This week saw two announcements by financial service companies in Europe and the US which should serve to provide more options for dairy producers, processors, and their customers to reduce the risk they face from volatile dairy markets.

CME Group (Chicago Mercantile Exchange) announced plans to launch new European dairy futures and options contracts before the end of this year, pending regulatory review. The company will introduce contracts for European skim milk powder, butter, whey powder and liquid milk.

The products will initially track EEX indices (European Energy Exchange) before transitioning to proprietary CME European dairy indices. The contracts will be listed on, and subject to the rules of, the Chicago Mercantile Exchange.

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The contracts will be settled in cash, rather than physical product. John Ricci, Global Head of Agricultural Products at CME Group, said: “By offering futures and options, we’re giving participants a more complete toolkit to deploy capital efficiently and manage regional price risk - all on a single platform.”

Separately, Amsterdam-based agricultural intelligence and commodity trading platform Vesper announced that Euronext, the continent’s largest stock exchange group, launched European butter and skim milk powder futures.

The futures which started trading on 19 October are, similar to the CME proposal, cash settled. They are benchmarked against the Vesper Price Indices (VPI) for EU butter and EU skimmed milk powder.

The products were developed, according to Vesper, at the request of dairy market participants who were looking for a hedging tool connected to physical markets. Alexander Sterk, Founder and CEO, Vesper said: “We built the VPI in 2020 so buyers and sellers could check a dairy price against the real market. Today that same benchmark settles futures on a regulated European exchange. For the dairy companies we work with, that means one shared reference for both physical contracts and hedging.”

Futures

These terms may not be part of everyday conversation, but they are tools that can be used to reduce risks from volatile prices.

Fundamentally, a futures contract is an agreement between a buyer and a seller to provide an agreed amount of product at an agreed price at a certain date in the future. For example, if a farmer places an order with their merchant in January for 3 tonnes of fertiliser to be delivered in March, then they both parties have effectively entered a future contract with each other.

Publicly available futures contracts arise in a market where there are lots of buyers or lots of sellers of a commodity. The commodity being sold in the market has to be fungible (one unit of the commodity is completely interchangeable with any other in the market), and is generally sold in lots for delivery at a specific date in the future.

The futures market that most people will be familiar with is the oil market. The global benchmark for oil is for a barrel of front month Brent crude. This refers to the price of a fixed quantity (a barrel) of a certain grade of oil (Brent) delivered on a set date (in one month).

Generally, futures markets have different contracts available for many months into the future. While the settlement dates might be different, the size and specification of what is delivered remains unchanged.

There is a very important difference between physical settlement and cash settlement of contracts. In physical settlement, the commodity is delivered to the holder of the contract on the day the contract expires.

The products announced by CME and Vesper are cash settlement. This means that when the contract reaches its delivery date, no actual product is shipped from the supplier to the buyer. Instead, the net financial difference between the contract price and the spot market price is paid or received in cash.

For example, Big Irish Dairy Co Ltd knows it will have butter to sell in January next year, but it is concerned that prices might fall over the coming months. To avoid this risk, it enters a futures contract to sell butter at €3,900/t in January. If, when January rolls around, spot prices (the VPI) have fallen to €3,500/t, the company will sell the butter at that price, and get €400/t from the futures exchange (the difference between the contract price and the spot price).

On the other hand, if the spot price rises to €4,300/t in January, then the dairy company will be able to sell its butter for that, but will have to pay €400/t to settle the futures contract. This means that under either scenario, the company will net €3,900/t for its butter.

What does it mean for farmers?

While it is unlikely that farmers will end up using dairy futures contracts to manage their own risk, they could benefit if their processors are carefully using futures contracts to manage price volatility.

Vesper’s dairy analyst Jasper Endlich told the Irish Farmers Journal: “Most farmers won’t trade them directly, but they can still benefit. Butter and SMP prices play a major role in setting milk prices throughout Europe. Once dairies can hedge those prices, it becomes easier for them to offer farmers a higher payout. The futures curve also gives everyone a forward view of market expectations.”

Looking at the futures market right now on the Euronext exchange, the price of butter is expected to rise over the coming months while SMP is expected to slip (see Figure 1).

It is important to remember that futures prices are not actually about predicting the future. Instead, they are a projection by market participants on where prices might be in the future based on the current outlook. As that outlook changes, so will the futures price.

Comment

While financial instruments and market moves might seem a little complicated and a long way from the day-to-day business of farming, there can be considerable indirect value for farmers in what happens in those markets.

If a processor can use futures markets to lock in more stable prices over the medium term (a process known as hedging) then they can provide more stable milk prices to their farmer suppliers.

Stability means avoiding the worst of the risk during sharp market moves lower, but it also means missing the best of the upside when prices move quickly higher. There is also a limit to how much hedging can do to avoid market risks.

If prices go into a longer-term slump, that will eventually be reflected in futures prices. As each contract reaches its expiry date, the processor can replace it with another contract, but that one will now reflect the expectations for lower prices, meaning the value that can be obtained will be lower.

Overall, futures are great for smoothing the effect of market moves, rather than avoiding them altogether.