Often a discussion about financial markets and hedging instruments like “options” and “futures” invokes images of Gordon Gekko-type characters shouting unintelligible instructions into their phone, and apparently making millions by doing so.

For most of us, a discussion on hedging at the moment would most likely centre around how much of their boundaries they have got cut since the opening of the season on 1 September.

While both might be valid, a recent conference in Dublin heard about how dairy producers can use financial markets to help manage risks they face from market price movements for their produce.

The Irish Farmers Journal sat down with Charlie Hyland, EU head of dairy at conference organiser StoneX, to get an understanding of why dairy farmers might want to learn a little about financial markets and how they can be used to reduce risk.

He explained that StoneX’s customers use of financial market instruments is fundamentally about managing the risk inherent in their business.

“When we started, there was zero risk management in dairy. We were talking to the co-ops and everyone in the supply chain, and they didn’t have any experience of these financial instruments.

“Once someone starts, the complexity in not that challenging, it’s just that there has to be commitment to learn some of it. It is also important to have a plan where you really are targeting a genuine risk inherent in the business.”

Hyland made the point that for farmers, the most important thing to maintain is their margin: “We saw what happened with the fixed milk price contracts in Ireland. The biggest issue there was that they didn’t have their raw materials prices fixed. If you have a process where you can fix those prices too, then you are fixing your margin. While this might mean you are missing out on some opportunities, you are ensuring you still make an income.”

US and New Zealand

Getting the right financial instrument depends on various factors, but the most important one is often scale – both in the size of the dairy enterprise, and in the size of the market where the instrument is trading. The US market is far ahead of the rest of the world in this regard, Hyland said, where individual farms can have 5,000 to 10,000 cattle and as a result can put in the investment and the knowledge to reduce their risk.

In New Zealand, where farms would not be as large, Hyland said that StoneX has “introduced a farmer product which is just buying put options. While that sounds complicated, it almost looks like an insurance product where farmers pay a premium to buy a put option which, if the market drops, compensates them for that drop. If the market goes up, they are not fixed, so can benefit from that rise.

“For example, if a farmer sets an option at 50c/l, they might pay 1c/l for that and if the market drops down to 40c/l they get paid the 10c/l difference, netting them 49c/l. If the milk price goes up to 60c/l, they are not locked into the 50c/l price, they just sell their milk normally at 60c/l and have just lost the 1c/l they paid for the option.

“The product in New Zealand allows farmers to set levels and essentially pay a premium to put a minimum price in. We can do that in New Zealand because it is a single market which has a well-established benchmark [the Fonterra milk price].”

Europe

The dairy landscape in Europe is different, as it is “a quite fragmented market,” Hyland explained.

“The milk prices are very different in Ireland compared to the UK, and compared to Germany. Also because we have a much more traditional structure, which is based on smaller farm sizes, [StoneX] tends to work more with processors and co-ops who will often provide solutions back and forth through the supply chain, including to farmers in some cases.”

He said that some of the dairies in Europe are looking further out the futures market when making decisions around valorising their milk.

“They have always looked at optimisation over the next three to six months, but we’re now saying you can look at that six, 12 or even 18 months out. This means that they can have a constant forward view of these different valorisation options.”

Hyland said that dairy farmers in Germany are starting to trade directly themselves against the European Energy Exchange (EEX) European liquid milk future, which is benchmarked against the German milk price published by that country’s government.

Comment

Farmers are probably generally wary of financial markets as the trading of claims on future production on exchanges seem complicated with plenty of chances to lose money for the uninitiated.

However, a little understanding can go a long way. It is important for dairy farmers to be aware that their co-ops are already looking at these markets and, in many cases, using them to reduce their own risk.

The futures market, fundamentally, is a current view on where the price will be at a fixed time in the future. Figure 1 shows where European butter futures prices were for the next 12 months on 1 August and where they were on 12 September.

There has been a notable change in the outlook for butter, with €1,500/t drop in the price for October delivery. A processor who hedged their autumn supply in July or early August would have protected themselves from that drop.

Conversely, any butter consumer, such as a large bakery business which had hedged its purchases at that time, would find themselves missing out on an opportunity to buy cheaper supply.

For dairy farmers the best solution would be to buy put options which would allow them to buy protection from a move lower in prices, but not be locked into a price.

These kinds of products are well established in the US and have recently been launched in New Zealand. However, from talking to Hyland it seems that they may be some way off for Irish dairy farmers. The lack of this risk management tool does put farmers here at a disadvantage to their competitors in the US and New Zealand, as it means they are reliant on their co-op’s risk management to shield them from the worst of global market volatility.

Know your options

Financial markets are filled with their own jargon, which might seem alien to anyone not involved in day-to-day trading, so here’s a simple breakdown of what the main terms are when looking to reduce price risk for commodities.

Futures contracts are generally used by industry suppliers and buyers to manage price risk. However, in large markets such as oil, they are also used for speculation where traders buy or sell contracts based on their view on how the market will develop, with a view to exiting the contract before the delivery date.

There are two types of options. A put option is one which limits downside risk by putting a floor on the price for a commodity (as outlined by Hyland above). A call option is the opposite which limits the effect of prices rises, and is useful for buyers of commodities as it limits their exposure to rising prices.

The price of option premiums depends on how far the strike price is away from the commodity price. An put option priced 15c/l below market will be significantly cheaper than only prices 1c/l below market.