Using milk futures to reduce price volatility and aid planning

Euronext is making a bid to develop a dairy market but Ireland could have leading role in exchange modelled on CME.

Using milk futures to reduce price volatility and aid planning

Joe Thome and his wife Diane run a very profitable 1,300-cow herd on Redtail Ridge Dairy, their family farm located near Malone, Wisconsin, in the United States.

Mr Thome was among the guest speakers at the recent IFA-hosted ‘Making Risk Management Work For Farmers’ seminar in the Heritage Hotel, Killenard, Co Laois.

Redtail Ridge Dairy’s success story was the case study around which industry leaders from Ornua, ICOS, IFA, the Department of Agriculture and FC Stone debated the potential for Irish dairy farmers to reduce milk price volatility by engaging with milk futures and options.

Ireland’s dairy co-ops are already operating a form of milk price hedging, for the fixed-price contracts they operate with farmers.

The advantages for the farmer and the processor include improved stability for forward planning.

One suggestion at the Laois event was that Ireland could take the lead in developing improved dairy product futures markets for Europe — with the Class 3 milk futures market on the Chicago Mercantile Exchange (CME) the standard to aim for.

Market analysts believe there is an appetite for a European dairy exchange.

The pan-European stock market Euronext is making a bid to develop the market, but the window remains open for Ireland to take a leading role.

If it does, it will have to come from industry rather than the Government.

However, government support is indicated by the commitment in the new programme for government to investigate development of a futures market for dairy produce, and to encourage price stabilisation tools to combat price volatility.

“The Irish dairy sector must decide for itself how much appetite there is for risk management mechanisms,” Brendan Gleeson, assistant secretary at the Department of Agriculture, told the Laois conference.

“These are commercial decisions which the industry has to decide for itself. Establishing an index to have a properly functioning futures market would be an important first step.”

The conference debated the change of mind-set needed for this to happen.

One question which Mr Thome repeatedly refuted was the view that his personal farming success was down to “beating the market” via astute hedging.

He said that this was the wrong mind-set to bring to hedging.

In years when the market price is good, his neighbours are quick to tell him he’s a fool for hedging, he noted.

This was confirmed by FC Stone senior risk manager, Charlie Hyland, who detailed 10-year figures for milk price hedging on the CME, which showed virtual parity in the effective incomes of the farmers who took the hedging route and those who did not.

However, the real gains from hedging are perhaps best seen by taking an overall view of how Redtail Ridge Dairy has evolved, while forward selling a portion of its milk.

In family hands since 1963, Redtail now has 26 well-paid, full-time staff, many of whom are with the Thomes more than ten years.

When the couple took on the farm in the early 1980s, they had 400 cows.

Since then, everything has soared: cattle numbers, their average outputs, and profits.

In 1982, Joe’s dairy cows were each producing around 20,000 lbs (9,000 kg/litres) of milk each on average.

Now the average output volume is around 32,000 lbs (14,500 kg/l) per cow.

The farm produces most of its own animal feed. It keeps a tight rein on costs, chief of which is staff costs.

Joe Thome says the seeds of the farm’s upswing were set in 1998, when he first began to teach himself about milk futures and options.

Since then, he has been reasonably happy with his choice of fixing some of his annual output with the LGM (Livestock Gross Margin), a US state-led fixed-price contract model, comparable to the fixed-price contracts offered by most Irish co-ops.

Joe said up to 50% of US dairy output is contracted into this model, including varying volumes of Redtail Ridge’s milk, which Joe puts at 10-30% of total output, but with huge seasonal variations.

By contrast, he didn’t see any great value in fixing any of his milk output with the MPP (Milk Price Protection Program), another state-led programme.

Instead, having done extensive reading, Joe decided that his best price-fixing route would be to forward sell a good proportion of his milk, perhaps a third in some years, on the Chicago Mercantile Exchange, guided by advice from a broker.

Many other US farmers do likewise, perhaps up to 20% of all US farmers. But, of course, most choose instead to live with milk price volatility.

For the past 16 years, Joe has focused on hedging, stabilising his annual income, giving him peace of mind and the financial platform upon which to plan his farm’s phenomenal growth.

At first, he read a lot of industry magazines, now he’s down to a 5-10 minutes daily scan on his i-Phone.

“In 1998, we started to learn about marketing our milk with the Dairy Farmers of America,” recalls Joe.

“With the co-op, we’d sell around 88,000 litres on the Chicago Mercantile market. In 2000, we switched to Cedar Valley Cheese, and at that time we also switched our management of the futures market to [financial brokers] FC Stone.

“You have to do a lot of learning with this. It was mind-boggling at the outset, but you talk to your broker every day in the first year. You soon learn. Now you can look up your broker’s advice in about 30 seconds on any given day.

“We do a mix of futures, options and fences. You manage it yourself, and make your own choices about how much milk to fix, and you’re insured against risk. That insurance costs about a penny per hundredweight on average. It’s not much, really.

“You need a good relationship with your broker, but I also read a lot about it, and that helps you make your choices.”

FC Stone’s Charlie Hyland estimated that the cost to the farmer of financing hedging stands at around 0.05c per litre.

Joe Thome added that for a €200,000 contract, you’d need to have around €800 in your account to cover any fluctuation in cost.

It has all worked out so well that Joe hasn’t been conducting an annualised review of his futures performance in recent years.

It was only when he was invited to the Laois conference that Joe pulled out the books and reviewed his years of hedging performance.

In brief, in terms of a simple ‘Farm Gate vs Futures’ milk price performance index, Joe broke even over the years.

However, the expansion on his farm gives the bigger picture. The real gain has been in bypassing market volatility, retaining control, and having the peace of mind to focus on his farm’s core business.

“When I reviewed our milk hedging performance from 1998 to 2015, the price worked out roughly at parity over that period,” said Joe.

“Some years, you’re glad you’re doing it. Other years, you might question the wisdom of it.

“In 2008, the open market price was 41c per litre average for the year; it was 25cpl in 2009.

"In 2008, when I was losing against the market, my accountant said I should think about getting out of the futures market, because I was losing too much against the market price. My neighbours were saying the same thing.

“Then, in 2009, the price crashed. I was really glad that I ignored their advice and chose to stay in. John F Kennedy said, ‘You are a fool if you think you are going to sell on the top all the time’. This year, being in the contract has helped quite a bit.”

Joe Thome has again bought into milk futures for the first half of 2017, he doesn’t anticipate any upturn in price.

Europeans slow to trade in dairy futures

Following the end of EU milk quotas on March 31, 2015, Euronext launched a dairy derivatives complex for trading in butter, skimmed milk powder and whey powder futures.

The Frankfurt-based EEX also trades butter, whey powder and skim powder commodities.

Both anticipate increasing interest from the European dairy industry in hedging its exposure to price moves, now that the price-steadying influence of milk quotas is gone.

However, exchange executives anticipate it will take some time for liquidity in those contracts to take off, because many in the EU dairy sector are not used to dealing in futures.

If the Euronext and EEX dairy derivatives markets get busy, they will take some of the spotlight from the twice-monthly auctions held by New Zealand’s Fonterra, the world’s biggest dairy exporter, which currently have a big bearing on global dairy markets.

Euronext had earlier launched a skimmed milk powder futures contract in 2010 but suspended it in July due to a lack of the level of interest needed for liquidity.

In contrast, the company’s grain futures have become recognised price benchmarks for the European market.

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