University of Wisconsin Center for Cooperatives

Rural Cooperatives, July/August 1996, Vol. 63, No. 4
Rural Cooperatives is published by the Rural Business-Cooperative Service, U.S.D.A. 

Managing Price Risks

Hedging by Dairy Co-ops Requires Care

K. Charles Ling

USDA Rural Business-Cooperative Service



Editor's Note: the following article is based on a new research report by Ling and Carolyn Liebrand, "Dairy Cooperatives' Role in Managing Price Risk," Research Report 152, published by the Rural-Business Cooperative Service of USDA Rural Development.

A fundamental role of dairy cooperatives is guaranteeing members a market for their milk. Dairy producers sign membership (marketing) agreements with their cooperatives, making them their exclusive marketing agent. Members then ship all the milk they produce to the cooperative and the cooperative finds a market for that volume. Pay prices for most milk are based on the pool blend price of federal milk market orders.

Cooperatives may add operating earnings to and subtract operating expenses from pool payments, then pay producers a "re-blended" price. A "13th check" at the end of the fiscal year distributes part or all of the cooperative's net savings from operations to its members. Such is the essence of a dairy cooperative's role in the traditional pricing system of milk.

This system has brought a degree of stability to the milk market. The federal government price support program provides a floor price for milk. Government programs, marketwide pooling and cooperative reblends have created pricing uniformity among producers over a wide region and dampen the fluctuation of milk prices.

Prior to 1981, the milk support price level was mandated at between 75 and 90 percent of parity. In the mid-1970s, support prices were frequently adjusted upward because of rapid inflation. High prices brought on expanded milk production and milk prices hovered around the support price level. This served as a floor under milk prices and--due to the milk surplus--it was, in effect, a price ceiling.

To reduce the surplus, 1981 legislation tied the price support level to the size of the Commodity Credit Corporation (CCC) purchases. Legislation in 1982 froze the support price level for two years and producers were assessed to help pay for the program. Support prices were lowered in the 1983 and in the subsequent legislation. The whole-herd-buy-out program that ended in 1987 helped create a relative balance of supply and demand.

With a lower floor price, milk prices were more responsive to market forces and started to fluctuate widely in 1988. The drastic price changes since 1989-90 have served as a wake-up call to the dairy industry that price volatility has become a fact of life as the industry moves toward a market-oriented dairy economy.

Dairy cooperatives have managed price risks by taking advantage of the flexibility in the business system, by changing their business practices or by forming business alliances with other firms to shift the risk. In many cases, cooperatives with multi-product, multi-plant operations have the flexibility to shift production among products that would return the highest margins. Other examples include faster inventory turnover to avoid inventory writedowns, integrating into the consumer and niche markets to avoid the volatile commodity markets, forming marketing agencies in common to gain better market intelligence or for coordinating product marketing, and forming joint ventures with other firms to shift some risks to partners.

Emergence of Hedging Contracts

Hedging mechanisms are now emerging for managing price risks. Commodity exchanges saw the opportunities in the price volatility in the dairy markets and offered futures and options for hedging price risks. The Coffee, Sugar and Cocoa Exchange began trading cheddar cheese and nonfat dry milk futures contracts in 1993 and started trading milk futures contracts in 1995. The Chicago Mercantile Exchange began trading milk futures contracts early in 1996. Some cooperatives have experimented with forward contracting for milk production, selling futures contracts to offset fixed price agreements with members.

Milk and dairy products have some unique characteristics that may affect the use of the emerging hedging mechanisms. Milk is produced daily. Therefore, milk is a flow product. By extension, dairy products such as commodity cheese, butter and nonfat dry milk are also flow products. Under the pressure of accumulated products, inventory management regulates dairy product flow to the market rather than for storing for later sales at anticipated higher prices.

Milk production is limited by the number of cows in individual herds. Cow numbers increase only gradually, so it is unlikely to have unforeseen drastic increases in milk production. This limitation on milk production undergirds the floor price of milk, although the floor may not be visible or rigid. On the other hand, consumption of milk and dairy products also changes gradually. Given a stable milk production level and a stable consumption trend, shocks to the milk market usually translate into upswings in milk prices. Hedging, by definition, is a break-even proposition. By shifting away undesirable price risks, a hedger actually takes on some new risks. (The risk of basis changes inherent in all futures contracts is not discussed in this report.)

For dairy cooperatives using the futures market to hedge price risks, possibilities exist that actual milk volume delivered by members may be lower than the short position taken by the cooperative on the futures market. (Short position refers to the volume represented by the futures contracts sold.) Part of the hedge may become speculation. For this reason, dairy cooperatives may have to limit the volume hedged to a certain fraction of member production.

Another possibility is that the futures implied cash price may be lower than the cash market milk price prevalent when the futures contracts expire, and the co-op may be out-paid by competitors. This would create a potential problem for producer relations. Still another possibility is that the futures market may not be liquid enough for the cooperative to liquidate its futures position by the settlement date. There may be some other possible unforeseen risks.

Dairy farmers who use the futures market to hedge may encounter similar risks. In addition, they may need to hedge input costs to make sure that the futures-implied milk price will yield profitable earnings. Furthermore, in the unlikely case of actual delivery on futures contract, some complicating side effects may arise.

Contract Types Vary

There are many variations of forward contracts. In dairy, the marketing agreement between producers and their cooperatives might be interpreted as one form of a forward contract that promises future deliveries without specifying volumes or prices. The so-called new-generation dairy cooperatives would issue delivery rights to members based on their equity subscription. The plan is similar to a conventional marketing agreement, except that the delivery volume is specified. Forward contracting as widely used in commodities other than dairy usually refers to contracts that promise future delivery of a commodity of a fixed volume and at a fixed price.

In essence, forward contracts shift price risks from the contracting producers to the cooperative. Because the cooperative is owned by the producers, shifting the risks from the producers to the cooperative does not diminish producers' collective risks. Contracted volume should constitute a separate pricing pool so that producers who are not under forward contracts will not have to share the contract risks and expenses.

Studies of other commodities show that forward contracting returns (on average) a lower price than cash market price because producers have to bear the costs of this service-an analogy is the purchase of insurance.

Under the traditional pricing system, wide-area pooling of milk prices and reblending by dairy cooperatives is similar to mutual insurance of milk prices by producers. Marketing agencies in common of dairy cooperatives that pool earnings and costs of marketing dairy products are also akin to institutions of mutual insurance. Marketing agencies in common may be particularly useful for dairy cooperatives in the export markets where price fluctuation is potentially more volatile than in the domestic market.

Because milk is produced continuously and priced regularly, theoretically the traditional pricing system is expected to pay producers an average price in the long run that is even with the average milk price yielded by "automatic hedging" (hedging all production all the time with futures contracts), without having to incur futures transaction costs.

Adapting to price instability by shifting or offsetting existing risks by changing business practices may create new risks. A multi-product, multi-plant cooperative may encounter chronic excess plant capacity. Faster inventory turnover may result in foregoing profitable sale opportunities because the cooperative is short of inventory. Integrating into the consumer product or niche markets requires a new set of business ingredients that the cooperative might be lacking. Joint ventures run the risk that the joint venture partner may not perform its side of the contract. The cooperative may also find the contract restricts its own operational flexibility.

Risk management should not be an isolated business function, but rather an integral part of the cooperative's corporate strategy. The cooperative should assess the overall risks of its operations and determine how the risks may impact on producer pay prices through the traditional pricing system. If some of the risks are deemed to be best managed by using the emerging hedging mechanisms, the board of directors should spell out the policy and prepare guidelines for using them.

The Key to Successful Hedging

The prerequisite for a sound hedging strategy is understanding what each hedge mechanism is, how it works, what it is used for and the risks involved in using it. Because the opportunities for using the emerging hedging mechanisms and the risks involved in using them tend not to be fully comprehended, they are susceptible to misuses. What is intended as hedging sometimes turns out unexpectedly to be speculating and wreaks havoc on the cooperative. This has been the experience in some commodities other than dairy. Therefore, careful management and prudent precautions are required in using them. The board of directors should determine a hedging strategy for the cooperative that should at least include the following:

    Treat risk management as an integral part of the cooperative's overall corporate business strategy, not as an isolated business function. Adopt an explicit policy for the use of the hedging mechanisms and spell it out to the membership.
    Set up a process to monitor the cooperative's uses of the hedging mechanisms. Have safeguards to ensure that controls are in place to protect against misuse and fraud.
    Require that risk exposures by using the hedging mechanisms be properly accounted for in the financial statements to inform members, creditors and other interested parties.

Rural Cooperatives, July/August 1996, Vol. 63, No. 4
Rural Cooperatives is published by the Rural Business-Cooperative Service, U.S. Department of Agricultural
```````````````` 

Managing Price Risks
Hedging by Dairy Co-ops Requires Care
K. Charles Ling

USDA Rural Business-Cooperative Service

Editor's Note: the following article is based on a new research report by Ling and Carolyn Liebrand, "Dairy Cooperatives' Role in Managing Price Risk," Research Report 152, published by the Rural-Business Cooperative Service of USDA Rural Development.

A fundamental role of dairy cooperatives is guaranteeing members a market for their milk. Dairy producers sign membership (marketing) agreements with their cooperatives, making them their exclusive marketing agent. Members then ship all the milk they produce to the cooperative and the cooperative finds a market for that volume. Pay prices for most milk are based on the pool blend price of federal milk market orders.

Cooperatives may add operating earnings to and subtract operating expenses from pool payments, then pay producers a "re-blended" price. A "13th check" at the end of the fiscal year distributes part or all of the cooperative's net savings from operations to its members. Such is the essence of a dairy cooperative's role in the traditional pricing system of milk.

This system has brought a degree of stability to the milk market. The federal government price support program provides a floor price for milk. Government programs, marketwide pooling and cooperative reblends have created pricing uniformity among producers over a wide region and dampen the fluctuation of milk prices.

Prior to 1981, the milk support price level was mandated at between 75 and 90 percent of parity. In the mid-1970s, support prices were frequently adjusted upward because of rapid inflation. High prices brought on expanded milk production and milk prices hovered around the support price level. This served as a floor under milk prices and--due to the milk surplus--it was, in effect, a price ceiling.

To reduce the surplus, 1981 legislation tied the price support level to the size of the Commodity Credit Corporation (CCC) purchases. Legislation in 1982 froze the support price level for two years and producers were assessed to help pay for the program. Support prices were lowered in the 1983 and in the subsequent legislation. The whole-herd-buy-out program that ended in 1987 helped create a relative balance of supply and demand.

With a lower floor price, milk prices were more responsive to market forces and started to fluctuate widely in 1988. The drastic price changes since 1989-90 have served as a wake-up call to the dairy industry that price volatility has become a fact of life as the industry moves toward a market-oriented dairy economy.

Dairy cooperatives have managed price risks by taking advantage of the flexibility in the business system, by changing their business practices or by forming business alliances with other firms to shift the risk. In many cases, cooperatives with multi-product, multi-plant operations have the flexibility to shift production among products that would return the highest margins. Other examples include faster inventory turnover to avoid inventory writedowns, integrating into the consumer and niche markets to avoid the volatile commodity markets, forming marketing agencies in common to gain better market intelligence or for coordinating product marketing, and forming joint ventures with other firms to shift some risks to partners.

Emergence of Hedging Contracts

Hedging mechanisms are now emerging for managing price risks. Commodity exchanges saw the opportunities in the price volatility in the dairy markets and offered futures and options for hedging price risks. The Coffee, Sugar and Cocoa Exchange began trading cheddar cheese and nonfat dry milk futures contracts in 1993 and started trading milk futures contracts in 1995. The Chicago Mercantile Exchange began trading milk futures contracts early in 1996. Some cooperatives have experimented with forward contracting for milk production, selling futures contracts to offset fixed price agreements with members.

Milk and dairy products have some unique characteristics that may affect the use of the emerging hedging mechanisms. Milk is produced daily. Therefore, milk is a flow product. By extension, dairy products such as commodity cheese, butter and nonfat dry milk are also flow products. Under the pressure of accumulated products, inventory management regulates dairy product flow to the market rather than for storing for later sales at anticipated higher prices.

Milk production is limited by the number of cows in individual herds. Cow numbers increase only gradually, so it is unlikely to have unforeseen drastic increases in milk production. This limitation on milk production undergirds the floor price of milk, although the floor may not be visible or rigid. On the other hand, consumption of milk and dairy products also changes gradually. Given a stable milk production level and a stable consumption trend, shocks to the milk market usually translate into upswings in milk prices. Hedging, by definition, is a break-even proposition. By shifting away undesirable price risks, a hedger actually takes on some new risks. (The risk of basis changes inherent in all futures contracts is not discussed in this report.)

For dairy cooperatives using the futures market to hedge price risks, possibilities exist that actual milk volume delivered by members may be lower than the short position taken by the cooperative on the futures market. (Short position refers to the volume represented by the futures contracts sold.) Part of the hedge may become speculation. For this reason, dairy cooperatives may have to limit the volume hedged to a certain fraction of member production.

Another possibility is that the futures implied cash price may be lower than the cash market milk price prevalent when the futures contracts expire, and the co-op may be out-paid by competitors. This would create a potential problem for producer relations. Still another possibility is that the futures market may not be liquid enough for the cooperative to liquidate its futures position by the settlement date. There may be some other possible unforeseen risks.

Dairy farmers who use the futures market to hedge may encounter similar risks. In addition, they may need to hedge input costs to make sure that the futures-implied milk price will yield profitable earnings. Furthermore, in the unlikely case of actual delivery on futures contract, some complicating side effects may arise.

Contract Types Vary

There are many variations of forward contracts. In dairy, the marketing agreement between producers and their cooperatives might be interpreted as one form of a forward contract that promises future deliveries without specifying volumes or prices. The so-called new-generation dairy cooperatives would issue delivery rights to members based on their equity subscription. The plan is similar to a conventional marketing agreement, except that the delivery volume is specified. Forward contracting as widely used in commodities other than dairy usually refers to contracts that promise future delivery of a commodity of a fixed volume and at a fixed price.

In essence, forward contracts shift price risks from the contracting producers to the cooperative. Because the cooperative is owned by the producers, shifting the risks from the producers to the cooperative does not diminish producers' collective risks. Contracted volume should constitute a separate pricing pool so that producers who are not under forward contracts will not have to share the contract risks and expenses.

Studies of other commodities show that forward contracting returns (on average) a lower price than cash market price because producers have to bear the costs of this service-an analogy is the purchase of insurance.

Under the traditional pricing system, wide-area pooling of milk prices and reblending by dairy cooperatives is similar to mutual insurance of milk prices by producers. Marketing agencies in common of dairy cooperatives that pool earnings and costs of marketing dairy products are also akin to institutions of mutual insurance. Marketing agencies in common may be particularly useful for dairy cooperatives in the export markets where price fluctuation is potentially more volatile than in the domestic market.

Because milk is produced continuously and priced regularly, theoretically the traditional pricing system is expected to pay producers an average price in the long run that is even with the average milk price yielded by "automatic hedging" (hedging all production all the time with futures contracts), without having to incur futures transaction costs.

Adapting to price instability by shifting or offsetting existing risks by changing business practices may create new risks. A multi-product, multi-plant cooperative may encounter chronic excess plant capacity. Faster inventory turnover may result in foregoing profitable sale opportunities because the cooperative is short of inventory. Integrating into the consumer product or niche markets requires a new set of business ingredients that the cooperative might be lacking. Joint ventures run the risk that the joint venture partner may not perform its side of the contract. The cooperative may also find the contract restricts its own operational flexibility.

Risk management should not be an isolated business function, but rather an integral part of the cooperative's corporate strategy. The cooperative should assess the overall risks of its operations and determine how the risks may impact on producer pay prices through the traditional pricing system. If some of the risks are deemed to be best managed by using the emerging hedging mechanisms, the board of directors should spell out the policy and prepare guidelines for using them.

The Key to Successful Hedging

The prerequisite for a sound hedging strategy is understanding what each hedge mechanism is, how it works, what it is used for and the risks involved in using it. Because the opportunities for using the emerging hedging mechanisms and the risks involved in using them tend not to be fully comprehended, they are susceptible to misuses. What is intended as hedging sometimes turns out unexpectedly to be speculating and wreaks havoc on the cooperative. This has been the experience in some commodities other than dairy. Therefore, careful management and prudent precautions are required in using them. The board of directors should determine a hedging strategy for the cooperative that should at least include the following:

  • Treat risk management as an integral part of the cooperative's overall corporate business strategy, not as an isolated business function. Adopt an explicit policy for the use of the hedging mechanisms and spell it out to the membership.
  • Set up a process to monitor the cooperative's uses of the hedging mechanisms. Have safeguards to ensure that controls are in place to protect against misuse and fraud.
  • Require that risk exposures by using the hedging mechanisms be properly accounted for in the financial statements to inform members, creditors and other interested parties.

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