Strategic feed buying creates business opportunity

Scott Stewart for Progressive Dairyman

The economic silver lining for many businesses has been lower commodity prices. Unless, of course, you locked in commodity inputs at a high price without protections against a price drop. Then you are left wondering if there is a better way to buy commodities in this new era of price volatility.

Businesses whose success is highly dependent upon the price of inputs benefit greatly from a strategic and disciplined approach to purchasing and pricing inputs. Take, for example, the airline industry.

Southwest Airlines has been widely praised for locking in a very low average per gallon fuel price. Fuel prices were going up, and many people thought they would never come down. The bet Southwest won in 2007 and early 2008 allowed them to keep fuel costs low while rivals saw their costs go way up.

Southwest had the opportunity to plow the fuel savings into other business investments, and pass along savings to its customers to gain market share.

We in the dairy industry are in a period of opportunity, as long as we maintain our perspective about commodity prices. We have seen commodity prices go from record-high levels to establishing new records for maximum price declines in the shortest amount of time. High levels of volatility are likely to continue. Despite the global economic downturn, demand for commodities is ever-present. Any major shortfall in the production of corn or soybeans will lead to a substantial push back toward the record highs we experienced this past year. Just remember, when meal was in the $400s and corn was over $8, everyone acted as if it would go up forever. Now those same people are thinking it’s going to go down forever. Maintain perspective. Crop prices are well below the cost of production for the majority of producers. That does not mean that prices cannot go lower, but it does mean they won’t go lower very far or for very long from these levels.

Buy what you can stomach
Feed prices in the next year or two could be relatively low or even flat. That’s good news for dairy producers. You need to take advantage of these low prices and start locking in significant future feed needs. There is more upward price risk for feed cost increases than there is downward potential to save money by waiting. This is what risk management is all about: weighing downward price potential and opportunity against upward price risk.

How far out to buy? Probably the easiest answer is to price as much as you can stomach, because odds are you won’t be sorry for doing it. If you want to be a bit conservative, do six to eight months. If you want to be a bit more aggressive, push toward a year’s needs. If you can cash flow it and emotionally handle it, doing upwards of 18 months or more of your feed is probably very good management at or near current price levels.

Forward purchases of cash commodity are advisable, especially if you can delay payment. Even if you have to take physical delivery and pay interest on the money, more than likely the upward potential the market has is more than enough to offset your storage and inventory costs.

Another approach is to “scale-in,” buying five, ten or upward of 20 percent on various increments over time. A variation of that approach is, as prices are selling off, to scale-down buy to increasingly improve your average purchase price. With each of these approaches, we suggest that you put a trigger point above the market that would get you forward priced before the market rallies too far and establishes too significant of an uptrend. We call this a stop point. It is a point where you put an order in to either make cash purchases, go long futures, or buy call options. It is a price point that triggers you to action. It stops your upward price risk by locking in your pricing.

Hedging tools further manage risk
Hedging is the act of protecting yourself against price risk. Airlines – and dairy producers – that forward purchased or locked in high prices for inputs without protecting against a price drop are feeling the pain as they fulfill these purchase obligations at levels above the current market price. Wise dairy producers can learn from this and manage price risk for their feed purchases with the various hedging tools available, such as buying puts on that inventory.

When price levels are much higher and you are forward buying feed, I might recommend buying some puts to manage the inventory value of that high-priced feed. That was wise to do the last half of 2008. At the much lower current price levels, however, the need to insure the value of any inventory you forward price is pretty minimal. We need to insure ourselves against the more likely risk that prices will go up.

At the current lower price levels, almost any tool you use to hedge your feed purchases is a good tool. The important thing is that you understand how each tool works, and the risks and rewards each strategy offers. Because the more advanced feed hedging strategies require a lengthy and detailed explanation, I’ve posted a step-by-step approach for these strategies at www.stewart-peterson.com

Get it done
If all of the work and decision-making with any one strategy overwhelms you to the point that you don’t make a decision, it’s not a good strategy for you. It is far more important that you buy something and get it done (even if you just hedge your entire purchase needs with one option strike price and month) than to overcomplicate your feed purchasing process and ultimately discourage yourself from making decisions and getting things done. Over the years, we have found that a disciplined, structured, strategic approach to marketing is far more important than anything else in determining success.

Keep in mind that not too many months ago, crop prices were rallying, milk prices lagged and you initially felt a severe pinch in your profitability. Nearly every dairy producer was far more worried about how to price feed than how to price milk. Milk prices were at historically high levels.

Now both have dropped dramatically, and most producers are thinking about how they could have (or should have) priced milk. Feed pricing is on the back burner again. But it should be on the front burner. When prices bottom and the commodity trends head back higher, feed prices will lead the way, milk prices will lag, and you will see your profits pinched.

We are in a time of opportunity. Use this opportunity of relatively low-priced feed to lock in your future needs. For the progressive business person in any industry, it’s all about strategically managing both input costs and output price for a desirable profit margin. PD

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Strategic feed buying creates business opportunity

Feed prices in the next year or two could be relatively low or even flat – good news for dairy producers as consumers of these commodities. However, what’s more important is to realize that prices are not likely to go a lot lower. That means that the risk of forward pricing at these levels is pretty minimal. You cannot be very wrong if you forward buy. If you don’t forward buy, you could really look like you’ve passed up a significant opportunity. There is more upward price risk for feed cost increases than there is downward potential to save money by waiting. This is what marketing and risk management is all about: weighing downward price potential and opportunity against upward price risk when you are considering your feed.

I will not predict that prices won’t go down, but I will say very confidently that there is more upward price risk than downward price potential at this point. You need to start locking in significant future feed needs.

All your concerns should focus on the possibility of prices going up at this point. All your hedging strategies should focus on how to be long corn, meal and other feed input needs. (Note that your approach for your petroleum-based energy input costs very likely should be the same as what we are looking at for corn, meal and other feeds.)

There are many different ways that you can go about getting your feed purchased. One approach is to start to scale-in, buying 5, 10 or upward of 20 percent on various increments over time. Another approach, as prices are selling off, is to scale-down buy to increasingly improve your average purchase price. No matter what you do, we suggest that you put a trigger point above the market that would get you forward priced before the market rallies too far and establishes too significant of an uptrend. We call this a stop point. It is basically a point where you put an order in to either make cash purchases, go long futures or buy call options. It is a price point that triggers you to action. It stops your upward price risk by locking in your pricing.

Hedging strategies for feed
At current lower price levels, almost any tool you use to get your feed hedged is a good tool. Here is a summary of strategies for protecting yourself against price risk.

• Forward purchases of cash commodity, especially if you can delay payment, are advisable.
Even if you have to take physical delivery and pay interest on the money, more than likely the upward potential the market has is more than enough to offset your storage and inventory costs.

• If you want to take a less risky approach, buying out-of-the-money distant call options can also work.
You may want to ladder your purchases (spread them out a bit). You can do so in two ways. You can ladder your purchases by varying the strike prices of the call options that you buy, by buying some that are closer to the current market (in the money) and some options that are further away from the current market (out of the money). The more expensive in-the-money options will give you greater leverage and respond quicker to market moves, but cost more. Larger quantities of out-of-the-money cheaper options will have less impact for small price moves, but will hedge you against any major significant upward price move that occurs.

If all you are looking for is a bit of peace of mind, piling on some inexpensive out-of-the-money options will put a ceiling on your feed costs and give you a lot of leverage in a big market move. They won’t do much good in a small market move and very likely may expire worthless, but in these kinds of markets, you can’t really manage your marketing if you are worrying about a 20- or 30-cent move in corn or a $30 move in meal. What you are worried about are the dollar moves in corn and the $100 moves in meal.

You can also ladder your option purchases by spreading them out over a number of months. Possibly start with call options toward the July contract and then spread them further out into the new crop contract such as December. By spreading the time frame around, you can save some money with the more nearby options but you also have greater risk that you will run out of time and they will expire worthless.

One key point about laddering options: If all of the work and decision-making overwhelms you to the point that you don’t make a decision, it’s not a good approach. It is far more important that you buy something and get it done (even if you just hedge your entire purchase needs with one option strike price and month) than to overcomplicate your feed purchasing process and ultimately discourage yourself from making decisions and getting things done.

• For those of you who have a deeper understanding of options, you could consider using ratio spreads, bull call spreads or fence strategies to hedge.
For example, a fence strategy where you buy a call option and sell a put isn’t very smart when corn is at $7. But when corn is in the $2 range and has just dropped nearly $6, a fence strategy suddenly looks a lot less risky and a lot more attractive. The downside risk on the sold put becomes rather minimal and the benefits of having the call at a low cost are definitely apparent. Like any strategy, you have to understand it or you shouldn’t do it. You have to manage the risk. For example, if you are selling a put to help pay for a call, be sure to have a stop on the put or be sure to have the financing in place to finance that option if it moves against you, so you don’t get into a tight cash flow situation and have to bail out of the positions at the worst possible time. Understand the risks and rewards of every strategy you consider, or don’t consider it.

• Lastly, at these historically low price levels after such dramatic declines, even long futures positions start to look attractive.
But always be aware and cognizant of the fact that these markets are volatile and almost anything can happen. Therefore, I suggest that, if you are considering a long futures hedge for your feed, consider buying a put option (possibly an out-of-the-money put) to limit your risk on your futures, so you have the ability to be long futures with a fixed risk, peace of mind and staying power.

We have found over the years that a disciplined, structured, strategic approach to marketing is far more important than anything else in determining marketing success. Be sure to match whatever strategy you use to your comfort level and your decision-making time and ability so that you work within your parameters for solid, professional decisions.

The Risk Management Tool Box

Hedging: The act of protecting yourself against price possibilities.

Forward contract: A contract calling for shipment of product in the future.

Futures: A contract bought and sold on an exchange representing either purchased or sold inventory in the future.

Put option: An option that allows the option buyer the right, but not the obligation, to sell the underlying futures contract at a specified price on or before the expiration of the option.

Call option: An option that allows the buyer the right, but not the obligation, to purchase the underlying futures contract at a specified price on or before the expiration date of the option.

Strike price: The price at which the buyer of a call or put may exercise the right to purchase or sell the underlying futures contract.

Fencing strategy: A strategy that combines calls and puts, establishing a range of possible hedge prices rather than just one price. By simultaneously buying a put and selling a call option, you create a price floor with your bought put and a price ceiling with your sold call. You are protected against downward moving prices with your floor price. Allowing a ceiling ensures a better floor price, even though it limits your upside opportunity.

In-the-money option: An option with intrinsic value; specifically, a call option whose strike price is below the current futures price (or a put option whose strike price is above the current futures price). Example: If you buy a $20 put option for milk and the current milk futures price is $19, your put option has an intrinsic value of $1 and is said to be “in-the-money.”

Out-of-the-money option: An option with no intrinsic value; specifically, a call option whose strike price is above the current futures price (or a put option whose strike price is below the current futures price). Out-of-the-money options are typically used because they cost less to buy. They are further away from having value.

Note: Whether or not the option is “in-the-money” or “out-of-the-money” is dependent on what the strike price of the option is and where the futures market lies. PD