price. The objective is to
protect a reasonable price and profit objective on the
cash market. Nevertheless, producers need to follow market
information -- cheese futures contract prices, dairy
situation and outlook reports -- in making their decision
to accept bids. Further, because bids do change, selling a
portion of month's production at more than one bid price
may be a better marketing strategy than selling all at one
bid price.

Table 1. Alto Dairy Cash Forward Milk Contracts, September
1994 - August 1995.

(Please contact the UWCC for a copy of this table, or view 
it at http://www.uwcc.wisc.edu/staff/cropp/alto.html)

Contract prices versus actual market price:

When producers use the cash forward contract option or
hedge directly on the futures market they need to know
their milk production costs. Further, they should have a
price and profit objective. Producers should only enter
into a cash forward contract or hedge on the futures market
when it meets the price and profit objectives.

A producer using the hedging strategy may or may not meet
the price and profit objective. This is because the basis
may change from what it was predicted at the time the hedge
was set. The net price from using a cash forward contract
or hedging may be either higher or lower than the actual
market price for a given month. Hence, sometimes producers
will receive a higher price than if they had remained
unprotective, and at other times, they will receive a
lower price. 

Of the 256 total cash forward price contracts, 136, 53.1
percent, ended up higher than the actual market price paid
by Alto Dairy for a given month, 119, 46.5 percent, ended
up lower than the actual pay price, and one, .4 percent,
was equal to Alto Dairy's actual pay price. (Table 2). 

Table 2. Difference Between Cash Forward Contract Prices
and Alto Dairy's Actual Producer Pay Price

                     # of Contracts ||    Range $ per 100'weight
Month
                   Higher      Lower   ||  Higher    Lower
---------------------------------------------------------------------
September       0           5              0          .27 - .61
October             0          17            --          .21 - .73
November        0            1              0              .48
December         0            2              0          .14 - .15
January            4            3      .06 - .08      .04 - .09
February*/      26        24       .02 - .19     .19 - .42
March              10        31       .04 - .12     .02 - .68
April                 24          6        .02 - .51    .03 -.19
May                  23          0        .01 - .15           0
June                   0        11               0          .07 -.42
July                  32          0        .32 - .76           0
August             17       19        .02 - .55     .07 - .16
 -----------------------------------------------------------------
 TOTAL           136        119       .01 - .76       .03 - .73
*/One contract was equal in price.

For the contract months of September, October and December
1995, all cash forward contract prices were lower than Alto
Dairy's actual pay price for milk not contracted. June 1995
was the only other month where all the ash forward contract
prices were less than Alto Dairy's actual pay price. For
two months, May and July, all contract prices were higher
than Alto Dairy's actual pay price. 

When cash forward contract prices were lower than Alto
Dairy's actual pay price for a given month, this difference
ranged from $.03 per hundredweight to $.73 per
hundredweight lower. When the cash forward contract price
was higher than Alto Dairy's actual pay price, the range
was from $.01 per hundredweight to $.76 per hundredweight
higher. On the average, the cash forward contract price was
near Alto Dairy's actual pay price for milk not contracted,
an average cash forward contract price $.003 per
hundredweight higher.

Future Contract Prices: Alto Dairy protected itself from
fixed cash forward price contracts accepted by its members
through a "short hedge" (selling a nearby cheddar cheese
futures contract). Although there were 256 total individual
cash forward price contracts, there were 201 short hedges.
Alto has two potential means for protecting cash forward
contract prices, hedging or offsetting with a cash cheese
sale. These unhedged cash forward contracts were protected
with corresponding cash cheese sales. 

When members holding a cash forward price contract
delivered the contracted milk Alto Dairy would lift the
corresponding hedge by going long (buying a nearby cheddar
cheese futures contract). If the price of futures cheese
contracts had declined, Alto Dairy would gain on the
futures market. Lower cheese futures normally corresponds
with lower cash milk prices. Yet Alto Dairy could fulfill
its milk price contract obligation by adding the futures
gain to the lower cash milk price.


If the price of futures cheese contracts had increased,
Alto Dairy would suffer a loss on the futures market. High
cheese futures normally corresponds with higher cash milk
prices. But, Alto Dairy would not be able to pay members
more than the contract price. The losses suffered on the
futures market would need to be subtracted from the higher
cash milk price.  

Of the 201 short hedges, 85, 42.3 percent were lifted at a
gain, and 112, 55.7 percent were lifted at a loss (Table
3). Four hedges, 2.0 percent were lifted at the same price
as they were set. 

Table 3: Gains and Losses Incurred by Alto on the Futures
Market, September 1994 - August 1995.

Month      # of Contracts   ||      Range (cents per pound of
                                                         cheese)
              Gains/a  Loss/b  Even  ||    Gain        Loss
September    0       4            1                 0         .6 - 1.5
October          3       4            2              2.5         .6 - 1.5
November      1       0           0              8.4             0
December      2       0            0            6 - 8.4         0
January         6       0            0            6 - 8.4         0
February     28     15            0            4 - 7.5    1.7 - 6.3
March          15     18            0            1 - 7.5    1.7 - 6.5
April            16        8           0            .2 - 7.5   1.7 - 6.5
May                6     17            0            .5 - 3.2       .8 - 3
June               5        5           1             .8 - 3.2      .5 - 6
July                0     27            0                  0        .5 - 14
August           3     14            0                 2              2
 --------------------------------------------------------------------
       TOTAL  Gain: 85 
                       Loss: 112 
                       Even:  4

a/ Lifting a short hedge at a lower price than what it was
set at. 
b/ Lifting a short hedge at a higher price than what it was
set at.

Gains in cents per pound of cheese ranged from .2 cents to
8.4 cents. Assuming a yield of 10 pounds of cheese per
hundredweight of milk this was equivalent to 2 cents to 84
cents per hundredweight of milk.

Losses ranged from .5 cents per pound of cheese to 14
cents per pound. This was equivalent to 5 cents to as much
as $1.40 per hundredweight of milk.

The average of all 201 short hedges was a loss of .6 cents
per pound of cheese or 6 cents per hundredweight of milk. 

Average Basis:

The average basis for the cheese futures contracts during
the period of September 1994 through August 1995 are given
in Table 4. The basis is the price difference between the
cheese futures contract for the nearby month minus the
National Cheese Exchange 40 pound cheddar block price at
the time the hedge was lifted. 

Table 4: Average Basis When Cheese Futures Contracted
Lifted, September 1994 - August 1995.

 Contract Month                      Average Basis*
                                            cents per pound cheese

September                               -4.25
October                                     -4.25
November                                -4.25
December                                 -4.48
January                                    -4.57
February                                  -3.14
March                                       -3.46
April                                         -4.00
May                                          -2.74
June                                         -5.25
July                                           1.35
August                                      3.15

* Basis = New York Coffee, Sugar and Cocoa Exchange
Cheddar Cheese Futures for the near month minus National
Cheese Exchange 40 pound cheddar block price.

Since under the cheese futures contract provisions,
cheddar cheese may be delivered from any place in the
United States, it would be expected that cheese would be
delivered from the area having the lowest price cheese, the
far West. Therefore, considering transportation costs from
the West to Green Bay, Wisconsin, cheese futures contracts
would logically be less than the National Cheese Exchange
price. For 10 of the 12 months this was the situation, but
for two months, July and August 1995, the opposite
occurred.

The size of the basis is not relevant to the net outcome
of a hedge. But the consistency and predictability of the
basis is. If the basis is different when the hedge is
lifted than what was assumed when the hedge was set, the
net price will differ to the same extent from the price
objective at the time the hedge is set. With a short
hedge, if the basis strengthens, the net price will be less
than the price objective. If the basis weakens, the net
price will be more than the price objective. Alto Dairy
assumed this basis risk. Members were always assured of
their contract price. Thus, offering a cash forward price
contract to members is a member service at some cost to
Alto Dairy. But the change in the basis is less than the
change in either cheese prices or farm level milk prices.
Hence, the basis risk is less than the price risk.


For six of the 12 months the basis was a -4 cents to -4.57
cents per pound of cheese. For one month, it was higher at
-5.25 cents. Two months the basis was -3.14 cents to -3.46
cents and one month -2.74 cents. However, for July and
August, the basis became positive and averaged 1.35 cents
and 3.15 cents respectively. Extremely hot weather had
depressed the components in milk which lower cheese yields.
It is argued that these circumstances kept cheese futures
prices at relatively high levels for both July and August
resulting in a positive basis.

Gains/Losses To Alto Dairy:

The basis is the difference between the cash and futures
price of a commodity. When placing and lifting hedges,
basis gains and losses may occur. Incorporated in the basis
calculation for milk is an assumption for cheddar cheese
basis since cheddar cheese futures were used for hedging
the raw milk cash forward contracts.

The dollar value of gain/losses to Alto is proprietary
information. But Alto did experience a net gain from all
cash forward contracts combined including brokerage
commission. The objective of Alto is to adjust the basis so
that the net gain/loss is near zero. The result of a
tighter basis would be a higher cash forward contract
price. As more data and cash forward contracting experience
is incurred Alto will be able to improve upon its basis
data and its quoted cash forward producer prices.


Summary:

Alto Dairy's pilot project using cheese futures contracts
to offer cash forward milk price contracts to dairy farmers
was successful. It demonstrated that farm level milk prices
can be protected with cheese futures contracts. Two
problems were encountered, a change in the basis, but more
importantly, a lack of liquidity on the Coffee, Sugar and
Cocoa Exchange, making it more difficult for Alto Dairy to
set and lift hedges on cheese. With increased liquidity
this problem would be reduced or even eliminated. However,
the change in the basis was only of major consequences
during July and August, 1995 when it became positive. Alto
did experience a net gain from all cash forward contracts
combined including brokerage commission. The objective of
Alto is to adjust the basis used in cash forward price
quotations so that the net gain/loss is near zero.


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at 608-262-3981, or write danz-hale@agecon.wisc.edu.
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Internet and Library Service Assistant
U.W. Center for Cooperatives-- Madison, Wisconsin
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