Key Elements for Strong Risk Management
The past few years have arguably been some of the most profitable the dairy industry has seen in recent times. 2023 will be a different story with producers having to squeeze out a profitable margin with what will be the highest feed prices in history. From a lender’s perspective risk management is a proven practice that will provide a pathway to profitability. When it comes to developing your strategy for a successful risk management plan there are key elements that need to be taken into consideration.
Financial Reports
Near the top of the list are accurate and timely financial reports. Understanding your farm’s cost of production helps you make the best decisions for your operation and lead to better outcomes.
Milk Check
An often overlooked, yet equally important, factor is understanding your milk check. Each processor can have their own method of how quality, components and federal orders are measured. These metrics will ultimately determine what a farm’s pay price is.
Risk Assessment
Next comes assessing the risk of your business. What are your debt levels? How much working capital do you have stored on your balance sheet and what is your financial risk tolerance? The answer to these questions will help determine what tools you use to manage risk.
Basis
Basis is defined as the difference between the announced Class III Milk Price and your mailbox price. Understanding how your basis behaves and taking that into consideration can be the difference between a positive margin or a loss.
Milk Flows
Finally, understand your milk flows so a known quantity of production aligns with the farm’s marketing plan. Having these key elements in place will bolster your confidence when it’s time to execute. Understanding your costs, risks and benefits takes the emotions out of building the plan. An important hurdle that all producers deal with is being “afraid of leaving money on the table.” The good news in this area is that there now are tools to help limit the impact of this concern.
Developing a plan that will work for you
When making decisions about risk management, it is important to include your team of advisors: your lender, consultant, and risk management specialist. An open discussion about your operation’s specific financial status helps you find the strategies that will work best for your situation. Common questions brought up in these discussions include,
- How far out should we be looking to set coverage? and,
- What percent of my production should I be protecting?
While there is no perfect one-size-fits-all answer to these questions, you can make educated decisions with your farm team by looking at margin potentials, considering milk prices and input costs. Once you have formulated a risk management plan, stick to it, but revisit it often with this team, and make changes when needed.
Risk Management Tools
The volatility of commodity markets trending higher than normal in the past few years created opportunities for producers to capture positive margins for the future, regardless of what lies ahead to trigger market fluctuations. There are a variety of risk management tools that can be used to give producers a peace-of-mind, knowing that their farm’s financial stability is not solely at the mercy of tomorrow’s potential market disruptions, such as sudden geopolitical changes, or another health crisis across the world.
Three government-subsidized tools available to dairy producers include the Dairy Margin Coverage (DMC), Dairy Revenue Protection (DRP), and Livestock Gross Margin – Dairy (LGM). One of the key benefits of using these tools is that they provide a “floor” revenue price/margin, allowing producers to capture the higher actual milk price, should markets rally up after coverage is taken. Yet, when prices/margins drop below the coverage threshold, indemnities are paid out to the producers, providing financial help in the times of market decline.
The DMC program, available through FSA, provides a cost-effective margin coverage for up to 5 million pounds of milk (Tear 1) annually, which may be only a small fraction of a dairy farm’s production, so supplemental protection is needed.
DRP is a quarterly-based price protection of Class III Milk Price, Class IV Milk Price, or Component Price (butterfat, protein, and other solids), or a combination of each.
LGM Dairy Coverage has recently gained momentum as it offers monthly price coverage, allowing the flexibility of different weighted margin coverages that include Class III Milk Price, and corn and soybean meal price.
As an example of these risk management tools, let's look back at the performance of DRP and LGM in 2022. These products did exactly what they were designed to do – allow producers to capture the sky-high prices of the first half of the year, and -- as markets cooled off in the second half of year-- many producers who continued to stay proactive in their risk management plans collected indemnities from the DRP and LGM insurance programs.
There are other risk management tools that include direct contracts through processors and futures contracts and options which can be purchased through a brokerage service. Many times, we have seen a combination of insurance products such as DRP or LGM and contracts work in tandem to provide a balanced and compressive approach to risk management. Please keep in mind that it is highly recommended you leverage your team of professional experts to develop the best risk management plan possible for your business.
If you have questions or would like more information on risk management plans, contact Amber Obrien or Greg Steele at Compeer Financial.