Volatility is something that crop and livestock operations have been dealing with for a long time, and it can take on many different forms.
In general, most people have a negative association with volatility, particularly when it comes to prices. It is seen as something that hurts our profitability and is bad for our operation, although it doesn’t have to be that way.
While volatility certainly presents a challenge, it also affords an opportunity in that if managed correctly, it can be harnessed in a powerful way to the benefit of one’s bottom line. As most readers will identify with, commodity prices have been highly volatile over the past several years. As prices have become more volatile, operating returns are now more uncertain than they have been historically.
Managing price and volatility are more important than ever for agricultural producers
There are many different tools available to assist with the process of navigating this uncertain landscape while attempting to control profit margins. In particular, flexible contracting through the use of futures and options can present powerful alternatives to producers in managing their forward profit margins.
The reason for this is twofold:
First, there is a strong relationship or correlation between cash prices paid or received at the farm level, and futures prices that trade on the exchange. Second, the futures market offers flexibility and liquidity. This means that the terms of standardization in the contract specifications allow for more participants to trade the contract. This large pool of market participants helps to assure an active, daily price discovery process where buyers and sellers are exchanging price commitments between one another. Because of this increased level of activity or liquidity in the market, it is possible to get in and out of contracts easily which creates added flexibility for producers in their price and margin management.
Let us consider a dairy example to examine this flexibility of using the futures market in conjunction with physical contracts in the cash market. Let’s assume it is autumn and November Class III Milk futures at the CME Group are currently trading for about $18.00/cwt. Let us also consider that the futures price has fluctuated in a fairly wide range between $16.25/cwt. and $19.00/cwt. Earlier in the summer, a dairy modeled their forward margins and determined that a very profitable opportunity existed in late July. With a profit margin of around $3.00/cwt. projected for Q4 at that time, near the 90th percentile of the past five years, a dairy may have been inclined to forward contract milk at the creamery and lock in feed input costs for this production period simultaneously.
By late September, milk futures had declined more than $2.00/cwt. off of their highs from earlier in the summer. While a dairy fortunate enough to have locked in a margin back in August might have felt relieved that their milk was sold well above the market, consider for a moment the opportunity that this development presents. The dairy may have considered purchasing a call option against their forward milk sale to the creamery in order to protect the equity they had built up in their sale commitment. Let us assume that the right to re-own the November milk contract at a level of $17.00/cwt. would have cost around $0.50/cwt. at that time.
This means that if the dairy already had about $2.00/cwt. of unrealized equity in their sale price, they would be spending about 25% of that to ensure they realized around $1.50/cwt. of that equity upon the closeout of the position. Another way to look at this is to consider the impact of the sale commitment at higher price levels. Should the market recover, the dairy effectively has traded the fixed sale commitment near $19.00/cwt. to a flexible sale where the call represents the opportunity to participate in all higher prices.
Notwithstanding basis, the fixed sale price can never be lower than the original futures level established at the creamery minus the cost of the call; however, the maximum sale price is now unlimited as the call option allows the dairy to participate in all higher prices above $17.00/cwt. Let us assume now that the market eventually recovers back to $19.00/cwt. by November. At this point, the call option which represents the right to buy milk at $17.00/cwt. is worth $2.00 in the open market, while the cost of this call was $0.50/cwt.
The net price of the dairy’s milk in November is therefore the $19.00/cwt. sale they initially established at the creamery plus the net gain of $1.50/cwt. on the call option, which represents the current market value less the 50-cent cost of the option in late September. This means the dairy effectively has a sale price on their milk of $20.50/cwt., exclusive of basis and PPD.
One point to highlight is the original decision to lock in a milk sale based upon a forward profit margin projection. In the above example, the initial position is created because a margin opportunity presented itself that was attractive for the dairy to protect. The subsequent adjustment to that initial position, adding flexibility back to a milk sale, is a function of working with what the market allows you to do. This goes to the heart of what being a margin manager means, namely, managing a position through time and price to improve on the margin opportunity that initially presented itself. It is allowing market volatility help you improve your profitability over time. Is volatility your friend or enemy and how well are you managing it?