Managing Counterparty Risk

Recent news that a dairy processor abruptly cancelled contracts with a group of Wisconsin dairy farmers has highlighted the need to address counterparty risk as part of your margin management plan.

Grassland Dairy Products, which handles a majority of the cream sold in Wisconsin, recently sent a letter to several of their milk suppliers saying that it would not accept any shipments from them after May 1. That was after the company had itself received only two days’ notice that its Canadian processor would stop buying Grassland’s ultra-filtered milk (UFM). The change, which represents a loss for Grassland of one million pounds of milk shipments per day, came about when Canada reclassified UFM as a lower-priced class of milk as part of a new national dairy ingredient strategy. As a result, Canadian UFM is priced at a discount to American UFM, which is now at a competitive disadvantage. Dairy processors in New York have likewise seen contracts canceled from Canadian customers. In all, about 100 dairy producers in the two states have been impacted and forced to find a new home for their milk on very short notice.

Challenges Raised
In addition to the challenge of finding new processors, the affected dairy producers face uncertainty over existing milk contracts for periods after May 1. Although some producers may have taken positions on the exchange to lock in or protect price levels on that milk production, other producers had established forward contracts with Grassland earlier in the year that set price throughout 2017 at more favorable levels. While Grassland has yet to announce what it plans to do with these contracts, the possibility that it may terminate them will add to the pain these dairies are already feeling in the face of milk prices that have dropped substantially since the beginning of the year.

The best path forward for these producers isn’t straightforward and will depend on several factors. For the lucky subset of these dairies that were able to find an alternative outlet for their milk supply, they will need to determine how they will be paid under any new agreement. That’s because any differences will impact the value of any exchange-traded contracts they may have put in place to manage their milk price and dairy margins. As a first step, they need to determine if they will be priced under a different Federal Marketing Order, particularly if they need to ship their milk out of state. Secondly, if they have a new hedge ratio between Class III and Class IV milk, they should look to reallocate their current hedge positions accordingly.

Additionally, if their mailbox breakeven price is higher due to increased hauling or balancing deductions, these producers may need to adjust their existing open positions and hedge policy. As an example, if a producer estimates their Class III/Class IV breakeven mailbox price to be $16.50/cwt. under a previous contract and a new milk handler will be deducting an additional $0.75 from the dairy’s milk check, the new breakeven price will be closer to $17.25/cwt. Let’s assume the producer has an open hedge position where they are short deferred Class III Milk futures at $17.00/cwt. to secure a $0.50 margin based on their old Grassland contract. Under this new hypothetical agreement with a different milk processor, the producer is now locked into a loss of $0.25/cwt. In that scenario, it may be prudent to replace the futures contract with an option position that would offer more flexibility for a positive margin to eventually be secured.

What about the likely larger pool of producers who are not able to find a new outlet for their milk? This is obviously more complicated and a producer may need to consult with their lender and risk management team about liquidating positions. Without a sure outlet for their milk supply, any producer that holds a short futures position would be facing higher risk. That’s because if milk futures prices rise to above the level of the short futures position, the producer could incur a loss on the contract and may also not be able to take advantage of the higher cash market price. A producer with a short futures position should, at a minimum, consider replacing that position with a long option position to minimize upside exposure in the event that the futures market rises. The best case scenario would be a producer who has a hedge position in the market with an unrealized gain. At the very least, these positions could be closed out without incurring losses or potentially converted to long option strategies using the accumulated equity in the position.

Make it Part of Your Margin Management Policy
As discussed in a previous article, a comprehensive margin management plan will go beyond the basics of defining triggers for establishing and adjusting margin protection; it will also spell out contingency levels of protection in case those triggers are never reached. Another key part of any comprehensive policy is a plan to address counterparty risk. Although a single processor might optimize payments and simplify your logistics, it also makes you extremely vulnerable to any disruptions from that processor. As the Grassland producers learned the hard way, issues that bring counterparty risk to the forefront often occur unexpectedly. That’s why you should think about addressing that risk in your margin management policy. For example, you might want to include the provision that you will always maintain more than one outlet for your output. You could address that requirement by establishing a relationship with a second buyer and regularly shipping some portion of your production to them.

Another way to manage risk is to use futures and options to protect forward margins. Because of their liquidity, these exchange-traded alternatives are valuable tools for managing risk. The clearing and settlement procedures of futures and options provide further safeguards that can help mitigate some of the counterparty risk entailed with using only local processors in the cash market.

You may also want to think about other counterparty risks you face and how to manage them. For example, you may want to consider diversifying supply sources for inputs as well as outlets for production, and mixing up contracting alternatives between the cash market and futures market to incorporate more flexibility.

If you have questions, or would like help identifying and addressing your counterparty risks, please contact CIH at 1.866.299.9333.