Building an accurate representation of your operation accounting for all costs and revenues is the first step in being able to estimate future profitability. Given that futures contracts are an unbiased estimator of what a specific commodity’s value is expected to be in a forward time period, a producer could use the forward futures price as a placeholder to represent a future cost or revenue. Certain inputs would need to be taken as fixed estimated values if no correlation exists between those cash prices and futures prices. From there, along with other estimations for operational costs and basis values, a forward profit margin can be discovered.
Once an accurate model of your operation is built, the next step would be to evaluate the forward profit margin represented, starting simply with whether the projected margin is a profit or a loss. If the forward margin is projecting a loss, not much can be done to secure a profit unless the margin improves. If, on the other hand, the forward margin is projecting a profit, the producer would want to know how good of an opportunity that profit margin represents. One way to objectively determine the opportunity is to rank the projected margin over a historical period comparing that profit margin to previous profit margin opportunities.
Let’s say for discussion purposes that a dairy producer is projecting a profit for 2Q 2015 of $1.30 per hundredweight today. While showing a positive value for a forward production period is a good thing, the question this particular dairy producer should ask is, how good is this margin historically and ultimately is this opportunity worth protecting?
Keeping the model for this dairy producer constant, i.e. production performance, ration, basis values for inputs and revenues, etc. how would this dairy have performed in previous second quarters throughout history? We can determine the historical performance of the second quarter for this particular dairy
by taking historical futures prices that would represent input costs as well as the futures prices that would represent revenues for previous years and attributing the values to the present ration and output performance thus generating historical margins. In doing this, we can compute an apples-to-apples comparison of the current opportunity.
After generating the historical margin opportunities, the producer can then rank how the present $1.30 per hundredweight margin stacks up against history. For this producer, the current profit margin may rank in the 90th percentile of the previous ten years. In other words, given the same operation over the past ten years in the second quarter, this operation would have had a better margin opportunity 10% of the time while having a weaker margin opportunity 90% of the time.
While other information such as fundamental changes in markets as well as seasonal or historical factors that may influence prices could be considered when ultimately determining strategies to protect the forward profit margin, a top down approach in first evaluating how strong or weak the projected margin represents will help the producer identify opportunities to begin protecting future profitability.