In the US, where dairy futures have been available for a longer period, contracts represent 12% of the domestic skim milk powder production.
The European Commission says use of dairy futures and options is still low, but significantly increasing in the EU, indicating a growing interest in futures for the dairy market.
Traded futures contracts could improve hedging and planning for farmers (and other operators in the dairy sector) by tackling high volatility.
These financial instruments can help farmers tackle risks stemming from unforeseen price shocks and enhance planning reliability.
Such dairy financial products have been available in the US since the 1990s, but contracts were only introduced in the EU more recently.
Why should dairy farmers be interested in futures?
Futures markets are already widely used in sectors such as cereals, where the perception of price volatility is also high, to hedge against strong price variation.
They can help farmers cope with the difficulties of running a sustainable business in times of price instability, especially if farmers have planned investments based on higher average milk prices.
How can futures help to address price volatility?
With a market oriented CAP focused on limiting the consequences of price fluctuations via income support (direct payments), rather than on reducing price fluctuations (even though a safety-net remains in place), private operators need to look for other solutions to address excess price variability.
For example, the CAP encourages creation of producer organisations to reinforce the position of dairy farmers in the supply chain.
However, a sound hedging strategy can protect from unforeseen price shocks and keep margins under control.
It allows a forward-looking strategy, for example to accompany an investment plan, or a change in a farm’s structure.
How does hedging works in practice for dairy products?
A dairy processor wants to secure his revenue for selling five tonnes of skim milk powder (SMP) by fixing the selling price of his dairy commodity in advance.
In September, the processor wants to fix the price at the time of production peak in May, about nine months ahead.
The processor wants a known and guaranteed price unrelated to how the market evolves in the meantime.
Regardless of the physical price today, the processor sells today a contract of SMP with expiry date May 2017.
In May, 2017, the processor physically sells his SMP on the physical market, and buys back the SMP contract at market price, thus cancelling the previous commitment.
This secures revenues, it works perfectly provided the underlying price of the futures contract is a representative price, reflecting the spot market’s conditions.
Market frictions could introduce some additional costs to the hedging strategy, and it should not be forgotten that there are transaction cost and possibly brokerage/intermediation costs, and margin costs/fees.
How would hedging work for selling raw milk?
For example, a co-op or producer organisation exposed to price fluctuations wants to secure its revenue.
The co-op wants to sell in the future 100 tonnes of raw milk.
Since there is no milk futures contract in Europe, it has to hedge on dairy products such as butter and skim milk powder (SMP). Contracts are cash-settled, without physical delivery, facilitating such transactions, and making the hedge possible.
Regardless of the physical price today, the co-op today sells an appropriately sized portfolio of butter and SMP.
For dairy farmers, the use of futures markets implies necessarily a collective approach such as co-ops or producer organisations.
Because of their size, processors can more easily operate on futures markets, to allow them offer more stable prices to farmers for milk deliveries. The necessary technically skilled staff and training needed to manage financial hedging are expensive, which may call for economies of scale.
What obstacles may affect expansion of dairy futures markets in the EU?
Dairy products are not as homogenous as grains/crops, for which futures trading is well established.
The amount of knowledge required for futures is high, and is lacking in the sector.
Milk and certain dairy products are not storable for very long periods, thus favouring cash-settled instruments which are perceived as too complicated and “speculative” by potential customers.
Liquidity is still low. Liquidity in the market is crucial for a viable and sound futures market. Willing speculators are needed to bear the risk, when adequately remunerated, which participants want to get rid of.
Futures markets depend on two main types of market players. They are commercial traders (generally called hedgers); and non-commercial traders (often called speculators).
Speculators try to profit from changes in the price of the underlying asset, for example, profit from an anticipated drop in the price by selling the related futures contract.
How does the EU compare with other dairy industries?
In the US, where dairy futures have been available for a longer period, contracts represent 12% of the domestic skim milk powder production. In the EU, SMP futures are significantly increasing, but only about 1% of the EU production.
New Zealand’s dairy industry also uses a significant amount of futures trading, mostly for whole milk powder.
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