In 1997, the Chicago Mercantile Exchange, now simply known as the CME Group, officially became the marketplace for participants in the dairy industry to manage price risk. What began as a Class III futures market grew to include Class IV as well as five dairy products (cheese, block cheese, nonfat dry milk, butter, and whey).
Today, each of these markets possess a healthy futures market as well as a vibrant options market. From this foundation, other programs have been developed over time to assist dairy market participants, specifically dairymen and dairy women, to manage price risk. We will touch on those other offerings a little later.
I have been a part of these dairy derivative markets from the very beginning, and I have witnessed some pretty dramatic moves that included the rallies of 2004 and 2008 along with the deep dip and hardships for dairymen of 2009. More recently was the rally of 2014, which saw Class III markets hit an all-time high above $24 per hundredweight (cwt.) in September.
The classic one-two punch would follow. The EU saw the sunset of its long-standing quota program, which invited record milk production growth and the consequent record stockpiles of skim milk powder. By early 2016, that same Class III market would register a price of $13 per cwt.; an $11 per cwt. decline from the $24 high.
Enter modern day where a larger EU milkshed has been matched by growing world demand. Add to that the uncertainty of trade wars, tighter global environmental standards, and a drought in Oceania, and you have all the makings of even more drama. But it is drama that helped lead us to $20 per cwt. Class III milk in late 2019.
More price swings
What we all know is that the dairy market (just like every other market) has volatility. That volatility is not going away. The more globally involved we become (which is good for U.S. dairy farmers), the more swings we will continue to see.
I led this article with the volatility of past moves to highlight the conversation of future risk management. While volatility continues to grow, so has the means by which dairymen can manage that risk. In the last five years, the evolution of these tools postures them well for the future.
In the pits
From the beginning until about the mid-2000s, the hedging instrument of choice was futures, specifically in Class III. I remember being in the trading pits at the CME in 2005. Orders were listed on “white boards” or “yes boards.”
This wasn’t too far away from the old pictures you would see at the exchanges showing exchange employees posting customers’ bids and offers with wooden numeric placards. That was how the industry knew the price levels at which they could manage risk.
In those days, participants were predominantly commercial customers hedging in a relatively illiquid market. Generally speaking, dairymen had no interest in using the marketplace unless they were in a Class III region and, more specifically, in futures, since many didn’t investigate or understand the options market.
From the mid-2000s to around 2014, explosive growth entered into the dairy markets. Daily volumes and open interest — a measurement of new positions established in a futures or options contract, which translates into more hedging activity — were setting year over year records. What was impressive about the growth is that participants were utilizing more than just the Class III futures contracts. The other dairy products were being utilized and options had become a very strong vehicle that were not only being used by commercial hedgers but dairymen as well.
Before 2009, many of the conversations with dairymen centered around the reasons to avoid managing risk. “Why would I manage risk?” “What does butter, nonfat, and cheese have to do with my milk price?” “I’m not in a federal order state, so I can’t manage risk.” “What you guys do is gambling!” That last statement still comes up every now and then.
The questions changed
Following the unfortunate downturn in the 2009 marketplace, many dairymen were looking for ways to avoid another year like the one they were in and were willing to start educating themselves on how to manage risk. The conversations and reasons went from “Why I shouldn’t” to questions like; “What did cheese do today on the exchange?” “Are we seeing exports picking up to Mexico?” “How is New Zealand’s weather?” “Should I use futures or options at these price points?”
The general mindset made an amazing turnaround. Dairymen across the nation made a serious commitment to managing risk. It became a staple of their daily business practices in the same way they use a nutritionist to produce the highest yield of top-quality milk.
This takes us from 2014 to present day. The tools on the exchange are and continue to be the preferred venue for many to use when managing risk. But just like anything else in life that is evolving and becoming more sophisticated, sometimes it’s just not enough.
Co-ops and processors have done well by the dairy industry to provide new platforms that assist dairymen with managing risk. Some come in the form of forward contracts (off exchange bilateral contracts) that act in many respects like hedging on the exchange, though in some cases are more customized to the dairyman’s true risk. In other cases, over-the-counter participants are managing risk with major banks or other agriculture institutions. Regardless, the toolbox has gotten bigger.
In all of this, dairymen have all the wherewithal of a large commercial institution when managing risk. In fact, one might argue they have even greater access to risk management solutions. New government programs (such as Dairy Margin Coverage) are available in the recent farm bill.
Old efforts to offer insurance-like coverage have evolved into perhaps the largest government sponsored risk management rollout to dairymen in all of their history. In October 2018, the Dairy Revenue Protection program, better known as “DRP,” came on the scene and has taken the industry by storm. When milk was reclassified from livestock to a crop, the creation of DRP became possible. This new “crop insurance” product provides financial protection against loss just like any other line of crop revenue insurance. Approximately 30 billion pounds of milk were covered with DRP in 2019 and the amount in 2020 could be even greater.
The practice of risk management has grown and evolved for dairymen since the CME rolled out futures and options in 1997. From highly liquid futures and options markets, to multiple forward and over-the-counter venues to insurance programs, dairymen have access to a wealth of tools to help them manage volatility and price risk in the years to come.