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.
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|
|Cash Market||Futures Market||Basis|
Mr. Smith accepts Alto's bid of $12.00/cwt. for March milk.
Alto sells May cheese futures at $1.30 per lb.
Mr. Smith delivered to Alto March production. The market price for March milk is $11.00/cwt.
Alto buys May cheese futures at $1.20 per lb.
|Loss: $1.00/cwt.||Gain: 10 cents||0|
|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.
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.
|Delivery Month||Number of Farms||Number of Futures Contracts||Total Pounds Contracted||Range of Contract Prices $/cwt.||Range of Bid Prices $/cwt.|
|09/94||3||5||125,000||$11.71 - $12.05||$11.11 - $12.05|
|10/94||10||17||450,000||$11.77 - $12.29||$11.13 - $12.29|
|11/94||1||1||30,000||- $11.82||$10.86 - $11.82|
|12/94||2||2||55,000||$11.70 - $11.71||$10.79 - $11.73|
|01/95||5||8||165,000||$11.33 - $11.78||$10.85 - $11.78|
|02/95||32||51||1,475,000||$11.58 - $12.19||$10.99 - $12.19|
|03/95||25||41||1,235,000||$11.37 - $12.17||$10.97 - $12.17|
|04/95||18||30||1,025,000||$11.36 - $12.06||$10.86 - $12.06|
|05/95||12||23||635,000||$11.51 - $11.65||$10.96 - $11.69|
|06/95||8||11||415,000||$11.11 - $11.46||$10.74 - $11.55|
|07/95||18||32||1,005,000||$11.68 - $12.16||$11.04 - $12.16|
|08/95||20||35||1,420,000||$11.66 - $12.41||$11.02 - $12.41|
|Totals:||---||256||8,035,000||--- ---||--- ---|
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
|Delivery Month||Number of Contracts||Range $ per hundredweight|
|September||0||5||0||.27 - .61|
|October||0||17||--||.21 - .73|
|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|
|July||32||0||.32 - .76||0|
|August||17||19||.02 - .55||.07 - .16|
|TOTAL||136||119||.01 - .76||.03 - .73|
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 cash 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.
|Contract Month||Number 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|
|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|
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.
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
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.